Dominion Resources Catches MLP Fever

| About: Dominion Resources, (D)

Shares of Dominion Resources (D) hit an all-time high last week. The catalyst: A proposed spin-off of the company's natural-gas assets into a master limited partnership ((NYSE:MLP)), with an initial public offering (IPO) in the second quarter of 2014.

We've heard similar talk from Dominion Resources in the past. What makes this time different is management set a timetable.

Dominion Resources has big capital spending plans, in natural gas as well as electric power in its regulated Virginia service territory. Current projections are for an average of $2.6 billion a year through 2018. And in recent years, launching MLPs has been one of the most reliable ways for companies to raise capital.

On the power side, management estimates it must bridge a 3,800-megawatt "generation gap" over the next 12 years. Earlier this month, Dominion paid $1.6 million in an auction to win development rights for offshore wind power, a tiny down payment on a project that could cost as much as $4.6 billion to fully exploit.

The utility is also planning a 1,300-megawatt natural gas combined cycle plant near the North Carolina border. And it expects to spend a total of $3.2 billion on eight power transmission projects currently under development.

Continued support of Virginia regulators is essential to translating this investment into earnings and eventually higher dividends. That makes every gubernatorial contest essential viewing for Dominion shareholders.

This November, voters will choose between Republican Ken Cuccinelli and Democrat Terry McAuliffe. Cuccinelli is the known quantity for investors, having taken a generally hands-off approach to the utility during his four years as state attorney general. McAuliffe, on the other hand, if elected would likely push Dominion hard toward green energy.

That's not necessarily a bad thing for investors, as McAuliffe's Washington influence could dislodge some serious federal dollars for the offshore wind efforts. And provided Dominion can earn a fair return on its investment, earnings growth will not be at risk.

But the possibility of having to boost renewables combined with the generation gap does leave a sizeable investment need for the company's power operations.

Gassing Up

As for natural gas, the company's single biggest investment in the next few years is a liquefied natural gas (LNG) export facility in Cove Point, Md.

Last week, the US Dept of Energy approved the company's plans for exporting gas. All that's needed now for the $3.8 billion project to go ahead is final OK from the Federal Energy Regulatory Commission.

Dominion states Cove Point's export capacity is already "fully subscribed," locking in revenues once it comes on line. Spinning off the facility and other natural gas assets into an MLP reduces funding risk to the parent as well, should cost overruns become an issue as they have for major LNG projects off the Australian coast.

Other assets prospectively included in the MLP are the company's half interest in the Blue Racer midstream services company in the Utica shale-and presumably the rest of its far-flung network of pipelines and midstream energy assets acquired in the late 1990s merger with Consolidated Natural Gas.

The company intends to invest between $5.8 and $6.2 billion in its gas business through 2018, presumably in addition to Cove Point. Those numbers include numerous projects extending Dominion's Marcellus and Utica shale infrastructure. And they could ramp up further, if Dominion can sell its remaining production acreage to companies with the deep pockets and patience to develop it.

What's Dominion's natural gas business really worth? The company believes its remaining Marcellus shale lands contain potential gas reserves of a trillion cubic feet. And while estimating a selling price now is purely speculative, there are reportedly several prospective buyers.

Dominion's real designs are almost certainly on gaining new business for its storage assets and other midstream assets, which are located adjacent to those lands. And if this sale follows precedent, it will include new contracts for the company to develop more infrastructure to handle the new output.

Coupled with the LNG facility and a series of other mostly tuck-in projects tied to existing assets, the sale would give Dominion MLP a lot of visibility on future earnings upside. That's essential for any successful MLP IPO, particularly as regards distribution growth.

Farrell's stated goal is for the MLP to be a transparent vehicle for financing its regulated gas business investments. And it will be a substantial player, even before growth initiatives.

LNG's The Key

Check out my table comparing the current Dominion Energy-the Dominion Resources division housing all of its natural gas business to Enterprise Products Partners LP (EPD) and Magellan Midstream Partners LP (MMP). Enterprise is the standard bearer for energy midstream MLPs, while Magellan has been highly successful focusing on oil and natural gas liquids.

(Click to enlarge)

Source: Bloomberg, Company Reports, Conrad's Utility Investor

The Dominion totals include regulated gas distribution utility operations, assets that have not typically been a part of MLPs. Energy Transfer Equity LP (ETE), for example, sold gas distribution assets as part of its acquisition of the former Southern Union.

In Dominion's case, transferring ownership of regulated gas utilities to an MLP - even one it continues to control-would require winning approval of regulators in Ohio and West Virginia. As a result, it's likely to keep those assets at the parent level, though management may elect to sell them to fund midstream growth at the right price, as it did some years ago in Pennsylvania.

Even without gas distribution, there's still more than enough on the table to generate as much as $2 billion in annual earnings, according to Farrell. Realizing that, however, will depend heavily on the success of Cove Point LNG, which appears to account for roughly 40 percent of the MLP's planned five-year capital spending, not accounting for the possibility of cost overruns.

Cove Point's success is also essential to timely development of Dominion's remaining lands in the Marcellus shale, and thereby any and all energy midstream projects in the region. Marcellus and nearby Utica shales have vast natural gas reserves that are attractive now solely for their liquids (NGLS) content.

Meanwhile, the price of the dry gas remains deeply depressed due to a continuing supply glut. Soaking that up isn't likely to happen until there's export capacity in place at Cove Point to create some price arbitrage. And until then, low prices will inhibit new production.

That Dominion announced MLP plans the day after winning regulatory approval for Cove Point is no coincidence. And selling MLP units is arguably much more about providing needed funding for LNG than to monetize what have been undervalued gas midstream assets.

It's not uncommon for MLPs to be concentrated in a single asset before launching, and diversifying later. Magellan Midstream Partners, for example, was initially spun out from Williams Companies (WMB) with ammonia assets that now constitute only a small portion of its overall income.

Equally, Cheniere Energy Partners LP (CQP) has proved the market appeal of LNG assets in an MLP. Its distribution won't grow until new LNG export capacity is in operation but the current level is secured by fixed contracts with super oils Chevron Corp. (CVX) and Total (TOT) that don't expire until 2029.

Odds of a functioning Cove Point multiplying the value of Dominion's current and future gas assets, therefore, are quite good. And management has a solid record of executing major engineering projects, in both natural gas and electricity. But there will be added risk here until there's actual cash flowing in from Cove Point.

As the MLP's launch is still months away at best, the question of whether the market is pricing in enough danger is a matter for Dominion Resources' shares only.

For disclosure purposes, I've been a holder of the company's dividend reinvestment plan since the 1980s. The value of my initial investment has multiplied many times, and my intention is to hold for many years to come.

On the other hand, utility stocks enrich investors slowly over a long holding period; anyone who lacks the patience to wait for a big capital project to pay off is better off hunting in other sectors.

Dominion will no doubt do what it takes to make the MLP IPO attractive, including building in distribution growth and promising asset "drop downs." But the new entity and its real value to Dominion itself will only reach full potential when Cove Point is operating, and that's not likely until 2018 at the earliest.

There's no reason not to expect Dominion to execute on its stated long-run goal of 5 percent to 6 percent earnings growth, with commensurate dividend increases.

Factoring out the weather, that pace is likely to be extraordinarily steady, as new assets enter the regulated rate base in Virginia. Earlier this year, Dominion simultaneously slashed its exposure to energy price swings and environmental regulation by disposing of its merchant coal power fleet.

This latest pop in the stock, however, seems a lot more to do with expectations of what it will be worth as a future LNG exporter, rather than what it is now.

Disclosure: I am long D, EPD, WMB. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.