Over the past few months, I’ve written several articles explaining various aspects of the master limited partnership (MLP) industry.
These articles continue to generate significant e-mail traffic, comments and queries, so we’ll continue today with yet another look at the group.
In a market where most income-oriented groups offer near record-low yields, investors are starving for income. All MLPs offer market-beating distributions, as well as attractive tax advantages, but fight the temptation to blindly reach for the highest yields.
Unfortunately, much like the sirens of ancient Greek mythology, the MLPs sporting the highest yields have an almost intoxicating allure for individual investors. Although most MLPs operate in stable businesses with little sensitivity to commodity prices, the high-yield cadre usually has significantly higher than average business risk.
The most recent example: K-Sea Transportation Partners LP (NYSE:KSP), a tank barge and tugboat company operating in coastal US waters.
A Cautionary Tale
Back in August, K-Sea paid a $0.77 quarterly distribution, the same as it paid for the prior four quarters in a row. From 2004 through August 2009, the MLP had nearly doubled its quarterly payout from $0.43 and had never cut its distribution. Trading around $19 per share in late August, the partnership offered a yield over 16%, among the highest in my coverage universe.
Thanks to its sky-high yield, K-Sea was a popular MLP; I and my co-editor on MLP Profits, Roger Conrad, were often asked for an opinion on the stock. Many were surprised--some were openly hostile--when we noted that we’ve had it rated a “Sell” since we started the service in May. Selling an MLP is a hard decision for many investors, apparently particularly so for those who owned K-Sea for years and enjoyed the steadily rising distributions.
But there were already myriad signs of trouble ahead for K-Sea earlier this year. The main problem is that K-Sea owns a significant number of single-hull tanker vessels; these vessels are legally required to retire from service no later than the end of 2014. Single hull vessels have a difficult time getting long-term contracts for work, and companies needing tanker barge capacity are willing to pay far lower rates for single-hulls.
In the company’s fiscal fourth quarter conference call back in August, K-Sea noted that it had nine single-hull barges go off long-term contracts in fiscal year 2009. These long-term contracts provided attractive economics, but once the ships came off contract they needed to be sold, scrapped or simply contracted under far less lucrative terms.
At the time of its fiscal fourth quarter call, K-Sea noted that it owned another 16 single-hulls under soon-to-expire contracts; the loss of this stream of revenue remained a significant risk. K-Sea noted that because of contract expirations only around 60% of its barges would be contracted by the middle of calendar year 2010.
Even worse, K-Sea management spoke of an overall softening in demand for barges in the spot market, the market for immediate use of ships. The company cited pressure on rates, and said that some vessels that it would normally lock into three-year deals at fixed rates were only able to garner one-year deals.
The obvious problem here is that falling US demand for oil and related products spells less volume to be transported between coastal refineries and storage facilities.
These were all signs of trouble for single- and double-hull ships coming off contracts and called into question K-Sea’s ability to replace revenue from the 40% of its capacity not under contract by the middle of next year.
K-Sea does have a number of new modern ships due for delivery in coming years. And capacity in the tank barge market should tighten as single-hulls are retired and demand for refined products in the US ticks higher again. But the question was, and is, one of timing. It looked unlikely that the new ships would arrive in time to offset declining revenue from existing barges coming off contract.
The story sounded eerily similar to that of US Shipping Partners LP, a tanker barge shipping MLP that filed for bankruptcy in 2008.
The end result: K-Sea slashed its quarterly payout to $0.45 and the stock halved in value overnight. With the current yield based on the lowered dividend near 16%, there’s still lingering concern that the MLP will be forced to cut its payout even further.
To make matters worse, K-Sea announced that it's likely to be in breach of its covenants with lenders regarding the ratio of debt to earnings before interest, taxation, depreciation and amortization (EBITDA).
The average MLP offers a yield of around 7% to 8% today, but some pay far in excess of that. Don’t fall into the trap of thinking that because these firms offer high yields they’re inherently safe. Yields above the group average imply higher-than-average risk; in investing you never get something for nothing, at least not without working for it.
This is one reason we have three model portfolios: The Aggressive Portfolio offers an average yield of 10.8%, the Growth Portfolio 8.9% and the Conservative Portfolio averages 7.4%. These three portfolios represent three distinct levels of risk.
That doesn’t mean that investors can’t generate yields from the group well in excess of 10%; reaching for those yields will require more careful monitoring and attention to fundamental details. Investors always need to evaluate an MLP’s ability to cover distributions with distributable cash flow (DCF).
But with our Aggressive Holdings we must be extra vigilant in monitoring the sustainability of DCF, debt position and the potential for the MLP’s general partner (GP) to offer support during downturns. Investors must also be willing to sell when the yield no longer justifies the heightened risk.
One MLP sub-sector where we’re seeing sustainable double-digit yields right now: Gathering and Processing (G&P). G&P is among the most commodity sensitive businesses an MLP can be involved in and was among the hardest hit in last year's commodity price collapse.
Gathering lines are small-diameter pipelines that connect individual natural gas and oil wells to processing facilities and, eventually, the interstate pipeline network. MLPs typically charge a fee based on the volumes of oil or natural gas they gather and, by extension, the number of wells they hook up to their gathering systems.
When commodity prices are strong, US producers tend to drill aggressively for oil and gas. The more aggressively producers drill, the more wells they need to hook up to gathering systems and the more demand there is for MLPs to expand their networks.
The health of the gathering business is closely tied to the active rig count, a measure of how many drilling rigs are actively drilling for oil or natural gas. Most drilling activity in the US targets gas, not oil; here’s a chart of the US gas-directed rig count. (Click to enlarge)Click to enlargeSource: Bloomberg
The US gas rig count collapsed starting in August 2008 as natural gas prices tumbled. The fall in the rig count accelerated into early 2009 amid a severe credit crunch that hit smaller producers’ ability to fund planned drilling programs. As gas prices continued to fall, more US gas fields became uneconomic to produce; producers shuttered wells and discontinued drilling, causing volumes of gas traveling across gathering systems and demand for new well hook-ups to tumble.
The US natural gas rig count has recovered slightly from a low of 665 rigs in July to 734 rigs more recently. But the drop from 1,606 rigs last August was the fastest and most dramatic fall in gas drilling activity on record. Gathering volumes remain weak but are showing some signs of recovery.
And remember that the gathering business is highly regional. Some regions of the US such as the deepwater Gulf of Mexico, the Haynesville shale gas play in Louisiana and the Marcellus in Appalachia have seen continued to see strong growth in volumes despite the commodity price collapse over the past year. So when one G&P MLP says the gathering market is improving it doesn't mean it's improving across the board.
Processing is the equivalent of refining for the natural gas industry. Gas processors take raw gas and strip out natural gas liquids (NGLs) such as ethane, propane and butane. Gas processors can also take a further step, known as fractionation, to separate the individual NGL components.
Gas processors make profits based on the relative value of NGLs and natural gas. Because processors essentially buy natural gas (a cost) and produce and sell NGLs (revenue), the higher NGL prices are relative to natural gas prices, the more profitable the processing business is.
Some G&P MLPs are not directly exposed to volatile processing margins. That’s because many G&P MLPs have fixed-fee contracts; in other words, they’re paid a fee based on the volume of gas and NGLs processed. But when gas processing margins are high, demand for processing services rises; even in a fee-based arrangement, there is some indirect exposure to margins.
Other G&P MLPs earn at least a percentage of their processing revenues based on processing margins and the relative prices of gas and NGLs. NGLs are produced with natural gas, but historically prices have tended to track crude oil more closely. That relationship broke down somewhat in late 2008 and early this year. But the relationship is stabilizing again, and NGLs pricing has been improving with oil. This is rapidly boosting processing margins.
A host of G&P MLPs are currently offering yields close to or exceeding 10 percent and continue to cover their distributions by comfortable margins. With the G&P market strengthening again, look for a resumption of distribution growth in 2010.
Williams Partners LP (NYSE:WPZ) reported solid results for its G&P business, beating analysts’ estimates and boosting its guidance for both 2009 and 2010 distributable cash flow by a wide margin.
MLPs with exposure to G&P were harder hit by the decline in commodity prices in late 2008 and early 2009 than those involved in the actual production of natural gas and oil. Only conservatively managed MLPs such as Williams Partners with strong general partner sponsors, in this case Williams Companies (NYSE:WMB), managed to escape last year’s commodity rout without distribution cuts.
But the rebound in commodity pricing and the G&P business is now a major tailwind, and the swing in Williams Partners’ results as a result of this upswing surprised many analysts.
The LP reported a 121% surge in DCF in the third quarter over the second quarter. DCF was still lower over the same quarter a year ago, that’s a tough comparison: The G&P business saw record profitability in the third quarter of 2008.
Williams Partners covered its quarterly payout by more than 1.8 times, among the highest ratios of any MLP in the MLP Profits coverage universe. Even more important, Williams Companies waived its right to incentive distributions in 2009 to help shore up Williams Partners’ cash position. Even if we exclude that benefit the LP managed to cover its payout by a still-healthy 1.5 times.
Two factors drove Williams Partners’ blowout results. First, the prices of NGLs such as ethane and propane improved markedly in the third quarter, helping the processing business.
Second, drilling activity has remained relatively robust near Williams Partners’ main areas of operation. Volumes of natural gas and NGLs flowing through the LP’s lines haven’t dropped off as much as many forecast.
The company’s Four Corners gathering system collects gas from the San Juan Basin of New Mexico and Colorado. Weak gas prices would typically translate into few new wells and, therefore, falling well connections and lower volumes of gas to be gathered by the Four Corners system.
But Williams Partners pointed out in its conference call that 85% of the wells connected to this system are more than five years old. Production from gas wells falls most sharply in the first few years of production; the older wells connected to the Four Corners System would see minimal annual decline rates. That means that volumes in this system aren’t particularly sensitive to gas drilling or prices.
Wamsutter collects gas from Wyoming, an area where wells are younger and should be more sensitive to drilling activity. However, Williams noted that a number of big producers in the region such as BP Plc (NYSE:BP), Anadarko Petroleum Corp (NYSE:APC) and Devon Energy Corp (NYSE:DVN) have continued to invest during the downturn and now have access to the new Rockies Express Pipeline to move its gas to markets in the East.
Prior to the building of this pipeline that gas would have been stranded in Wyoming. Also helping has been a narrowing of basis differentials--the different in gas prices between different trading hubs in the US. Gas prices in the Rockies have traditionally been at a steep discount to gas prices elsewhere and to the New York Mercantile Exchange (NYMEX) futures prices, but those discounts have narrowed sharply in recent months; prices for gas producers in the Rockies have improved markedly even as US gas prices generally have been weak.
Williams Partners’ Discovery system in the Gulf of Mexico benefited from increased production from new deepwater oilfields as well as the final repairs to damage caused by the 2008 hurricane season. Another point management noted is that gas volumes from the deepwater Gulf have typically contained an unusually large amount of NGLs and therefore require significantly more processing than gas produced onshore.
Management said that well connect activity has actually been accelerating at Wamsutter lately, suggesting that a further increase in volume is likely for the fourth quarter.
Management was also asked about the potential for growth and acquisitions and hinted that it may soon be in a position to begin new drop-downs from its general partner Williams Companies. Drop-downs are typically among the cheapest and easiest ways for an LP to grow, and Williams Companies has a large number of drop-down candidates suitable for sale to the LP. The LP hinted that its first drop-down candidate might be an expansion project connected to its Wamsutter system.The rapid improvement in Williams Partners’ business likely means that it can resume distribution growth at some point in 2010. Williams Partners LP, with a yield near 10%, rates a buy under 28.