MLP Master: A Conversation With Elliott Gue

by: Benjamin Shepherd

Despite the prevailing economic uncertainty, many master limited partnerships (MLPs) have performed extraordinarily well, generating solid returns for investors through tax-advantaged payouts and capital gains. We spoke with Elliott Gue, co-editor of MLP Profits and editor of The Energy Strategist about his outlook for the group and some of his favorite MLPs.

Q: What’s your outlook for MLPs over the next year?

A: Last year the Alerian MLP Index soared more than 70 percent. But that rally represents a recovery from depressed valuations that prevailed at the end of 2008, and the group remains cheap by any historical measure. The Alerian MLP Index still yields around 6.8 percent, some 300 basis points over the 10-year Treasury and more than 200 basis points above the Philadelphia Utility Index. This represents a historically attractive spread.

The Alerian MLP Index won't rally another 70 percent this year, but the group should generate solid returns thanks to distribution growth. Although few MLPs actually cut their payouts in 2008-09, many didn’t boost distributions while others slowed the pace of distribution growth to conserve cash.

But over the past nine months, MLPs have taken advantage of improving market conditions to raise billions of dollars in capital by issuing new units and selling bonds. The best names are putting the proceeds to work by building and acquiring pipelines, storage facilities and other energy infrastructure. All of these deals tend to add to distributable cash flows, which should lead to higher distributions for MLP holders.

Another potential catalyst for the group is an increase in US tax rates. With income taxes and taxes on dividends slated to rise, investors will looking to reduce their liability. Since MLPs offer considerable tax-deferral advantages, the group will benefit from investors seeking tax-advantaged investments that offer solid current income.

Q: The Barnett Shale has brought a lot of attention to unconventional natural gas resources here in the US. Are there others, and what is the investment potential?

A: The Barnett was the first major gas shale to be developed in the US, but it isn’t the only play. Some believe the Haynesville Shale in Louisiana and parts of East Texas may be larger than the Barnett.

The Marcellus Shale, located in Appalachia, is another hotbed of activity. The most productive wells drilled in the Marcellus appear to be in Pennsylvania and parts of West Virginia, though natural gas is widely distributed throughout the region. The Marcellus also benefits because it’s located near the Northeast US, a key region for natural gas consumption.

Arkansas’ Fayetteville Shale, the emerging Eagle Ford Shale in South Texas and the oil-focused Bakken Shale of Montana and North Dakota are other shale plays.

Natural gas from unconventional fields already accounts for over half of all US production, and estimates from the Energy Information Administration (EIA) suggest that this shift will only pick up steam. ExxonMobil’s (NYSE:XOM) entry into the Barnett Shale via its acquisition of XTO Energy (XTO) could catalyze investment in US unconventional gas and oil production.

Producing all that unconventional gas will require a major build-out of energy infrastructure. Companies will need new pipelines in key shale regions to move gas from all those new gas wells to gas-processing facilities and, ultimately, to end-market consumers.

Producers will also need new processing capacity. Some of the most important US shale plays produce “rich” or “wet” gas that contains a large quantity of natural gas liquids (NGLs).

Finally, a growing role for natural gas in the US energy mix will require additional storage capacity. Storage is a buffer between supply and demand. If demand increases, the size of that buffer also needs to grow to prevent shortages of gas during periods of high demand.

Although it gets far less attention in the media, energy infrastructure is every bit as crucial to the development of unconventional US gas plays. Energy infrastructure is the bread and butter of the MLP industry; these volume- and fee-based assets produce the steady, reliable cash flow necessary to back up MLPs’ generous distributions.

Growth in US unconventional gas production will result in myriad opportunities for MLPs to build new cash-producing assets and will kick off a new wave of distribution growth. The long-term outlook for gas production from US shale is bright, and the nation recently overtook Russia as the world’s largest natural gas producer.

But depressed gas prices prompted many producers to scale back drilling activity in 2009. Although EIA data on US gas production is highly volatile and subject to revision, recent releases suggest that gas production is falling and that the decline will accelerate into 2010.

The only regions showing growth contain some of the lowest-cost shale gas plays. Most producers have indicated they need gas prices in the range of $6 to $7, at a minimum, to bump up drilling activity.

Q: Can you give us a couple of your favorite producer plays?

A: Roger Conrad and I recommend three companies involved in natural gas and crude oil production: Linn Energy LLC (LINE), Legacy Reserves LP (NASDAQ:LGCY) and EV Energy Partners LP (NASDAQ:EVEP).

Of the three, Linn Energy is the least risky because it has hedged almost 100 percent of its production of both oil and natural gas over the next two years. That being said, the company does benefit from rising commodity prices because it’s able to lock in attractive prices on new hedges for years beyond 2011.

Improving commodity prices make it easier for Linn to fund acquisitions. The partnership also has easy access to credit; the partnership has raised substantial capital via a $500 million private offering of senior notes, a renegotiated revolving credit facility and a secondary offering of units.

The company also announced a deal to acquire gas-producing assets in the Antrim Shale of Michigan and oil properties in the Permian Basin of Texas. Management has signaled its intention to do more deals.

For most MLPs, secondary offerings generate an immediate dip in unit prices. But in situations where the deals are likely to be accretive, these drops amount to great buying opportunities because the units quickly recover.

Legacy Reserves is primarily an oil-focused play. Oil prices in the $70 to $85 range are high enough to generate solid returns on invested capital. Meanwhile, M&A activity in Legacy’s core

Permian Basin area of operation is heating up, making Legacy a potential target in its own right.

EV Energy is the play most directly exposed to US natural gas prices. Although the partnership hedges some of its production, its charter prohibits it from hedging all of its output. To compensate, EV Energy pays out a lower portion of its distributable cash flow; even relatively large changes in gas prices don’t impact the outfit’s near-term ability to pay current distributions.

Q: Are there any MLPs that are less leveraged to commodity prices?

A: Pipeline operators are involved in fee-based business lines and have minimal commodity-price risk--this group is known for consistent cash flows and steady performance. All of the operators in our coverage universe reported solid results for 2009, and most noted the potential for growth in 2010--either through new organic expansion projects or via acquisitions. Although most of our favorites have minimal commodity-price exposure, strong demand for NGLs and stable oil demand are at least modest tailwinds for the year ahead.

Magellan Midstream Partners LP (NYSE:MMP) operates an extensive petroleum product pipeline and terminal system that serves the middle of the US. In the fourth quarter of last year it reported distributable cash flow (DCF) - the key profitability metric for MLP - of $104.9 million, a new quarterly record. That took full-year DCF to $328.4 million, considerably higher than management’s November 2009 guidance of $310 million.

Magellan Midstream Partners maintained but didn’t increase its distribution in 2009, partly because it purchased its general partner (GP) last year. Funding this deal represented an immediate outlay of cash, but the move exempts the partnership from paying an incentive distribution rights (IDRs) fee to its GP every quarter.

This leaves more cash available for distributions; during its conference call, management forecast that the fourth-quarter 2010 distribution would be an impressive 6.5 percent higher than the fourth-quarter 2009 payout.

Q What’s your best advice for investors?

A: There’s a temptation for investors to associate dividends or distributions with safety, but that's definitely not the right way to look at the sector.

Linn Energy and some of the other names we recommend offer yields of 10 percent or more, but many of the highest-yielding MLPs are also the riskiest.

For example, we received plenty of questions about K-Sea Transportation Partners (NYSE:KSP) in the first nine months of 2009 because we rated the MLP a “Sell” despite its astronomical yield.

K-Sea Transportation operates a fleet of tank barges and tugboats in US coastal waters. The company had long-term contracts covering many of its older barges and offering attractive cash flows. But as those contracts expired, the MLP wasn't able to secure new deals at attractive rates.

As a result, K-Sea Transportation slashed its distribution, and the stock plummeted from the mid-$20s in late October to under $9 today. Management highlighted the risks associated with barges coming off contract on several occasions, but the yield zombies blindly invested their hard-earned money in the MLP.

Just because MLPs are an income-oriented group doesn't mean you can let down your guard. You must examine the underlying business that generates distributable cash flows to determine sustainability and risk from commodity prices.

Disclosure: No positions