Master Limited Partnerships Are Thriving...What Credit Crunch?

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Includes: AMJ, EPD, KMP, NKA, NMM, PNG, VNR
by: Elliott Gue

Since its inception, the benchmark Alerian MLP Index has rallied nearly 670 percent, equivalent to an annualized return of 15.2 percent per year. That’s almost five times the 150 percent gain put up by the S&P 500 over the same period.

The group has been consistent, even in periods of extreme market turmoil. MLPs managed to return 24 percent from the end of 1996 to the end of 1998, even though oil prices slumped to multiyear lows around $10 a barrel. The Alerian Index soared more than 40 percent in both 2000 and 2001 despite the collapse of the late-1990s stock market bubble and a recession in 2001.

In fact, the Alerian MLP Index has outpaced each of the 10 S&P 500 Economic Sector Indexes since 1995 by a margin of at least 270 percent.

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There is one blemish to the group’s otherwise stellar track record: The Alerian Index tumbled 36.9 percent in 2008, by far its largest decline in any single year. Prior to 2008, the index’s worst decline was a 7.8 percent pullback in 1999.

It’s tempting to assume that commodity prices played a leading role in this swoon; crude collapsed from highs near $150 a barrel to lows in the $30s between summer 2008 and year-end, and natural gas prices declined by half and remain depressed.

While commodity prices impact MLPs engaged in gas processing or involved in the actual production of oil or natural gas, as a group MLPs are less sensitive to commodity prices than most other energy sectors. History suggests commodity prices weren’t the main source of weakness in 2008; the group performed well in the late 1990s despite weak oil prices and enjoyed a strong 2001 despite a near 70 percent collapse in the price of natural gas.

Credit markets drove the selloff in 2008 and the 76.4 percent rally the Alerian Index enjoyed last year. Partnerships are an income-oriented group; the most important driver of performance is high and rising distributions, the equivalent of dividends. MLPs grow their payouts in two main ways: acquisitions or organic growth projects such as new pipelines.

Both growth strategies require capital: The heavy, fixed assets MLPs own generate copious and dependable cash flows but require large up-front investments to build. Buying assets or other MLPs can be expensive, particularly in healthy market environments.

It’s normal for the price of an MLP to fall immediately after announcing a secondary issue of units; issuing new units dilutes the value of existing unitholders’ stake in the business. However, MLPs issue units to raise capital to buy or build new assets, and the value of cash flows from these new assets is often more than sufficient to offset any near-term dilution. In fact, MLPs typically pursue projects that are almost immediately accretive to cash flows; new deals and projects are usually the precursor to hikes in distribution payouts.

We’ve issued numerous Flash Alerts over the past year in MLP Profits, advising subscribers to buy our recommended MLPs on the dips following secondary issues. That pattern has proved consistently profitable, allowing investors to buy into our favorites at discounted prices. Investors’ willingness to buy secondary unit offerings over the past 12 months is the hallmark of a bull market in the group.

In weak stock markets investors are reluctant to buy new unit issues. In mid-2008 it became increasingly difficult for MLPs to raise capital by issuing new units. From September to December 2008, the height of the credit crunch, there were no new MLP unit issues -- the market was simply too weak to absorb new supply.

MLPs can also raise capital by issuing bonds or borrowing money from banks -- typically through revolving credit lines with a consortium of lenders. Both debt markets died in mid-2008. Even the largest and most creditworthy borrowers had trouble taking on new debt at the height of the crunch, while smaller, high-yield issuers were locked out of credit markets entirely.

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This graph tracks the yield spread between 10-year bonds issued by industrial companies and the 10-year US Government bond. The graph shows the yield spread for bonds rated A, BB and B by Standard & Poor’s from early 2006 to the present. US credit markets began to show signs of stress in late 2007; yields for all grades of corporate bonds increased relative to Treasuries.

At first the rise in spreads was slow and steady, but corporate bond yields spiked sharply in spring 2009 when Bear Stearns imploded. The failure of Lehman Brothers (OTC:LEHMQ) in September 2008 sent spreads to the moon. At the height of the crisis, bonds of B-rated industrial issuers were yielding a record 15 percent (1,500 basis points) more than Treasury bonds of equivalent duration and even A-rated investment grade bonds traded with yield spreads close to 4 percent, another record.

The slow and steady improvement in spreads throughout most of 2009 also stands out. The freeze-up in credit markets in late 2008 prompted fears that MLPs would be unable to grow their payouts or fund new projects. Similarly, the improvement since early 2009 has sparked an increase in plans for organic expansion projects and a jump in merger and acquisition (M&A) activity across the industry.

Greek sovereign credit markets have exhibited signs of stress since late 2009 when Dubai World announced it would need to restructure its massive debt burden. European Union (EU) credit markets showed early signs of contagion in late April and early May as yields on Spanish, Portuguese and even Italian sovereign debt began to rise amid fears these countries would ultimately face the same fiscal constraints as Greece.

Some fear that EU credit contagion has infected other credit markets, including the market for corporate bonds. A credit crunch akin to that witnessed in 2008 would derail the more than year-long rally in MLPs but there’s no sign that the recent EU debt crisis has limited MLPs’ access to capital.

As you can see, the yields on 10-year bonds, even for companies rated B, have barely increased in recent weeks despite the negative credit headlines out of Europe. Spreads for all three issuer grades are lower than they were at the beginning of 2010 and a small fraction of the highs reached in 2008 and early 2009. In fact, the yield spreads on A-rated debts are no higher than they were in 2006.

Even more important, several MLPs have issued new bonds and/or placed secondary unit offerings since the EU credit crisis hit the headlines in late April. These deals went off without a hitch. Consider the $2 billion in new bonds recently issued by Enterprise Products Partners LP (NYSE:EPD), one of our favorite recommendations in MLP Profits.
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On May 20, Enterprise issued three different bonds: a 5-year, 10-year and 30-year issue, with a total face value of $2 billion.

The most important column in this table is the final one, the yield spread to Treasuries at the time each bond was issued. For example, the bonds maturing on June 1, 2015, yielded 134.5 basis points (1.345 percent) more than equivalent 5-year US Treasury bonds when they were issued.

For the sake of comparison, I’ve listed other bonds issued by Enterprise over the past two years. The six bonds issued on Oct. 27, 2009, carry much higher yields but aren’t relevant for comparison--these weren’t new bond issues. Enterprise issued these bonds in exchange for TEPPCO Partners’ existing notes when it acquired the firm last year.

The most relevant note for comparison purpose is the October 5, 2009, issue of $500 million worth 10-year bonds. At the date of issue the bonds yielded 189.9 basis points above US Treasuries, or 5.216 percent. This is significantly higher than the spread on the 10-year bonds issued Enterprise issued a few days ago. Enterprise’s cost of capital is actually lower than it was last October, long before anyone was talking about a credit contagion in Europe.

The final two bonds on the table are issues from April and December 2008. The former was issued around the time of the Bear Stearns crisis; the latter was issued not long after the height of the 2008 credit crunch. There’s no comparison between the spreads on bonds the MLP issued on May 20 and the two series from 2008: Enterprise’s cost of capital has fallen sharply over the past two years and remains at rock bottom despite the EU credit crisis. There is no sign that the crisis is affecting Enterprise’s ability to access the capital it needs to grow.

Enterprise isn’t the only MLP to raise capital since Greece’s fiscal crisis came to the fore. Kinder Morgan Energy Partners LP (NYSE:KMP) raised $1 billion by issuing two different bonds on May 19. The table lists salient details on this most recent issue and previous bond issues.
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As with Enterprise Products Partners, there’s no sign that recent headlines from the EU have increased Kinder Morgan Energy Partners’ cost of capital.

The 10-year notes Kinder issued on May 19 yielded around 176 basis points over equivalent Treasuries, while a similar issue of 12-year notes Kinder sold in mid-September 2009 traded at a higher spread of close to 240 basis points. A similar pattern is visible in the 30-year notes the MLP issued last September and this May.

Of course, both Kinder and Enterprise are large investment-grade issuers; it’s logical that their cost of capital would be less vulnerable to Europe’s woes. Many smaller and less-established MLPs don’t issue bonds at all, relying on bank loans and new equity issues to raise capital.

The market for secondary issues also remains remarkably strong despite the pullback in the broader markets. The Alerian MLP Index is down roughly 10.5 percent since hitting an all-time high on April 26; however, several MLPs have priced secondary unit issues since late April. Here’s a table showing all of the new unit issues since the Alerian Index hit its April highs.

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Pay close attention to the final column in this table, which lists the one-day reaction in units of each MLP following the announcement of a new unit issue. As I noted earlier, MLPs typically slip after announcing a secondary offering because issuing new units dilutes the stakes of existing holders. In stronger markets one would expect a less dramatic impact because investors eagerly absorb the new units.

For example, Vanguard Natural Resources (NYSE:VNR), a small partnership that produces oil and natural gas, sold 3.25 million units on May 12, raising around $75 million. In the first day after announcing its intention to offer new units, the partnership’s units finished the day 6 percent lower. Although that’s a sizeable one-day selloff, it’s actually a smaller drop than Vanguard Natural Resources experienced last August when it sold 3.5 million units.

Navios Maritime Partners LP (NYSE:NMM) announced its intention to sell 4.5 million units on April 30, and the stock fell 5.6 percent in the next session. The selloff was almost identical to the reaction after Navios sold 3.5 million units back in early February.

Bottom line: Even smaller, more leveraged MLPs have been able to issue units in recent weeks without offering a large discount to tempt buyers.

The initial public offerings (IPO) of PAA Natural Gas Storage LP (NYSE:PNG) and Niska Gas Storage Partners (NYSE:NKA) underscore this point.

PAA Natural Gas owns two natural gas storage facilities in Michigan and Louisiana with combined storage capacity of 40 billion cubic feet (bcf). PAA plans to aggressively expand its capacity through organic growth projects surrounding these two facilities. PAA’s business is almost entirely fee-based; customers pay to reserve capacity in its storage facilities regardless of whether those facilities are fully utilized.

PAA sold 13.48 million units -- 11.72 million units as part of the offering and 1.76 million units as an over-allotment option -- at $21.50 on April 29, raising nearly $300 million. The MLP traded as high as $26 and continues to trade well above its offering price despite significant volatility in the broader market since its IPO.

Niska Gas Storage owns 185.5 bcf worth of natural gas storage capacity in the US and Canada. The MLP completed its IPO on May 17, selling 17.5 million units and raising $331 million after fees.

Unlike PAA, Niska hasn’t performed well since its IPO; the stock has dropped to as low as $17 after an offering price of $20.50. That being said, it’s somewhat encouraging that the Niska IPO was completed at all in the face of weak global markets and continued volatility in EU credit markets.

The IPO market is among the most sensitive to broader market demand. When investors’ appetite for risk disappears -- as was the case during the height of the credit crunch -- it’s almost impossible for new companies to issue stock and go public. That two MLPs have completed IPOs since the credit crunch suggests there’s still demand for risk.

Results of recent MLP bond offerings, secondary issues of units and IPOs suggest that any comparison between the current environment and the credit crunch of 2008 is massively overdone.

Disclosure: No positions