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Many investors think of Master Limited Partnerships (MLPs) as interstate pipelines that operate like toll roads and are agnostic to commodity prices. The reality is that long-haul "toll road" pipelines account for less than half of MLP sector profits and many MLPs actually have substantial commodity price exposure. Obviously, MLPs like Linn Energy (LINE), that actually produce oil, gas, or coal have direct commodity exposure. But beyond these companies, the numerous MLPs involved in the natural gas liquids (NGLs) value chain have more exposure than many investors realize.

The most exposed of this group are G&P MLPs, which gather and process natural gas - companies like Markwest Energy (MWE), Copano Energy (CPNO), and Targa Resources (NGLS). Many of these companies receive revenue in the form of the NGLs extracted during processing. Because of this, these MLPs are effectively long on NGLs. NGLs are substitutes for petroleum products in some types of petrochemical production, so their prices tend to track crude oil rather than Natural Gas. For example, crude and propane have had a near perfect correlation over the last twenty years (R^2=.96). Other NGLs (ethane, butane, isobutane, and natural gasoline) are similar.

So the recent run-up in oil prices has been a tremendous boon for these companies. And there's icing on the cake: some of these companies also have what are known as "Keep Whole" contracts, which require them to replace the extracted NGLs with an equivalent BTU volume of gas. So they are effectively long NGLs and short natural gas. There's hardly been a better place to be since 2009. For 20 years, the ratio of crude oil to natural gas prices has averaged around 10:1. In 2009, the ratio began to climb dramatically, and is now well over 20 - a whopping three standard deviations above average.

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Right now I can hear hundreds of G&P MLP unit-holders yelling at their monitors: "But my MLP has mostly fee-based contracts. Anyway, they're hedged."

First, I would note that fee-based contracts account for less than half of MLP processing volumes. I emphasize volumes because MLPs often list their contract types by volume, even though what matters are margins, not volumes. For example, Oneok Partners (OKS) has 37% keep-whole contracts by volume, but 62% by margin. In other words, keep-whole accounts for a minority of contracts, but a majority of profits. If the pricing environment changes, more than half the profit is at risk.

So what about hedging? As a group, the G&Ps are hedged for less than half of their commodity price exposure over the next three years. G&Ps may actually give you more commodity price exposure than oil and gas production MLPs, like LINE, which are well hedged for as much as 5 years. If a company's profits are heavily dependent on a commodity price, you have to question whether two or three years of hedging gives you enough comfort.

It's Not Just About the Price
Beyond commodity price exposure, MLPs also face volumetric exposure, which is actually more important, because it affects supposedly secure "fee-based" processing, as well as all the other NGL businesses MLPs engage in: fractionation, and shipping raw and refined NGLs. Nobody's thinking about volumes right now, because staggering volumes of NGLs are flowing.

With oil prices near $100/bbl, NGL demand is soaring worldwide.

Foreign and domestic petrochemical plants that formerly used naptha (from petroleum) to produce ethylene are switching to the ethane (an NGL). Beyond raw ethane, the U.S. is now also a competitive and prolific exporter of ethylene.

On the supply side of the equation, natural gas producers are struggling to make money on dry gas, which is barely economic in many basins. So they are feverishly ramping up production in rich-gas areas. At the last IPAA conference, it seemed like a slide on drilling the rich-gas Eagle Ford shale was required for every Powerpoint. Eagle Ford has become the "cloud computing" of the gas industry. Some producers brag they can make money at $0/mcfe just by selling the liquids.

This has all created a "perfect storm" favoring MLPs. G&Ps are making a killing on percent-of-liquids and keep-whole contracts; NGL pipelines have more demand than they know what to do with; and fractionators are all operating at full capacity. Processing margins, which have historically averaged around $0.25, now hover around $0.85. This is well understood by MLP executives, who are cautiously allowing distribution coverage ratios to increase, rather than increasing distributions as fast as distributable cash flow (DCF).

However, I think this is underappreciated by insouciant investors. The executives know that a lot of that wonderful DCF growth depends on the oil/gas price ratio remaining well above historic levels. If we returned to a $60/$6 or even a $70/$7 oil/gas price ratio, things would change very quickly - and not just for G&P MLPs. At a $60/$6 ratio, domestic and global demand for ethane would quickly wither: processors would go into ethane rejection mode, leaving NGLs in the gas stream because they're worth less than gas. The NGL pipelines and fractionation facilities recently built by MLPs like Enterprise Products would see drastically lower volumes.

What we think of as the traditional products for MLPs to ship - crude oil, natural gas, and refined petroleum products - are subject to volumetric fluctuations due to weather or the economic cycle. But these fluctuations tend to be a few percent this way or that. By contrast, NGL volumes can vary hugely according to global oil prices.

Large-Cap Integrated MLPs (EPD, OKS, KMP) Are Exposed Too
Now it's time for the large-cap integrated MLP unit-holders to yell at their monitors: "I don't own a risky G&P. I own a diversified midstream MLP." I recommend teasing apart your MLP's earnings. If you own a big MLP that has done really well in the past two years, it's quite likely because of NGLs - if not gathering and processing, then NGL pipelines, or fractionation. For example, consider Oneok Partners' great growth last year: its long haul gas pipes were up a paltry 5%, but G&P revenue was up 30%, and the NGL business was up 50%. The boring old natural gas and crude pipelines aren't seeing big demand growth. It's all in the NGLS.

Look at the dozen big, investment-grade MLPs: their returns line up roughly with their exposure to the NGL value chain. At the one end, Boardwalk Pipeline Partners (BWP), the pure-play long-haul pipeline with no NGLs, went up a measly 2.5% for the year. At the other end, Williams Partners (WPZ) with lots of G&P, NGL pipelines, and fractionation, was up 47%.

The total return for the MLP sector was roughly 35% last year. But that was starkly divided: on the one end, the G&P segment returned over 60%; on the other end, storage returned less than 10%. I know there are some exceptions to what I'm saying - funeral homes, propane distribution, and so on. But generally speaking, the excellent DCF growth in the MLP sector over the last two years is largely an NGL story. That is to say - it's a commodity price story, dependent on expensive crude oil and cheap natural gas. Since 2009, the market has acknowledged this, with the Alerian MLP index (AMZ) tracking crude oil in a way that it never has before.


I for one think the oil/gas price ratio will probably stay high for some time. But it's important to acknowledge that a lot of the big MLP growth depends on it.

What To Do
I stand by my prior assertion that MLPs are close to full value and may undergo the sort of sudden and violent corrections they've had in the past. I'm not selling, but I'm not going to accumulate either. MLP unit-holders, including those who own large-caps like Enterprise Products and Oneok Partners, should consider that these companies aren't just toll roads - they are at least partly tied to commodity pricing. If you own a G&P MLP, you should identify how much NGL risk it has - not just pricing risk, but also volumetric risk.

Source: MLPs: The Stealth Commodity Play