Many investors mistakenly assume that collapsing commodity prices were the biggest challenge master limited partnerships (MLPs) faced in fall 2008 and early 2008.
Some MLPs have exposure to the price of oil, natural gas and natural gas liquids, and a handful of smaller names had to cut their distributions when energy prices plunged.
But these firms represent the exceptions rather than the rule. Most MLPs have only modest exposure to economic conditions and commodity prices, thanks to a combination of hedges and long-term, fee-based contracts. Although the Great Recession and plummeting commodity prices were an undeniable hindrance, the vast majority of MLPs did not cut their payouts during the 2007-2009 swoon.
In fact, frozen credit markets presented the biggest challenge to energy-focused MLPs at the height of the financial meltdown. New pipelines, processing plants and storage facilities require significant up-front investment to build. MLPs usually raise capital to fund these projects by issuing secondary units or tapping the credit markets; the credit crunch prevented MLPs from making these investments and growing their distributions.
To worsen matters, many MLPs relied on credit lines that needed to be rolled over frequently and were subject to periodic redeterminations. In some instances, the interest rates on these loans were indexed to the London Interbank Offered Rate (LIBOR), which soared when the credit crunch hit.
Some MLPs relied on private investment in public equity (PIPE) deals in which the MLP would raise cash by selling shares of restricted stock to a hedge fund or other institutional investor. Desperate for liquidity at the height of the credit crunch, many of these investors dumped their MLP units to raise cash.
Although some MLPs still rely on credit lines, most have taken advantage of robust investor demand for additional units and ultra-low cost of capital available in the corporate bond market.
For example, Linn Energy LLC (LINE), which formerly relied on PIPE deals and credit lines to finance its growth projects, has replaced these funding sources with 10-year bonds. Unlike credit lines, these bonds don’t have to be rolled over frequently, and they carry fixed rates.
Now the company tends to use its $1.5 billion credit line to fund deals and then repays the balance by issuing new units or selling bonds. As my colleague Roger S. Conrad pointed out in his Seeking Alpha article, "Linn Energy: Fattening the Pockets of Unitholders," Linn Energy has also announced a “continuous equity offering,” under which it will sell $500 million in units over a period of time. This is another easy and relatively inexpensive way for Linn Energy to raise capital without exposing itself to short-term financing risks.
In other words, most MLPs have restructured their finances, reducing their vulnerability in the event of another global credit crunch.
Reading the sensationalist headlines in much of the media, you might think that the EU’s ongoing sovereign-debt crisis had already shut down credit markets. But the TED spread--the three-month LIBOR minus the yield on a three-month Treasury note--continues to hover at levels that are well below those that prevailed in summer 2010, when Greece’s fiscal crisis first sent investors scurrying for the exits. When the TED spread spikes, it shows confidence in the banking system has eroded.
The past few weeks have brought a modest bifurcation in the corporate bond market. Investors have piled into the safest investment-grade names, depressing yields. Meanwhile, high-yield fare has come under modest selling pressure. Consider that the yield on Linn Energy’s 10-year bonds--rated B by Standard & Poor’s--has ticked up to about 7.5 percent in recent weeks. Nevertheless, this is a fraction of the almost 12 percent it paid to borrow money in early 2009.
With access to capital at relatively low costs, most of the MLPs Roger and I track for our advisory service, MLP Profits have no problem funding growth projects that will ultimately lead to higher distributions. The recent sell-off reflects weakness in the broader market; the group’s fundamentals remain intact. Although the stock market’s downdrafts can be terrifying, investors should regard these pullbacks as an opportunity to lock in higher yields in their favorite MLPs.
Disclosure: I am long LINE.