MLP-specific factors have taken a backseat in recent weeks to the latest news from Europe.
In this environment, few investors are thinking about the latest initial public offerings (IPO). However, ignoring this market is a huge mistake. You don’t need to be one of the lucky insiders to receive units before the MLP trades on a public exchange; some MLP IPOs are outstanding buys long after they go public.
Partnerships often grow their distributions rapidly in their first two years as a public company.
I gave two examples in my April 2011 InvestingDaily.com article, MLP IPOs: Big Income from New Stocks. The first example I mentioned was Williams Partners LP (NYSE: WPZ), which in its first two years as a publicly traded partnership boosted its quarterly payout to $0.575 per unit from $0.35 per unit. This growth was fueled by a series of asset drop-downs from its general partner, Williams Companies (NYSE: WMB). These deals helped the stock soar 80 percent from the close on its first full day of trading.
The second example, Sunoco Logistics Partners LP (NYSE: SXL) enjoyed a similar pop. The refined products pipeline giant increased its payout 23 percent in its first eight quarters as a public company, and the stock gained 100 percent. There’s nothing like rapid distribution growth to attract investors’ attention.
Investing in MLP IPOs can be lucrative, but selectivity is critical to distinguishing the winners from the losers. Some new MLPs boast solid assets and a workable strategy to grow their distributions; others go public so their sponsors can exit their position and turn a profit. Understanding the difference between solid and questionable MLP IPOs requires taking a close look at the firm’s underlying assets and growth prospects.
One recent IPO that caught my eye has been the Oiltanking Partners LP (NYSE: OILT) IPO. Let’s take a look why.
Oiltanking Partners LP owns two major oil and refined products terminals, one in the Houston Ship Channel and the other in Beaumont, Texas.
Oil and refined products terminals generate steady, fee-based revenues. In Oiltanking Partners' case, about 75 percent of its cash flows are locked in under-capacity reservation deals. In a capacity reservation agreement, a major oil or natural gas company such as ExxonMobil Corp (NYSE: XOM) pays Oiltanking Partners for guaranteed access to storage capacity--regardless of whether the customer uses the facility. The average remaining duration of Oiltanking Partners’ contracts is a little more than six years.
The remaining 25 percent of the MLP’s cash flow can fluctuate slightly based on the volumes of oil and refined products stored at its facilities. About 20 percent of the firm’s cash flow comes from throughput fees Oiltanking Partners receives to accept delivery of a certain volume of crude oil on behalf of a customer. Ancillary services such as fuel blending account for the remaining 5 percent of the firm’s cash flow. None of these fees directly relates to the price of the commodities Oiltanking Partners transports and stores.
When demand for oil and refined products falls, demand for ancillary services and throughput might decline. But even during severe recessions, the volume of oil and refined products moving through the Gulf Coast refining network historically has deteriorated only modestly. Bottom line: Oiltanking Partners is a low-risk MLP.
But just because Oiltanking Partners’ cash flows are steady and primarily fee-based doesn’t mean the MLP lacks growth opportunities. The firm has two major avenues for growth: adding tanks and storage capacity at its existing terminals and the potential for drop-down transactions from its parent and general partner (GP), Marquard & Bahls AG.
The MLP’s Houston terminal has total capacity of 12.1 million barrels, but Oiltanking Partners has leased additional acres adjacent to the facility through 2035. In total, the firm has identified the potential to add 7 million barrels of storage capacity to its facilities--provided that it can obtain long-term capacity reservation contracts from its customers. Building new assets based on demand rather than speculation is part and parcel of an MLP’s success.
The firm also owns a sizable tract of unused land near its 5.7 million-barrel Beaumont storage facility. This acreage could house another 20 million barrels of storage capacity. Management plans to add as much as 5.4 million barrels of capacity, demand permitting. These contracts should be an easy sell in the heart of the Texas Gulf Coast, a region that’s home to a large number of refineries, pipeline hubs, gas processing plants and import-export terminals.
With new pipelines scheduled to bring additional oil volumes from the West Texas Permian Basin, oil sands of Canada, Eagle Ford Shale in south Texas and the Bakken Shale of Montana and North Dakota, these storage deals should be an easy sell. Rapidly increasing oil production from these unconventional plays will necessitate a commensurate investment in infrastructure to transport and store these liquids. Oiltanking Partners is well-placed to benefit from this trend.
Drop-down transactions are a well-established and low-risk growth opportunity for MLPs. In a drop-down deal, the GP sells assets to the MLP at prices that allow the MLP to immediately increase its payout to unitholders. The best drop-down growth stories are MLPs with GPs that are well-established in the energy business and have an inventory of attractive assets. Marquard & Bahls is a privately held German energy company with terminal and storage assets in 22 countries worldwide. Marquard & Bahls’ stateside assets include terminals in Texas City and Port Neches, Texas, and Joliet, Ill. All of these assets could be candidates for drop-down transactions. In addition, the parent also owns dry-bulk handling terminals that could fit into the MLP structure. Since Marquard & Bahls regards Oiltanking Partners as a growth vehicle, I would expect a stream of drop-dawn deals.
The GP owns the incentive distribution rights (IDR) of the MLP, meaning that it receives a fee for managing the LP. For those unfamiliar with IDRs and how they’re calculated, I offered a detailed primer in the Nov. 20, 2009, article, Faster Growing Income. Because IDRs are based on the distributions paid to common unitholders of Oiltanking Partners, the GP has a built-in incentive to increase the limited partner’s payouts over time. In addition, Marquard has retained a 73 percent ownership stake in the MLP, providing an additional incentive to pursue growth strategies that would boost the distribution.
Oiltanking Partners went public in mid-July, so the company has yet to pay quarterly distribution; brokers’ websites and Yahoo Finance indicate that the stock yields zero percent. Even after the MLP dispenses its first quarterly payout, most financial websites will persist in listing the incorrect yield until after the firm has paid four quarterly distributions.
In the MLP’s registration statement with the Securities and Exchange Commission, management indicated that the MLP plans to pay a minimum distribution of $0.3375 per quarter, or $1.35 per year. The third-quarter 2011 distribution will likely be prorated because the stock hasn’t been public for an entire quarter. Nonetheless, at current prices, an annualized payout of $1.35 per unit equates to a yield of about 5.5 percent. Although that’s below-average for many MLPs, Oiltanking Partners’ low-risk, fee-based cash flow and significant growth potential justify a lower yield.
The IDRs paid to the GP begin to increase once quarterly distributions top $0.38813 per unit and again $0.42188 per unit. I would expect Oiltanking Partners to boosts its payout to $0.38813 per unit over the next 12 months.