M&A Heats Up In Energy MLPs

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 |  Includes: EPB, KMI, KMP
by: Kent Moors

Kinder Morgan Energy Partners LP's (NYSE:KMP) recent announcement that it was acquiring El Paso Corp. (EP) is shaking up the pipeline picture. The $38 billion deal involves cash, stock, and warrants (with KMP also absorbing about $17 billion in EP debt). It will create the largest pipeline holding in the country, the fourth-largest company in the U.S., and by far the largest midstream service company.

It is this last factor that will have the biggest impact – for two reasons. First, the merger puts renewed focus on other similar actions among midstreams. These are the companies that connect producing fields (upstream) with refineries, distribution, and retail sales (downstream). Midstream services include gathering, initial processing, feeder pipelines, transport (certainly by larger intrastate and interstate pipelines, but also by tanker and barge), terminals, and storage.

Storage, as I have noted on several occasions, is especially important in this era of surplus production in natural gas and excess crude oil volume sitting in Cushing, Oklahoma (where the daily West Texas Intermediate benchmark price is determined for NYMEX trade).

You see, midstream companies that control storage (which usually includes a large percentage of available pipeline capacity, as well as underground stockpiling sites) generate revenue whether product is moving or sitting put. However, there is another element in this transaction that may be even more important and, in the process, may telegraph where we should expect to see the sector move with further M&A action.

What M&A Means for the MLP Sector

This newly announced merger brings together two Master Limited Partnerships. MLPs are designed to move all profits to the partners, avoiding corporate taxes altogether. They act the same way an "S" corporation does for individual taxpayers. When an MLP decides to spin off an equity issue, the portion of profits reflected by the stock must be passed through to the shareowners.

That means an MLP equity issue provides genuine potential for both price appreciation and a dividend well above market averages. Among the EP assets included in the merger is El Paso Pipeline Partners LP (NYSE:EPB), which controls primarily interstate regulated pipelines (and provides a nice complement to KMP assets). All told, the new $94 billion giant will control more than 80,000 miles of pipeline.

Typically, the initial announcement results in the acquiring company's share price declining and the acquired company's share price moving up. That's why traders' reactions to this mega-announcement were most unusual.

In this case, both were up strongly at the open of trade today, in an otherwise downward-trending market session.

The KMP-EP announcement will be followed by others, as the sector increases consolidation. That will only improve the opportunities for the individual investor.

Prospects Improve for Two (Very Desirable) Results

I have been advancing a range of MLP plays for my Energy Advantage subscribers for some time now. That's because, with each of these moves, prospects improve for two very desirable results. First, the new consolidated entity will garner a greater percentage of the midstream market, resulting in expected increases in revenues and a pop in the share price. Second, the dividend of the new company will increase, too.

Currently, KMP offers an annualized dividend of 6.4%, and EPB is at 5.1%. While these are certainly much better than market averages, they are well below several dozen MLP equity issues that are part of my tracking and trigger lists. Those currently offer yields between 9% and 12% (one is even approaching 21%).

Remember, MLPs have no choice but to boost dividends as their profits rise. Their legal structure requires it.The only wrinkle in all of this is the possibility of a decision out of Washington to eliminate the tax break and apply corporate levies on MLPs.

But if you ask me, this won't happen any time soon. To make such a move, Congress would also need to end the "S" corporation option for individuals. There are hundreds of MLPs, but there are millions of S corporations. The S approach is the fastest growing segment of small business. The Beltway crew could not end the tax advantage without shooting any budding economic recovery in the foot. In other words, it seems the MLP is here to stay -- and MLP investors should prepare for significant upside potential.

Disclosure: None

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