What The Market Is Telling Us About MLP Valuations

by: Roger S. Conrad

Every bull market eventually comes to an end. The catalysts pushing profits, dividends and share prices higher ultimately dissipate. Equity valuations become so high that the expectations built into them become almost impossible to achieve.

Finally, the air goes out of the balloon. Growth slows to a crawl or shifts into reverse. Share prices start to come down slowly. Then, the selloff accelerates as investors lose heart and bail out. Expectations eventually go so low that it’s nearly impossible for companies not to beat them. At this point, the cycle begins anew on the upside.

The current bull market for master limited partnerships (MLPs) eventually will end. Investors’ expectations will ratchet up to levels where almost any news is a disappointment. The massive deficit in energy infrastructure will become a surplus as MLPs overbuild to meet anticipated demand, rather than inking contracts with customers beforehand.

Prospective returns on new projects will fall as capacity becomes cheap, even as capital costs rise and squeeze profits. Distribution growth will slow to a crawl, and some MLPs will slash their payouts. Finally, share prices will head lower. The bull will at last be broken.

Today, however, is not that day. New MLP debt and equity offerings have become slightly scarcer in recent months because of the prevailing uncertainty and volatility in stock and credit markets. But the bull market for MLPs remains intact: Valuations remain reasonable, capital is readily available at historically low rates, and low-risk expansion opportunities abound to support rapidly growing production from US unconventional oil and gas plays.

Enterprise Products Partners LP’s (NYSE: EPD) 57-year debt still trades at a yield to maturity of just 6.24 percent. The MLP’s five-year debt also has a yield to maturity of only 2.28 percent, though its credit rating of BBB- is barely investment grade. Linn Energy LLC’s (NSDQ: LINE) B credit rating places the oil and gas producer firmly in the junk category. But Linn Energy’s 10-year debt sports a yield to maturity of only 6.73 percent.

As for equity valuations, the Alerian MLP Index has been on a tear since Oct. 4, 2011, when it briefly touched a low of 316.35. The benchmark index has rallied almost 20 percent in subsequent weeks, clawing its way back to its early July high. This resurgence should encourage MLPs to finance growth by issuing new units, even as the window to issue debt is wide open.

In a recent issue of our advisory service, MLP Profits, my colleague, Elliott Gue, highlighted MLPs’ acquisitions of major pipeline companies--deals that would have been out of the question just a few years ago. A number of prime takeover targets are still unspoken for, including Williams Companies (NYSE: WMB), which only a few weeks ago was bidding against Energy Transfer Equity LP (NYSE: ETE) for the right to buy Southern Union (NYSE: SUG) and its portfolio of midstream gas infrastructure.

Southern Union has set Dec. 9, 2011, as the meeting date for shareholders to vote on the proposed takeover. The deal got a further boost this month from yet another transaction: AmeriGas Partners LP’s (NYSE: APU) $2.9 billion purchase of Energy Transfer Partners LP’s (NYSE: ETP) propane operations. The drop down of a $2 billion, 50 percent interest in a giant Florida pipeline from Energy Transfer Equity to Energy Transfer Partners is a critical piece of the general partner’s financing to buy Southern Union.

There had been questions about Energy Transfer Partners’ ability to finance drop-down transactions of Southern Union’s assets from Energy Transfer Equity because of the MLP’s sizable investments in natural gas liquids (NGL)-related infrastructure with Regency Energy Partners LP (NYSE: RGP).

The sale of Energy Transfer Partners’ propane business solves this problem by providing $1.5 billion in cash and a 34 percent equity stake in AmeriGas Partners. The deal also makes sense for AmeriGas Partners. Not only will the new assets increase the scale and reach of AmeriGas Partners’ propane-related infrastructure by about 60 percent, but the MLP also gains a financially sound limited partner in Energy Transfer Partners.

I expect more MLPs to step up to the plate and buy whole companies in coming months. Meanwhile, there’s no shortage of smaller deals in the works. The pace of new projects also shows no sign of slacking. Enterprise Products Partners, for example, this month announced plans to further expand its NGL assets. Energy Transfer Partners also inked a long-term, fee-based agreement to build a 117-mile gas gathering pipeline and to provide related services for ExxonMobil Corp (NYSE: XOM) unit XTO Energy. The MLP will also build a major processing plant.

XTO Energy is seeking to improve its access to midstream infrastructure to process and transport the natural gas and NGLs produced from its extensive reserves in the Haynesville Shale and other unconventional plays. Energy companies throughout North America face similar needs; the rapid development of shale oil and gas plays requires an extensive build-out of supporting infrastructure.

MLP investments are well-positioned to take advantage of this secular growth trend. All this construction adds up to higher distributions and, ultimately, higher unit prices.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.