By The Valuentum Team
The energy complex continues to feel the pain of lower energy prices. Two downgrades by Moody's may foreshadow the avalanche to come.
West Texas crude oil prices (NYSEARCA:USO) recently broke through $30 per barrel to the downside for the first time since 2003. Share prices of those in the energy complex (NYSEARCA:XLE) continue to reel, and we maintain our view that the tremendous fallout in energy master limited partnerships (NYSEARCA:AMLP) may not be over. From our perspective, the MLP business model may not survive in its present state, as equity markets continue to "wise up" to the artificial equity pricing paradigm that has centered on the group's financially-engineered payouts. Without an artificial pricing paradigm to "prop up" their equity prices, for example, the incentive to perpetuate such a business model is substantially reduced. Distribution cuts would then inevitably ensue as a recirculation of capital from the equity and debt markets into unitholder pockets would make little sense, bear little fruit.
For those that are new to the terminology, a financially-engineered distribution/dividend is one that is supported by the financing section of the cash flow statement (debt and equity issuance), not via traditional free cash flow generation, as measured by cash flow from operations less all capital spending, or earnings. We maintain our view that the MLP industry's definition of "cash flow" is severely imbalanced in that it accounts for incremental net income driven by growth capital spending, but does not deduct the growth capital spending within the calculation itself. Valuentum continues to encourage executive teams to disclose non-GAAP free cash flow, as measured by cash flow from operations less all capital spending, so investors can better ascertain the severe capital market dependency of the MLP business model.
Perhaps surprising to many that are beholden to a recency bias calling for a return to $100+ per-barrel crude oil prices, crude oil prices today (~$30 per barrel) remain at the high end of the long-term inflation-adjusted range ($10-$35 per barrel) spanning a period of 100 years from 1870-1970. Commercial inventories of crude oil in the US continue to reside at 80+ year highs for this time of year, and OPEC continues to produce with intentions to retain/grow market share (not support the price). Geopolitical risk, which traditionally has added a speculative premium to energy resource pricing, is now acting to the contrary. For one, tensions between Saudi Arabia and Iran are expected to result in even more "overproduction" as the former seeks to put incremental economic pressure on its Middle East rival, perhaps now even more so than US independents.
From our perspective, a not-so-virtuous cycle has taken hold, and absent an unprecedented level of defaults in the upstream arena in the US (a terrible situation), nothing will stop energy resource pricing from heading lower still. Continued lower energy resource pricing would then only force US independents to produce more to sustain cash flows in hopes to keep credit lines open and creditors at bay, moves that would only further exacerbate the energy resource oversupply situation. Sadly, even if US independents wanted to cut production to levels to appease OPEC, they may not be able to do so without committing "economic suicide." The credit rating agencies are expecting a surge in defaults across the energy arena in coming years. Existing equity holders of the most leveraged entities may end up with nothing.
What's worse, collapses in local Chinese equity markets (FXI) have only increased concerns about emerging market demand for energy resources, and the very probable prospect of $20 per barrel crude oil may become reality before this year is up. Energy bulls seem to forget that it was as recent as 1998 that crude oil prices averaged just $12 (twelve) per barrel. Given current supply/demand conditions, there's nothing to say the energy complex can't revisit those levels and even stay there for some time. The risk, from our perspective, is still to the downside, both with respect to energy resource pricing and the equities across the energy arena themselves. In many cases, we believe Exxon Mobil (NYSE:XOM) may be the only true "safehaven" across the energy complex. Its integrated business model and AAA credit rating speaks to tremendous flexibility, and it may be sitting back waiting to scoop up depressed assets at the right price. Over the past few years, we've removed both Chevron (NYSE:CVX) and ConocoPhillips (NYSE:COP) from the Dividend Growth Newsletter portfolio.
As we had expected, Moody's downgraded the credit outlook of Energy Transfer Equity (NYSE:ETE) to stable from positive late last week, and we're not sure how creditors continue to sit by and allow the payment of massive dividends and distributions to unitholders as credit metrics within the ETE portfolio deteriorate. We continue to believe investors should evaluate Energy Transfer Equity's consolidated financial statements to assess holistic counterparty (related party) risk associated with its umbrella of master limited partnerships. ETE has severe financial leverage, is burning through free cash flow in an unprecedented fashion, and yet is still paying out distributions to unitholders.
Also, last week, Moody's lowered the credit rating of ETE proforma subsidiary Williams Partners (NYSE:WPZ) to Baa3 (negative), noting that WPZ is "exposed to a high level of customer concentration with Chesapeake Energy (NYSE:CHK)." (We note that Plains All American (NYSE:PAA) is also heavily dependent on Chesapeake's financial health.) In the past, ETE management has pointed to confidentiality agreements to prevent disclosures of its customers, at least to us, and we applaud Moody's for emphasizing WPZ's severe customer concentration risk to help investors better assess the likelihood of a fallout should upstream entities fail; of note, WPZ accounts for a significant portion of ETE's pro forma cash flow.Midstream equities are levered to energy resource pricing, if not directly, then through their customer base.
According to ETE's December 7-8 presentation at Wells Fargo (page 15), for example, WPZ is expected to contribute more than half of the proforma cash flow to ETE in 2015 and about half of it in 2016. If Chesapeake folds, which it might, the timing perhaps the only degree of uncertainty, contracts will be renegotiated under Chapter 11. Even if it does not fold, we would expect Chesapeake management to look for cost savings in order to stay afloat for as long as it can to preserve some equity value for shareholders (option value). No matter how one looks at it, however, the outlook for WPZ is meek in light of its weakening customer credit profile, and we can't help but emphasize that what's not good for one soon-to-be subsidiary is not be good for another, Energy Transfer Partners (NYSE:ETP).
We expect ETE to support its subsidiaries in the event of hardship, though we fail to see how it might do so when ETE itself is at least more than 6.25x leveraged (on the basis of our calculations) and is burning through billions of free cash flow as it bleeds more from distributions. Operating income at ETE and ETP has fallen considerably, to the tune of 20%-30% during the third quarter of the year, and acquisitions aren't "hiding" core organic deterioration even if they pad EBITDA via "purchased," acquisition-related depreciation. Frankly, we're not sure what ETE management should or can do (it might not be able to do much). ETE is a massively leveraged entity that is burning through free cash flow and experiencing sharp drops in operating earnings as it takes on severe customer concentration risk from one of the weakest upstream players in anyone's coverage universe, all the while it keeps its payout to unitholders.
Of considerable note, the downgrade of WPZ may be the beginning of more credit downgrades across ETE's portfolio, namely ETP. Operating income at ETP fell to $576 million from $810 million in the third quarter of 2015, a whopping decline of nearly 30%, a huge fall for a company that is supposedly not levered to a declining energy resource pricing environment. Long-term debt of $27.5 billion is materially greater than the firm's ~$860 million cash balance at the end of the third quarter, and free cash flow, consisting of $2 billion less capital expenditures of $6.5 billion, of -$4.5 billion (negative) through the first nine months of the year is simply frightening. Distributions to partners and distributions to non-controlling interest stood at $2.5 billion through the first nine months of the year, resulting in a $7 billion cash outflow for the trailing nine-month period. There is absolutely no way, in our view, that ETP is an investment-grade entity.
We believe many continue to hold onto the belief that the MLP business model is sustainable, but the jig is up, in our view. The only path to recovery that we see is one in which energy resource pricing surges, but that scenario has long odds, at least at the moment. We do not hold any MLPs in the newsletter portfolios.
Disclaimer: This article or report and any links within are for information purposes only and should not be considered a solicitation to buy or sell any security. Valuentum is not responsible for any errors or omissions or for results obtained from the use of this article and accepts no liability for how readers may choose to utilize the content. Assumptions, opinions, and estimates are based on our judgment as of the date of the article and are subject to change without notice.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.