Compelling Bear Market Potential From High Yield MLPs

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Includes: APLP, CEQP, EEP, MEP, NGL, NGLS, SXCP, TLP, TRGP
by: Tim Plaehn

Summary

MLP yields above 20% to as high as 40% indicate market expectations of deep distribution reductions.

These companies are taking steps to support current distribution levels, and starting to state that distributions will not be cut.

Even if a few cuts do happen, a handful of these high-yield MLPs could generate 100% plus total returns as a group over the next few years.

The energy sector bear market caused by the steep declines in energy commodity prices has produced truly ugly results in the share and unit values across the energy spectrum, from upstream, through midstream, and including downstream. One result of the massive sell-off is an extensive list of MLPs with very, very high current yields. As I write this, one-fourth of the MLP space is yielding over 20% and two-thirds yield over 10%. These yields indicate that one or two beliefs from the market:

1. That there will be massive distribution cuts across a large portion of the MLP space.

or

2. Investors have decided that they don't like the price volatility and will accept any value just to get out of these investments.

I think lately it's been more number 2 vs. number 1. As I just read in an interview with an MLP focused fund manager, "Predicting irrational behavior is a fundamentally flawed exercise." It seems likely that many/most/a majority of the midstream MLPs that are now priced to yield over 20% will be able to maintain or even grow their distribution rates. These companies still have business that are primarily fee based and not dependent on energy commodity prices.

These level of potential irrational prices provide the opportunity for tremendous total returns from current MLP unit values. Those returns depend on what yield is reasonable in a normalized market for a tax-advantaged higher yielding investment with stable revenues and free cash flows. It wasn't too long ago (early 2015) when those yields were 8%, 10% or lower, depending on distribution growth outlooks. If we expect MLP yields to drop out of the 20%'s and back to single digits, the math indicates unit value gains measured in multiples of the current levels. Consider the hypothetical MLP that now yields 25%. To get back to 10%, the unit price must increase by 250%. If it takes a couple of years to get back to a 10% yield, the distributions earned will chip in another 50%. If this isn't the end of the world for midstream MLPs, the future is very bright for investors who get in now.

At this point picking winners and losers may be no more than a crap shoot (kind of like guessing). However, if you invest in say, six high yield MLPs, four could go bankrupt and if two generate 300% total returns you still end up at near break even. More likely than the worst individual MLP outcome bankruptcy would be a steep distribution cut until energy prices recover or an smaller MLP gets acquired at a higher than current value (but possibly much lower than if you bought units in 2014). Any outcome where at least two out of six MLPs can get back to normal yields will produce a nicely positive return. If more than two can sustain distributions, you will look like an investing genius a few years down the road. Here are six MLPs with current very high yields and business operations that have decent potential to survive the current energy sector scare.

Crestwood Equity Partners LP (NYSE:CEQP) currently yields 41%. CEQP owns a diversified portfolio of midstream assets, ranging from North Dakota crude gathering and railcar loading to East Coast natural gas pipelines and storage. In 2015 Crestwood merged the separate operational and GP MLPs. In December, the controlling firm of the general partner announced a $100 million purchase plan for CEQP units. From the press release:

"The current market environment has created a large disconnect between CEQP's market value and the fundamental value of our diversified portfolio of strong cash flow producing assets," said Robert G. Phillips, Chairman, President and Chief Executive Officer of Crestwood's general partner. "We remain steadfast and confident in Crestwood's ability to navigate through this downturn in the energy industry and we believe in the long-term growth potential of our assets."

SunCoke Energy Partners LP (NYSE:SXCP) yields 35%. This company operates in the despised coal industry, producing coke for the steel industry and providing coal logistics services. SunCoke definitely faces challenges in its sector. In response, management has stated it will hold the distribution level in 2016 (distributions grew by 13% in 2016). EBITDA is being guided to 11% growth in 2016 and excess cash flow will go to pay down debt.

Targa Resources Partners LP (NYSE:NGLS) currently yields 26%. This MLP will be rolled into its general partner, Targa Resources Corp (NYSE:TRGP) in the first half of 2016. NGLS unit holders are scheduled to receive 0.62 TRGP shares per unit. Targa Resources Corp yields 18%. With the cost savings from the merger, the company expects 10% annual dividend growth through 2018.

Archrock Partners LP (NASDAQ:APLP), formerly called Exterran Partners, LP, yields 25%. The company is the largest independent provider of gas compression services. Compression is required at the well, into and along pipelines, at processing plants, and at storage facilities. Growth prospects for APLP come from taking over compression duties from gas producers, processors or storage companies. According to management, compression services revenue has remained steady through the full range of energy commodity prices. In 2015 DCF coverage remained well above one times, at 1.3 times the distributions paid.

NGL Energy Partners LP (NYSE:NGL) yields 24%. The company provides retail propane sales, natural gas liquids processing and storage, and is building a crude oil pipeline. Earlier this month, NGL Energy Partners sold its GP interest in TransMontaigne Partners (NYSE:TLP) for $350 million. That works out to 40 times the cash flow the interest was producing for NGL. The $350 million covers planed growth spending for the next year, and management has stated the distribution will remain at the same rate through at least 2016.

Midcoast Energy Partners LP (NYSE:MEP) yields 21%. This natural gas gathering and transport MLP was spun off by Enbridge Energy Partners LP (NYSE:EEP) in late 2013. Enbridge Energy Partners has repeatedly indicated its willingness to support MEP's growth plans. EEP continues to own assets that can be transferred to Midcoast at attractive values to support both the current distributions and future payout growth.

I am an optimist and expect all of these to produce very attractive returns from here as energy prices stabilize and recover. But as I noted earlier, you just need three or four to get through this market without reducing distributions and you will generate a very attractive total return on an investment spread over the six MLPs.

Disclosure: I am/we are long TRGP, AROC.

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.