Is It Time To Get Back Into MLPs?

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Includes: EPD, ETE, KMI, MMP, PAA, WMB
by: Thoughtful Investor

Summary

The MLP sector has seen a significant sell-off in the wake of the collapse in oil prices.

Certain sophisticated investors have recently initiated positions in the sector.

Lay investors are encouraged to consider factors such as an MLP's exposure to gathering operations, its access to capital, and management's incentives.

Several commentators have observed that most MLPs have been significantly penalized by the market in the wake of the slide in oil and natural gas prices. Some now suggest that the sell-off is overdone and that it might be time to reinvest in the sector. After all, reputable investors like Berkshire Hathaway, David Tepper and Renaissance Technologies all took positions in the sector in the last quarter of 2015. Potential investors interested in investing in the MLPs that make up the bulk of the Alerian MLP Index should consider the following factors, which are discussed at a high level, before making a decision.

While some of the issues raised might seem discouraging for a potential investor, the foundation for any analysis must be the fact that MLPs do own a lot of infrastructure that is and will be essential for the world's greatest economy to continue functioning as it does. The investor is encouraged to consider the issues discussed below and then think of how they would like to gain exposure to this essential infrastructure. The analysis here largely ignores natural gas prices despite the significant exposure that many MLPs have to natural gas, as the boom and bust in MLPs since the Great Recession has largely tracked the boom and bust in oil prices.

Uncoupling of the Price of Oil and MLPs (Or, the Importance of Geology)

While MLPs generally followed the price of oil down, it does not follow that the sector will rebound with the price of oil. The price of oil will only rise if there is a meaningful decline in production. While demand for oil steadily rises, given the billions of barrels currently in storage around the world, markets are focused on declines in production. Many now point to declining production in the U.S. and cancellations of exploration projects worldwide as factors that bode well for a rebound in oil prices.

Some commentators also note that oil produced from wells in shale plays in the U.S. typically decline at a faster rate than wells producing conventional reserves. Others have observed that while shale wells decline more rapidly, new wells can also be brought online much quicker than certain types of conventional wells (think deep sea or Arctic) in the event of a rebound in prices and that oil produced from these plays is easier to get to market than oil produced in more remote regions.

The issue that an MLP investor needs to wrap his or her head around is how these declines in production and rebound in prices and subsequently in production will play out. Most of the growth in U.S. oil production and the build-up of transportation infrastructure that MLPs subsequently undertook beginning around the time of the Great Recession was tied to the shale plays which aroused the ire and remain the target of the Saudis and other Middle Eastern producers.

Declines in production from these plays which support a rebound in the price of oil will also likely mean that the MLPs which collect a "toll fee" per barrel on their crude oil gathering systems and related crude transportation pipelines will gather and transport fewer barrels. Greg Armstrong, the CEO of Plains All American Pipeline (NYSE:PAA), has noted that "every basin is currently overbuilt or will be overbuilt" because of work already under way. An MLP investor interested in MLPs with exposure to upstream operations must therefore establish a thesis regarding his investment's horizons.

Oil might rebound on a nearer horizon as meaningful production declines occur but many MLPs may not see a corresponding change in their prospects and unit prices on the same horizon. When and how their unit prices recover will depend on a multitude of factors such as the plays and basins to which an MLP is exposed, its competition and its access to capital.

While many MLPs touted the geographic diversification of their gathering and related transporting activities as a plus while raising capital during the boom years, diversification might not be a good thing going forward as those with concentrated (or the ability to concentrate) exposure to acreage with the lowest producing costs will be winners. Given the E&P companies' tendency to obscure how much it costs to actually extract a barrel of oil, the investor has their work cut out for them.

But if an investor can gain exposure to prime producing acreage, they can benefit from smaller drops in production as we go through the trough of this cycle and exposure to presumably stronger E&Ps as operators. The notion that when prices return to higher levels the spigots will be turned back on everywhere (and cause another reduction in the price of oil) must be considered in light of the injuries that will have been done to U.S. E&Ps by bankruptcy and related restrictions on access to cheap capital and rising costs as oilfield service providers ramp their capabilities back up.

Another related factor for the investor to consider is the impact of the marketing activities of certain MLPs on revenues. In the period leading up to the collapse of prices in 2014 and 2015, several MLPs derived a significant portion of their revenues from their marketing activities, which typically included the bulk purchase of oil, gas and natural gas liquids (NGLs) in the hope of realizing margins by sales further downstream. MLPs would buy oil/gas/NGLs (often at a discount in areas with limited takeaway options) and then use their ability to store, process or source oil/gas/NGLs in more cost-effective ways than E&Ps to sell the purchased volumes in end markets for a healthy profit.

As the prices of oil, gas and NGLs collapsed and processing/takeaway infrastructure continued to be built, profits from marketing activities have been greatly reduced. Another factor driving down marketing margins is the large take-or-pays that were premised on growing production from the various producing basins. Another factor to consider is that U.S. E&Ps trying to fulfill onerous ship-or-pay commitments are competing with MLPs to buy barrels in areas of production, which has sometimes resulted in inversions of traditional differentials (e.g., oil being sold in Midland for a premium vs. the price at Cushing).

An investor trying to forecast marketing revenues must negotiate these new developments that were largely absent in the run-up such as the collapse in the price differential between WTI and Brent (a negative factor for U.S. E&Ps and some MLPs as most Gulf coast refineries for the most part run more efficiently while processing grades of oil whose price is linked to Brent) and more takeaway options (a positive factor for the producer but likely not for the MLP transporter).

Impending Bankruptcies of E&Ps

Many industry insiders expect a wave of bankruptcy filings to be made by U.S. E&Ps. As some have already pointed out, these bankruptcies could have a significant impact on an MLP's revenues if an MLP is materially dependent on gathering and transporting oil and gas. Historically gathering contracts were considered to be beyond the reach of bankruptcy courts, but the bankruptcy court reviewing the petition of Sabine Oil & Gas (one of the early filers of bankruptcy) allowed Sabine to reject one of its gathering contracts because of the way in which the contract granted rights to the gatherer. (To summarize, the gatherer wanted to claim that it had a covenant "running with the land," which could not be attacked in bankruptcy court, but the court held it had acquired no such interest because of the wording in the contract.)

While some commentators claim that the wording in the rejected contract is fairly unique, I have spoken to industry insiders who note that the problematic wording or similar constructions are widely used. I point out the risk of contract rejection not to dismiss out of hand MLPs with gathering and other upstream exposure, but rather to present another risk that must be considered. The investor may decide that at current price levels the risk is justified. The investor might also consider that gas is, of necessity, typically much more protected than oil. Gas can only be piped, so rejecting the contract may mean you're shutting in the well and therefore a gas gatherer whose system is hooked up to primarily gas wells has some substantial leverage with even a bankrupt E&P, whereas an oil gatherer does not.

Massive Capital Expenditures by MLPs

The massive and rapid rise in oil production from the shale plays tempted many MLPs to attempt to speedily transform themselves from being staid toll collectors to exciting growth companies building out transportation and other related infrastructure As Plains All American's CEO noted, this has resulted in "every basin" being or about to be overbuilt. The balance sheets of certain MLPs reflect the costs of this construction boom. For instance, if the much-discussed Energy Transfer Equity (NYSE:ETE)-Williams Companies (NYSE:WMB) merger goes through, Energy Transfer Equity will have consolidated long-term debt of over $60 billion (compare with Kinder Morgan (NYSE:KMI) at $42 billion, Exxon Mobil (NYSE:XOM) at $20 billion and Chevron (NYSE:CVX) at $34 billion).

While Energy Transfer and Williams may have pursued growth with fewer reservations than most, MLPs with growth aspirations have generally incurred relatively large debt loads as a matter of necessity, given the pressure to distribute all available cash (often in excess of true earnings) to their partners. Any potential investor must consider what these debt loads mean in a world in which MLP revenues could very well trend downward or sideways in the near term.

Uncooperative Capital Markets

During the years in which U.S. oil production was rapidly rising, MLPs were able to benefit from the ideal set of circumstances in which to raise capital from equity and debt markets. In a time of low interest rates and rapidly rising oil production, equity investors were attracted by distributions that often handily beat returns obtained by other investments and promises of growth in such distributions. Debt investors largely bought the growth narrative as well and loaned funds at reasonable rates. As growth has turned negative, MLPs now face significant challenges raising capital.

The first MLP equity offering of 2016 did not occur until almost the end of the first quarter, when Shell Midstream was able to launch an offering. The issue here is that MLPs, which have traditionally financed all their growth through capital raises and not through retained earnings will have to re-imagine how they finance projects that could increase EBITDA and distributions to unitholders. Many of the solutions that MLPs have turned to recently typically come with a prohibitive cost of capital. Investors are advised to consider MLPs with higher coverage (e.g., Enterprise Products Partners or EPD) that are substantially less dependent upon capital markets and, hence, much better positioned to weather adverse circumstances.

Diverging Incentives of General Partners and Limited Partners

Finally, a factor that most MLP investors do not pay much attention to is that all MLPs have eliminated all fiduciary duties that are typically owed by management and replaced them with narrow contractual and implied requirements that certain actions which impact an MLP must be taken in subjective good faith, which is a very low bar to hurdle. MLP investors were told to look to the incentive distribution rights given to general partners (which are usually owned by management and other larger investors or even publicly traded themselves) as a means by which the interests of general and limited partners were aligned.

In good times, the wide latitude given to general partners did not arouse much concern, but in times of scarcity, limited partners are well-advised to be wary. Management ownership concentrated at the general partner level in conjunction with incentive distribution rights may incentivize (and arguably has incentivized) the payment of distributions at a level that does not benefit the MLP in the long term (see the discussion of the difficulty of funding growth projects in the current environment).

Concluding Thoughts

Investors might be hard-pressed to address some of the issues raised in this article. A large number of MLP investors are retail investors and may be unable to parse financial statements and reserve reports of E&Ps to figure out costs of production and tie them out to the relevant MLPs. Some of the data required is not available to investors (even at the institutional level). Investors are better served by picking their points of entry when purchasing MLPs such as Magellan Midstream Partners (NYSE:MMP) and Enterprise Products Partners (NYSE:EPD), which have relatively low exposure to the negative factors outlined above.

Neither of these MLPs has a general partner with incentive distribution rights and both earn enough to pay the distributions they make and retain a higher proportion of the cash they earn. While MMP derives most of its income from transporting refined products like gasoline, diesel and jet fuel and providing storage for these products, EPD has more exposure to gathering (primarily gas, but also some crude). On certain occasions over the last few months, both MMP and EPD have sold off at the same rate as MLPs that have high exposure to negative factors. Common sense indicates that at those moments, the market is mispricing the assets represented and could represent a good entry point if an investor has developed an investment thesis.

A Note on Natural Gas

I chose not to focus on the price of gas as oil production in the U.S. has begun to decline from its highs, whereas natural gas production in the U.S. continues what seems to be a relentless march upward. An MLP investor should also note that while natural gas prices have continued their trend downward in the U.S. over the last few years, they have seen a collapse internationally over the same time frame. And that puts the business model for the LNG export projects undertaken by certain MLPs at risk. A counterpoint to the negative impact of the decrease in natural gas prices is the increase in utilities switching from coal to natural gas.

Disclosure: I am/we are long AMLP, AMJ, PAGP, EPD, MMP.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.