Pipeline MLPs: A Hedge Against Market Downturn

Even though valuations and stock price appreciation have gone up exponentially for oil and gas stocks over the past several years, we remain optimistic that more upside is out there. We recently sat down with Zacks senior oil and gas industry analyst Sheraz Mian to get his take on one of the specific groups within the general sector.

What’s your take on the vitality of the oil and gas pipeline companies, considering all the recent success in this sector as a whole?

This is a fairly specialized group within the broader oil and gas sector – industry players that own and operate the country’s oil and natural gas pipelines, storage tanks, and terminals. These are hard assets that generate steady fee-based earnings and cash flows. As such, the group’s results are not directly tied to commodity prices and can be viewed as defensive plays.

Just as a brief background on the group, you may recall a number of industry players ventured into other areas in search of growth during the late 1990's. These forays into unrelated businesses stretched their balance sheets and dragged them down when the economy went south.

However, not everyone in this space succumbed to the lure of asset-light business models (Enron was fond of touting its asset-light business model); quite a few remained focused on their core businesses and shielded their shareholders from a lot of pain. The first group includes those who diversified and are now restructuring their way back to the core business, and the second group, those who remained committed to the energy transportation and infrastructure business and enjoy strong financial health.

Those that restructured include high-fliers of the recent past, such as El Paso (EP) and Dynegy (DYN), while the latter group includes names such as Kinder Morgan (KMI). In addition to these two groups, there is a third group in this space that we find more interesting and attractive. Securities in this group have a unique corporate structure called a master limited partnership [MLP] that exhibits hybrid financial features (fixed income as well as equity).

How did these MLPs come about?

Most of these partnerships have been created by companies in the oil and gas industry, as this structure enabled them to monetize cash flow-generating infrastructure assets on a tax-efficient basis. These partnerships have stable and predictable cash flow, as their income depends primarily on the volume of products transported, not on the current price of oil.

Ownership interests in the partnership are divided into publicly traded units, which are comparable to shares in other publicly traded companies. These partnerships offer potential tax advantages, as a portion of the payouts, termed "distributions," can be tax-deferred.

Do these companies provide good dividend yields, as well?

Yes, MLPs are yield plays. A good way to think of MLPs is like a hybrid of equity and fixed income. So, an MLP will have features that are similar to common stocks, but it behaves a lot like bonds.

Yields of publicly traded pipeline MLPs tend to track the yield of the 10-year Treasury bond, with the spread between the MLP yield and the Treasury yield averaging roughly 300 basis points over the last ten years. More specifically, the MLP pipeline group's yield spread has averaged closer to 200 basis points, while the MLP propane group's spread has been closer to 400 basis points.

Are these MLPs good investments during economic downturns, generally?

Partnership units tend to trade inversely with interest rates such as fixed-income instruments. But unlike bonds, MLP units, which already offer tax advantages, may be used to hedge against inflation through distribution growth.

Over the last few years, publicly traded pipeline partnerships have significantly outperformed the broader market indexes. We believe that the favorable acquisition and growth environment that has prevailed during this time period is the primary catalyst for this performance. This supportive environment is characterized by divestitures of non-core assets by major oil companies and troubled merchant energy companies, and by a more favorable funding environment.

With that said, what is your outlook for this group?

We believe that there are three critical factors that will impact MLP performance over the next 12 months. On the negative side are restricted access to capital in the wake of the sub-prime credit crisis and fears of an economic slowdown/recession. Since MLPs give out substantially all of their cash to unit holders, they depend entirely on outside financing for growth initiatives. As such, maintaining steady distribution growth in the face of unsettled markets will be a challenge for the group.

Offsetting these negatives is the increase in funds flowing into MLPs. Several closed-end funds have emerged to invest in MLPs, and more importantly, legislative changes in the last few years have enabled MLP distributions to be classified as qualifying income; therefore, allowing institutional buyers and mutual funds to invest in this asset class. Ultimately, we believe the likelihood of continued distribution growth, for the quality names, along with the increased interest for these assets will offset the challenges facing the group.

What are some of your most recent Buys among pipeline MLPs?

Calgary-based TC Pipelines (TCLP) posted strong fourth-quarter 2007 results, driven by increased Tuscarora and Great Lakes contributions. Importantly, the partnership acquired the remaining 2% GP interest in Tuscarora during the quarter, raising its ownership interest to 100%.

Additionally, TCLP raised its quarterly distribution by 11% year over year to the annualized rate of $2.66 per unit. We continue to believe that the partnership’s much-improved distribution-growth prospects, stemming largely from the roughly $1.5 billion worth of acquisitions completed in the recent past, are not reflected in its discounted valuation relative to the peer group.

Elsewhere, we are reiterating our Buy recommendation, earnings estimates, and price objective for Williams Companies (WMB) shares. The company remains well positioned to capitalize on attractive growth opportunities in its low-risk E&P [exploration and production] business and also enjoys strong leverage to continued strength in natural gas liquids margins in its Midstream business.

Production is expected to grow at double-digit rates this year, after increasing 15% last year. Also, the recent creation of a pipeline MLP and a $1 billion buyback program are some important catalysts for future growth.

Finally, we are maintaining our Buy rating on the Enterprise Products Partners (EPD) stocks to reflect the partnership’s attractive distribution growth prospects on the back of a strong inventory of organic growth projects. The partnership raised its fourth-quarter distribution by approximately 7% to an annualized run rate of $2.00 per unit, representing the 14th successive increase. We continue to view Enterprise as a core MLP holding due to its diversified asset base, strong distribution-growth prospects and attractive valuation.

Sheraz Mian is a senior analyst covering the oil and gas sector for Zacks Equity Research.

Comments

[Loneflycaster:]

"Production is expected to grow at double-digit rates this year, after increasing 15% last year. Also, the recent creation of a pipeline MLP and a $1 billion buyback program are some important catalysts for future growth."

I am mystified by your reference to a new MLP. TCLP is an MLP already. Are you referring to the new LLC, Bison Pipeline LLC?

Also I have not seen any reference to a buy-back program in the time I have owned the units. Is this old news?

Why do a buy-back when increasing the distribution will accomplish the same thing, i.e., increase the yield and thereby increase the value of the MLP units?

2008 Apr 09 06:34 PM

[Dan Jacome:]

WMB just hit a 52 week high -- nice call.

2008 May 18 06:49 PM