Source: George S. Mack of The Energy Report (7/26/12)
Fossil fuels have to be transported and stored. This is the classic midstream industry that resides between the producers and the marketers and that generally makes money regardless of the price of oil, natural gas or natural gas liquids (NGLs). Now with the boom in production coming from unconventional oil and gas shales and the enhanced technologies that produce fuels in areas where it was once impossible, the demand for midstream oil and gas infrastructure is growing. In this exclusive interview with The Energy Report Morgan Stanley Managing Director and Master Limited Partnership (NYSE:MLP) Analyst Stephen Marsesca makes his case for a handful of MLP and common stocks that will generate increasing cash flow and dividend payouts.
The Energy Report: In your last interview, you told The Energy Report it was a good time to be involved in midstream plays. What about now?
Stephen Maresca: It's still a good time to be involved in midstream stocks. A lot of unconventional oil and gas shale plays are increasing production and require new infrastructure to bring their supply to market. The growth outlook is still as strong as it was a year ago, even though recent commodity price weakness has created some investor concern.
We are now adding duration to this growth story: Midstream companies are adding projects not for just this year, but as far as three years out. When those projects are completed, they will add incremental cash flows for these companies. Over the next few years, we estimate about $60 billion ($60B) in growth capital is going to be spent among our companies under coverage, and we believe a lot of that has been derisked. Many new projects are coming on line with volume commitments from producers and many of these long-term contracts are not tied to commodity prices. It is becoming a more visible story.
TER: The midstream industry seems very unusual given current market conditions.
SM: That is largely because the energy landscape has improved so much over the past five years, with advancements in oil and gas technology, horizontal drilling and lower drilling costs. The technological improvements have really been a game changer for the energy industry, and that is why this story is so visible. There have been remarkable supply shifts and production growth from areas that did not previously have infrastructure or end-demand markets. For example, the oil being found up in North Dakota needs to be moved out into end markets where it can be used by refiners (like the Gulf Coast or Northeast). This is where the midstream companies play a critical role in building the interconnects to bring the new oil supply to end-use markets.
Specifically, we think the midstream group of MLPs is attractive on a value basis with yields where they are now. The median yield in our coverage universe is currently 6.5%, and we think distribution growth over the next couple of years is likely to be 7% on average. Year-to-date MLP stocks have experienced modest share appreciation, about 1%, but with where things stand right now we see average potential total stock returns at 13-14% for the group.
TER: If you could put your theme in a nutshell, how would you describe it?
SM: Building critical North American energy highways. This is an organic building story. This type of opportunity did not exist before because we did not have this type of supply shift and production growth, and now we do. These are still-in-the-ground, non-discretionary, essential energy assets that are helping to advance energy independence for the U.S. We now have increasing oil production in addition to the increasing gas production that we have had for several years. The gas derivatives, the NGLs-ethane, propane and butane-are also increasing in volume and need to be handled. End users like utility companies, petrochemical companies and refiners are going to benefit from this new and increasingly abundant supply of oil and gas.
TER: What does this increasing production portend for capacity? Can fees rise?
SM: We believe revenues are going to rise handsomely over the next three or four years because of the $60B in spending that I mentioned. We see cash flows for these companies, in many cases, rising 11-12% per year over this time period because of the buildout.
There are many asset locations where we are constrained in capacity, so we need to build more. We are constrained in areas like the Eagle Ford shale in South Texas, North Dakota and the Marcellus and Utica shales. Increasing volumes in these areas are creating the need for new building.
TER: Are you seeing net inflows of funds into these instruments?
SM: We are seeing money flow into the sector. I think the MLPs have become more of a mainstream sector with more investors participating. Larger companies, market caps and daily trading volumes are attracting broader participation across all types of funds-institutional funds, mutual funds, closed-end funds and hedge funds. This is an important and growing part of the energy industry and it is likely to stay that way.
TER: Is the midstream industry healthy today, and does it represent value for investors?
SM: Balance sheets are, for the most part, quite healthy given lower levels of debt to cash flow and recent equity raises. Distribution payout coverage is higher today than it was four years ago. The amount of commodity sensitivity, in general, is declining for the industry as more fees and volumes come on line that are not directly tied to commodity prices. So, bottom line, I would say the sector is healthy in terms of the financial structure and fundamentals.
Yields still trade wider on a spread to 10-year bonds than they have in the past, which is one metric we review. They are about 70 basis points wider than historical norms. With interest rates overall looking to stay low and growth rates sustainable for the next year or two, the risk-reward opportunity for the long term is attractive.
TER: Some of the MLPs in your coverage universe are up double digits over the past month. Is a good earnings season upon us?
SM: Not necessarily. I think some of the stock rebound recently was reflective of an oversold sector and an increase in recent fund flows. Investors have concerns about commodities pulling back and some of those concerns are valid, as it can impact a portion of cash flows and longer term could impact volumes. Now, we have recently gotten some support in commodity prices. West Texas Intermediate (NYSE:WTI) oil price has moved back up from below $80/barrel to nearly $90/barrel. NGL prices have gone from $0.80/gallon up to $0.90/gallon. Things have calmed with support for the commodity.
I think second quarter earnings will be weak in certain spots. You have some companies that will see subdued results because of the lower commodities during the quarter. I do not think this changes the forward forecast for volumes and project growth, hence our positive longer-term view.
TER: What MLPs and C-corps do you recommend for your clients?
SM: One of the names that we've been recommending is Kinder Morgan Inc. (KMI:NYSE). We think this is one of the lower-risk growth names in our coverage universe. It's trading at a 4% current yield, and we think you'll see 16% dividend growth in the next 12 months.
It just recently purchased El Paso Corp., and that closed about six weeks ago. We think this was a very good purchase, and it helps to lower Kinder's risk profile because the assets are essentially long-haul, eight-year weighted average contracted natural gas pipelines with 93% of the capacity under contract. There's not a lot of variability associated with the assets purchased.
Kinder is poised to expand on what we think is one of the better footprints in North America in terms of expansion of pipelines because of a growing volume story. It's working on a large oil pipeline up in western Canada called Trans Mountain that could be more than a $4B investment. And it clearly has a lot of opportunities now with the El Paso assets that it can drop down into its MLPs, both Kinder Morgan Energy Partners L.P. (KMP:NYSE) and El Paso Pipeline Partners L.P. (EPB:NYSE), which will help funnel cash back up to Kinder Morgan Energy Inc. to help grow its dividend. It's a well-run company with one of the better management teams in the space, and there are a lot of synergies from buying El Paso. Kinder Morgan originally talked about $350M in synergies, and now it's gone up to $400M.
TER: Kinder Morgan Energy is a C-corp, not an MLP. Is there any advantage to the C-corp?
SM: Not particularly. They own a lot of similar assets compared to MLPs, such as pipelines, terminals, gathering and processing plants. The big difference about a C-corp common stock is that it is a taxable entity, and it's a common stock, so you get qualified dividend tax treatment. Being a C-corp doesn't really offer many advantages other than possibly more trading liquidity, depending on the size of the company.
TER: What's your next promising name?
SM: We like Williams Companies Inc. (WMB:NYSE). The current dividend yield is over 4%. We expect dividend growth over the next 12 months of about 22%, and our target price is $37. I think the interesting thing about Williams is that it has really set up a promising footprint in the Northeast. We feel it is going to become one of the dominant players in the Marcellus and possibly Utica shale plays. It has a great set of pipeline assets in that region, as well as in western Canada. It has one of the best balance sheets and we think the company will see continued volume increases in the Northeast from gas and liquids production.
Williams' Transco pipeline goes from the Gulf Coast up to the Northeast, and I think it is one of the better pipelines in the U.S. It is close to the Eastern Seaboard, and there will be a lot of expansion because of increases in demand from utility companies. There could be upward of a couple billion dollars of expansion projects on that pipeline alone because of increases in power generation and ongoing abundant gas supplies.
TER: Who else stands out in this space?
SM: I would say another one right now would be Atlas Energy L.P. (ATLS:NYSE). This is more of a small-cap name. The current yield is about 3.3%, but it has the highest distribution growth of any company that we cover right now. The distribution is currently $1 per unit, and we see it growing to $1.87 per unit for the full year 2013. Atlas is unique in that it owns the general partner of two separate companies. One company is Atlas Resource Partners L.P. (ARP:NYSE) and the other is Atlas Pipeline Partners L.P. (APL:NYSE). The Atlas Pipeline assets are in some of the best basins-Oklahoma, Mississippi and West Texas-where there is a tremendous amount of expansion opportunities. We believe Atlas Pipeline will be growing cash flow by 10% or so over the next year. Atlas Resource Partners is a unique exploration and production (E&P) company with very little debt on its balance sheet that has been out buying assets from distressed E&P companies. The combination of the organic build at Atlas Pipeline Partners and the acquisition and production growth story at Atlas Resource Partners is fueling Atlas Energy L.P. Our target for Atlas Energy L.P. is $48. We see a lot of upside there.
TER: Stephen, is there one more you can mention?
SM: One last one I would mention is Energy Transfer Equity L.P. (ETE:NYSE), which has a current 6% yield. We have the distribution growing 10% next year. The company recently purchased Southern Union Co., and it is now in the process of acquiring Sunoco Inc. (SUN:NYSE), which owns an interest in Sunoco Logistics Partners L.P. (SXL:NYSE). I think the purchase of Sunoco is an important step for Energy Transfer as it adds an oil pipeline, storage and refined product business that it didn't have before. This will help diversify Energy Transfer. Sunoco Logistics already had strong excess cash flow, a good balance sheet and a unique footprint with over 5,000 miles of oil pipelines in the Midwest, as well as a sizeable oil storage position along the Gulf Coast and some refined product terminals in the Northeast. It's very well positioned for the increasing oil production flows in the United States, and I don't think Energy Transfer Equity is getting full credit for the Sunoco purchase yet.
TER: Thank you, Stephen.
SM: Thank you.
Stephen Maresca is a managing director of Morgan Stanley covering energy Master Limited Partnerships (MLPs) and diversified natural gas companies. Prior to joining Morgan Stanley in 2008, Maresca spent 10 years at UBS focused largely on the energy sector. From 2001 to 2008 he was a director in UBS' equity research division covering energy MLPs. From 1998 to 2001 he was an associate director in UBS' investment banking energy group and from 1997 to 1998 he was in PaineWebber's fixed income department. Maresca holds a Bachelor of Science degree in accounting from Providence College and the Chartered Financial Analyst designation. He is a member of the New York Society of Security Analysts.
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1) George S. Mack of The Energy Report conducted this interview. He personally and/or his family own shares of the following companies mentioned in this interview: None.
2) The following companies mentioned in the interview are sponsors of The Energy Report: Energy Transfer Equity L.P. Streetwise Reports does not accept stock in exchange for services. Interviews are edited for clarity.
3) Stephen Maresca was not paid by Streetwise Reports for participating in this interview. Click here for disclosures.
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