Despite inexhaustible cheerleading by Jim Cramer and others, publicly-traded midstream energy MLPs have taken quite a beating in the first half of 2015. The story told over and over in the financial press is that these players are not exposed to commodity prices, that they have guaranteed consistent fee-based income, and that they are fundamentally sound. Everything from hedge fund selling to panic in the energy sector in general has been pointed to as the cause of the selloff, rather than considering the possibility of fundamental weakness in the group.
For an in-depth look at the basics of MLPs and why they are generally exposed to commodity pricing, check out my blog here.
As we head into the middle of Q2 earnings season, the underlying problems in the midstream MLP model are starting to surface. While some are still holding it together and making earnings estimates, some like MarkWest Energy (NYSE:MWE) and Crestwood Midstream Partners (NYSE:CMLP) missed in a big way. With the drop in share prices, distribution yields are rising. Are MLPs like high-yield bonds? Is there underlying risk that no one is talking about?
While US oil and gas production has risen in the last 5 years, so too has investment in the infrastructure to bring that production to market. An IHS study showed a 60% jump in capital spending between 2010 and 2013, with projections of continued growth. The estimate for total investment in oil and gas midstream and downstream infrastructure in 2014 alone was $90 billion. We all know that this was driven in some part by the favorable tax treatment of earnings by the MLP rules, not unlike the REIT rules that encouraged investment in real estate in the mid-2000s.
With billions pouring into midstream infrastructure chasing yield and safety, competition for projects became intense. Asset prices spiked and E&P companies enjoyed a host of options to meet their gathering, processing, and transportation needs. They could often choose between multiple competing projects or take the opportunity to own the assets themselves and drop them into a partnership, turning a cost center into a prized partner with its own value and ability to raise cash for the parent.
Here's the history that led to the shaky fundamentals for many of today's midstream MLPs.
First, on the revenue side. Many contracts between midstream operators and producers do charge a fixed fee per throughput volume and are therefore touted as "fixed-fee" in every presentation. However, these agreements generally only require a dedication of production from a given area of a producer's operating area, or a so-called "acreage dedication." That means if the producer chooses to stop drilling in the area, it is under no obligation to pay anything to the midstream operator unless separately stated. For example: Antero Resources (NYSE:AR) has commitments to Antero Midstream (NYSE:AM). Antero Midstream acknowledges that currently 100% of revenue is provided by Antero Resources. AR's commitment to AM consists of a dedication of 609,000 total potential leasehold acres for gathering and compression services (from AM's Q2 '15 presentation). Therefore, AM is totally dependent on AR's ability to grow production on these acres. As it happens, AR is in the process of reducing its drilling rig count from 21 to 11 rigs, and its completion crews from 10 to 7 (from AR's Q1 '15 press release). AR still projects production growth on this reduced drilling schedule, due to an inventory of currently uncompleted wells expected to come online later in 2015 and 2016. Once the backlog is cleared, AM will be exposed to reduced drilling as well as steep declines in the Marcellus and Utica wells. Meanwhile, AM projects $438 million in Capex in 2015, of which only 43% is actually protected by minimum volume commitments from AR.
Another contract type requires the MLP to take a percentage of proceeds from the sale of oil, gas, and liquids. This creates risk to revenue by adding commodity price risk. These contracts aren't as popular as the fixed-fee arrangements, and won't be as loudly trumpeted in press releases. But they were signed often during the rise in oil prices and still exist behind the scenes. For example: During Q1 2015, propane and butane prices dropped 30% from Q4 2014 levels. During this time, Midcoast Energy Partners (NYSE:MEP) reported an increase of 3% in throughput volume from its three segments (ETX, Anadarko and NTX), up from year-end 2014. However, total gross margin from the 3 segments dropped 55%, from $203 million to $118 million. It's apparent that a good deal of commodity price exposure existed in MEP's processing contracts.
Counterparty stability is another risk to revenue. In the case of midstream partnerships with a single revenue stream from the parent company, distribution yields are often lower than the bond yield of the parent, even though the same credit risk exists. For example, at its current distribution level, Rice Midstream Partners (NYSE:RMP) has a yield of 4%. The parent, which provides 85% of RMP's throughput volumes, has a bond yield of around 7%. Therefore, the investor in RMP assumes nearly the same counterparty risk as the Rice Energy (NYSE:RICE) bondholder, for less yield, with the added cost of lower liquidation preference and depreciating assets.
The atmosphere of dollars chasing investment in recent years also affected the cost side of the MLP profitability equation. There is an inherent conflict between the midstream service providers and the E&P companies when it comes to building, gathering, processing and transportation systems. The driller, since it only pays when it uses the system, naturally wants it to be built as large as possible, big enough for every potential molecule or barrel that it might one day produce. Given that production estimates and predictions were extremely aggressive at $100+ oil and that E&Ps had more leverage in these agreements than those pitching midstream projects, many of these systems were built much larger than needed and will have excess idle capacity, leading to higher-than-projected ongoing per-unit costs. If we agree with Goldman Sachs that low prices will lead to the market rebalancing, then production must decline. As this happens, operating costs and depreciation per unit of throughput will naturally increase further. Since rates charged to the producer will not increase to cover these costs (remember "fixed-fee"), earnings decrease exponentially as production falls.
Not to pile on but... Rising interest rates will also be extremely costly for the more debt-laden operators, as they also will be unable to pass through any increase in borrowing costs to their E&P customers.
The profitability of many of these partnerships was shaky from inception. Revenue is uncertain due to the lack of committed volumes, disguised commodity price risk, and counterparty credit risk. Expenses are high due to overbuilt facilities and already rising borrowing costs. Far from a rebound, the value of these partnerships will only fall farther as the domestic energy market rebalances itself and production declines to match demand and export capabilities.
One caveat - as I mentioned in my previous post, legacy players like Enable Midstream (NYSE:ENBL) and Kinder Morgan (NYSE:KMI) that have diverse customer bases, low borrowing costs, and historical leverage with producers due to their dominant position in certain areas will have more ability to weather the storm of declining throughput. Some of these could look like a buying opportunity in the coming months as prices get more attractive. In addition, some lower-cost basins will experience less production loss than other, more expensive, areas for producers and therefore service providers. I will explore the cost differences and sort out the winners and losers in a future post here and at level2energy.com.
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. I have no business relationship with any company whose stock is mentioned in this article.