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A Tale of Two MLP IPOs

By Peter Staas on Jul. 6, 2017

In an environment where energy prices remain lower for longer and short-cycle US onshore plays take market share, midstream master limited partnerships (MLP) with the best growth prospects remain some of our favorite picks.

The pace of initial public offerings (IPO) in this space has slowed considerably in recent years, reflecting a challenging tape that raised questions about whether this route still represents the best way to monetize energy assets.

Gone are the days when all manner of energy-related assets ended up in the MLP structure, regardless of their cyclicality and the sustainability of their cash flows.

Oil-field service outfit Mammoth Energy Services (NSDQ: TUSK), for example, rightly opted to make its debut as a C-corporation after initially filing to debut as an MLP—a bid to piggyback off the initial success of Hi-Crush Partners LP (NYSE: HCLP) and Emerge Energy Services LP (NYSE: EMES), proppant producers that did away with their distributions when market conditions soured.

Meanwhile, distribution cuts by blue-chip MLPs such as Kinder Morgan Energy Partners LP, Energy Transfer Partners LP (NYSE: ETP), Williams Partners LP (NYSE: WPZ) and Plains All-American Pipeline LP (NYSE: PAA) likely scared off some investors—or at least made them more discerning.

The market also soured on drop-down stories where a sponsor creates an MLP as a vehicle to monetize midstream assets at favorable valuations while retaining control of this critical infrastructure.

The sharp selloff in MLPs that occurred in late 2015 and early 2016 served as a reminder that many of these structured growth stories depend on a partnership’s ability to access capital at favorable rates. With bond and equity yields surging, some drop-down MLPs’ growth stories ground to a halt.

Investors also chafed at some MLPs’ willingness to issue equity publicly to fund asset deals; the market regarded these transactions not as a show of strength during a period of turmoil, but as a sign that the sponsor’s goals may not be aligned with the partnership’s unitholders.

The value proposition associated with drop-down transactions has also changed dramatically over the past decade, with assets selling for higher valuations today and, in some instances, offering fewer near-term opportunities for organic growth.

The divergent performance between two IPOs from the past 12 months demonstrates Investors’ preference for MLPs that can deliver organic growth over those that rely on asset drop-downs to increase cash flow and quarterly distributions.

(Click graph to enlarge.)
NBLX vs HESM

Noble Midstream Partners LP’s (NYSE: NBLX) highly successful initial public offering in fall 2016—the stock has roughly doubled in value since then—provides insight into what MLP investors want in 2017.

Spun off from Noble Energy (NYSE: NBL), the midstream MLP offers exposure to two avenues for potential growth: asset drop-downs from its sponsor and robust organic growth as the exploration and production company ramps up its drilling and completion activity in the Niobrara Shale and Permian Basin.

In this instance, Noble Energy’s strong balance sheet and focus on developing its franchise assets should drive throughput growth on Noble Midstream Partners’ existing systems and create expansion opportunities over the long term.

Noble Midstream Partners stands out from the crowd because of its close association exploration and production company that’s positioned to take market share in an environment where energy prices remain lower for longer.

Similarly, Hess Midstream Partners LP (NYSE: HESM) offers exposure to future drop-down transactions and Hess Corp’s (NYSE: HES) growth plans for its 577,000 net acres in the oil-rich Bakken Shale.

Hess Energy had planned to spin off its midstream assets in 2014, but the collapse in oil prices and energy-related equities scuttled the IPO; instead, the company sold a 50 percent interest to private-equity outfit Global Infrastructure Partners for $2.675 billion. With the IPO window temporarily reopened, the joint venture jumped at the chance to issue public equity.

Like Noble Energy, Hess boasts a strong balance sheet and a revenue mix that includes short-cycle shale plays as well as longer-cycle offshore developments that generate significant free cash flow.

However, Hess’ onshore exposure is in North Dakota’s Bakken Shale, not the Permian Basin.

Hess’ guidance calls for its hydrocarbon production in the Bakken Shale to come in flat or decline by 5 percent this year, a conservative outlook that could be due for revision when the company reports second-quarter results and provides an update on its new completion designs. Stepped-up drilling activity and enhanced completion techniques could set the stage for production to surprise to the upside in 2018.

Hess Midstream Partners owns interests in three operating companies, each of which has 10-year agreements with Hess Energy that include minimum volume commitments and the unilateral right to renew each contract for another 10-year term when they expire in 2024.

The gathering assets in which the MLP owns a 20 percent interest comprise 1,121 miles of gas lines that can carry up to 345 million cubic feet per day and 365 miles of oil pipelines that can move up to 161 million barrels per day.

Hess Midstream Partners’ processing and storage business includes 20 percent of the Tioga plant, which will be debottlenecked to 300 million cubic feet per day in 2018, and 100 percent of a propane storage facility in Mentor, Minnesota. Finally, the MLP owns a 20 percent stake in terminal assets and an under-construction header pipeline.

The partnership has the right of first offer to purchase incremental interests in these assets, representing about 4 times the MLP’s current cash flow. Management expects these drop-down transactions, coupled with any organic growth on its existing assets, to drive annual distribution growth of 15 percent in coming years.

Although the hype surrounding the Permian Basin has somewhat dimmed the market’s view of the Bakken Shale, North Dakota’s Williston Basin remains a world-class oil play and continues to benefit from advances in drilling and completion techniques.

That said, Hess Energy hasn’t proved itself to be the highest-quality operator in the Bakken Shale and owns a sizable chunk of noncore acreage. During the recent down-cycle, the company also suffered a larger production decline than peers that focus exclusively on the Bakken Shale.

Long-term contracts with minimum volume commitments and fee escalators should help to offset some of these concerns–these agreements made up for volumetric weakness at Hess Midstream Partners’ midstream franchise in the first quarter.

Concerns about Hess’ track record as an operator and the quality of its acreage in the Bakken Shale suggest that Hess Midstream Partners will depend on drop-down transactions to drive cash flow and distribution growth. This distinction helps to explain why Hess Midstream Partners’ units have lagged the Alerian MLP Index by almost 600 basis points since its IPO in April 2017.

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