All too many investors have bought the line that fee-based, long-term contracts make midstream names impervious to falling oil and gas prices, glossing over the devil that’s in the details.
These investors overlook the real pain that some gathering and processing names suffered when energy prices collapsed in late 2008 and early 2009; if oil and NGL prices had remain depressed for a longer period, we would have seen more distribution cuts and bankruptcies.
Meanwhile, a boom in initial public offerings and the growing breadth of businesses housed in the MLP structure mean that there’s a lot of junk in circulation—names that own only a single asset, focus on marginal basins, serve struggling customers or operate with far too much leverage.
With the recent pullback in energy stocks, these marginal names often offer above-average current returns—an alluring flame that ultimately could burn yield moths that have been conditioned to buy the dips.
As long as their underlying businesses continue to generate stable cash flow, these names will maintain their distributions. But the elevated risk associated with the have-nots in the MLP space could lead to further downside.
To avoid getting burned, investors must understand their MLPs’ exposure to volumetric risk; fee-based agreements don’t necessarily protect against lower throughput. Names generate most of their cash flow from marginal basins that were already out of favor before the swoon in energy prices have the most to lose.
This headwind tends to gradually erode the underlying business, though upstream spending cuts and reduced access to capital could accelerate this process in some instances. Be concerned if management teams facing this predicament stick their heads in the sand and don’t try to offset lost cash flow through credible expansion projects.
Counterparty and re-contracting risk are much greater causes for concern.
No contract is stronger than the finances of the company on the other end of the agreement.
With oil hovering around $45 per barrel and NGL prices down more than 50 percent since the end of the second quarter, many oil and gas producers find themselves under intense pressure to cut costs to the bone. Mounting evidence suggests that some small fry can’t afford to pay the fees on their processing and transportation agreements.
Crestwood Midstream Partners LP (NYSE: CMLP), for example, modified its gathering contract with Quicksilver Resources (OTC: KWKA) to give the customer a break on fees in exchange for running another rig in the Barnett Shale.
Bloomberg has also reported that unnamed customers have sought to shop their firm transportation capacity on TransCanada Corp’s (TSX: TRP, NYSE: TRP) MarketLink pipeline, as compressed differentials between oil prices at Cushing, Oklahoma, and on the Gulf Coast have pressured economics.
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Elliott and Roger on Feb. 26, 2019
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