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High-Yield MLPs: The Good, the Bad and the Ugly — Part 1

By Roger S. Conrad on Feb. 18, 2015

DCP Midstream Partners LP (NYSE: DPM)

DPM price graph

Although DCP Midstream Partners LP boasts one of the most extensive and best-positioned gathering and processing asset bases among publicly traded partnerships, the company’s less-than-ideal contract structure entails significant sensitivity to commodity prices.

The majority of this exposure comes from DCP Midstream Partners’ gas-processing operations.

Natural gas transported over interstate pipelines to end-users cannot contain these impurities. Gas-processing plants separate NGLs–a heaver group of hydrocarbons that includes propane, butane and ethane–from the gas stream.

Fee-based agreements guarantee that the processor receives a volume-based payment; in these deals, any upside comes from an uptick in drilling activity and production. These lower-risk arrangements accounted for about 55 percent of DCP Midstream Partners’ gross margin last year.

Percent-of-proceeds contracts, on the other hand, grant the processor a portion of the natural gas and/or NGLs–an attractive proposition when commodity prices are on the rise, less so when prices plummet.

In a keep-whole deal, the processor receives all the NGLs removed from the stream and collects a volume-based fee for the natural gas. These arrangements generate the best returns when gas prices are low and NGL prices are elevated.

The majority of DCP Midstream Partners’ commodity exposure comes from percent-of-proceeds deals, though the firm does have some keep-whole contracts on the books.

To counter these risks, DCP Midstream Partners maintains a robust hedge book, engaging in transactions that cover about 90 percent of its exposure to commodity prices in 2014 and 80 percent in 2015.

This percentage drops to 25 percent in 2016, at which point the MLP’s distributable cash flow would come under considerable pressure if NGL prices haven’t recovered.

In the near term, a sustained rebound in NGL prices would appear to hinge on a production response; however, the start-up of new petrochemical capacity in 2017 and beyond could provide some relief for ethane, propane and butane. Natural gasoline prices look set to remain under pressure.

The biggest near-term challenge for DCP Midstream Partners, oddly enough, appears to be its general partner, DCP Midstream LLC, which is jointly owned by Spectra Energy Corp (NYSE: SE) and Phillips 66 (NYSE: PSX).

Unlike Targa Resources Corp (NYSE: TRGP) and other pure-play general partners, DCP Midstream LLC develops gathering and processing assets and then monetizes these investments by dropping them down to DCP Midstream Partners.

This strategy means that DCP Midstream LLC carries its own exposure to NGL prices, which has jeopardized its credit rating. During Spectra Energy’s recent Analyst Meeting, DCP Midstream Partners’ management team outlined the combined entity’s sensitivity to commodity prices.

With only 35 percent of its operating margin coming from fee-based contracts, management estimates that every $0.01 per gallon change in average NGL prices translates into an $11 million move in earnings before interest, taxes, depreciation and amortization.

Given DCP Midstream Partners’ robust hedge book for 2015, much of this exposure to commodity prices occurs at the general partner.

When NGL prices have dropped in the past, Spectra Energy and Phillips 66 have righted the ship by temporarily giving back their distributions to DCP Midstream LLC. Once again, both parents have agreed to this measure to support the general partner.

DCP Midstream LLC could also drop down some of these assets to DCP Midstream Partners to shift some of this risk off its balance sheet, potentially weakening the MLP’s distribution coverage.

Management indicated that the general partner had mailed requests to its customers to rework contracts, but we don’t expect this effort to yield much relief, as exploration and production companies continue to feel the pain from lower commodity prices.

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