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Kicking the Tires on Large-Cap MLPs

By Elliott H. Gue on Jan. 1, 2016

Over the past several months, we’ve fielded innumerable questions about whether specific master limited partnerships (MLP) will be able to maintain their distributions, with readers focusing on higher-yielding Portfolio holdings and names that we highlighted when we ran The Energy Strategist and MLP Profits. (Roger and I have covered MLPs for almost a decade.)

Our focus has always been on the quality of an MLP’s underlying assets and cash flow—the foundation for long-term wealth building. But in this environment, liquidity and cost of capital can also exert a profound influence on a partnership’s distribution policy, particularly for names with significant capital spending needs.

In this issue, we delve into many of the popular large-cap MLPs to evaluate the pressure points in their underlying businesses if energy prices remain lower for longer and their ability to meet near-term debt maturities and planned capital expenditures.

In This Issue

1. The payout cuts announced by Kinder Morgan (NYSE: KMI) and Teekay LNG Partners LP (NYSE: TGP) have several important implications for MLP investors. See Taking the MLP Market’s Temperature.

  • Present, Not Past: An MLP’s track record for distribution growth and sustainability isn’t a legitimate investment thesis in and of itself. The 2008-09 downturn, though severe, was relatively short-lived and gave way to the shale oil and gas revolution, a boom period for midstream development that drove impressive distribution growth and total returns. The midstream industry stands on the cusp of a refractory period where US onshore oil and gas output must adjust to the market’s constraints, with marginal producers and acreage coming under the most pressure—a vastly different business environment. History is instructive, but only when combined with an understanding of current market dynamics and each MLP’s strengths and weaknesses.
  • A Painful Rerating: From 2010 to 2014, the shale oil and gas revolution transformed formerly sleepy MLPs—a security class that had been the province of investors seeking steady, above-average income—into one of the market’s most compelling growth stories. In other words, the focus shifted from yield to yield compression, or price appreciation that outstrips distribution growth. The number of fund products offering significant exposure to a universe of about 125 MLPs exceeded 85 offerings the last time we checked. Institutional investment in the space also increased significantly. The binge on MLP equity from 2010 to 2014 has entered the inevitable purge phase, characterized by forced liquidations and year-end selling for tax losses. Comments from Teekay LNG Partners’ management team suggest that some growth-oriented buyers may not return to the market.
  • Key Risk Factors: A solid underlying business remains the foundation of any high-quality MLP, but Kinder Morgan and Teekay LNG Partners’ distribution cuts demonstrate that asset quality doesn’t guarantee distribution safety. Besides the health of the underlying business, investors should also consider an MLP’s distribution coverage ratio, contract expirations, near-term debt maturities, overall leverage, cost of capital and funding needs. In this market, MLPs with tighter distribution coverage and near-term debt maturities have less wiggle room, especially if they have a slate of growth projects to fund and a high cost of equity capital.
  • Projects Become Near-Term Liability: MLPs that have committed to major growth projects have sought to reduce their near-term funding needs by seeking joint-venture partners and raising money through private placements. But some high-yielding names could opt to cut their distributions and retain cash flow to fund projects and handle bond maturities until the debt and equity markets recover.
  • A Buying Opportunity: For MLPs with high-quality assets that have long-term value, the selloff that accompanies a distribution cut creates a compelling buying opportunity, usually with near-term upside. Teekay LNG Partners’ stock has rallied hard since the MLP slashed its payout, as investors realize that the MLP’s underlying revenue remains solid and reinvesting cash flow will drive future growth in a challenging equity market. This resilience is a crucial distinction from Linn Energy, Hi-Crush Partners and other names that cut their payouts because of deterioration in their actual businesses. If extended weakness in the capital markets prompted one of our Portfolio holdings to reduce its distribution to repay debt and fund growth projects internally, we would grit our teeth through the pain and buy hand over fist. We will keep our eyes peeled for these opportunities, hopefully in names that we don’t hold in our Portfolios.

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In October 2012, renowned energy expert Elliott Gue launched the Energy & Income Advisor, a twice-monthly investment advisory that's dedicated to unearthing the most profitable opportunities in the sector, from growth stocks to high-yielding utilities, royalty trusts and master limited partnerships.

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