The Alerian MLP Index dipped to an intraday low of 435 on Tuesday morning—an almost 20 percent decline from the all-time high reached in late August 2014. This pullback reflects the indiscriminate selloff that engulfed the midstream master limited partnerships (MLP) that make up about 88 percent of the index.
North America’s 10 largest midstream companies by market capitalization tumbled an average of 17 percent from their highs before finding some traction yesterday.
Midsize MLPs fared even worse, though names with market capitalizations of less than $2 billion took the hardest hit.
The eight Canadian midstream operators that we track in our International Coverage Universe held up reasonably well in local-currency terms. However, when you convert to US dollars, these names have absorbed an average hit of 19 percent from their highs.
Although our Portfolio Holdings took on some water during the recent selloff, our picks have generally held up better than their peers.
In fact, all have posted positive total returns so far this year, vindicating our generally conservative choices and our focus on value when determining our entry points. Our buy targets reflect a stock’s quality and implied return, as measured by yield plus distribution growth.
Although MLPs and other midstream operators rallied yesterday, further downside could be in store if oil prices drop further.
If this recent selloff marks the start of a bear market—for stocks in general or just the energy sector—there could be a lot more damage to come. After all, most of the 41 midstream companies and MLPs that we cover are still comfortably ahead for 2014.
At this juncture, we need to address three vital questions:
A confluence of factors contributed to the recent bout of selling in the midstream space:
Every bull market teaches us that there’s no automatic cap on valuations. To some investors, a particular favorite becomes a buy at any price. And it can be hard not to jump on the bandwagon.
But the higher the expectations, the greater the potential damage when things don’t go according to plan.
Of the catalysts outlined in our list, only the drop in oil prices represents a potential shift in midstream economics. The rest fall into one of three categories: the ephemeral, those based on popular misconception and those that can be avoided with careful analysis of individual companies.
Stock market momentum is ultimately irrelevant to returns for those who buy and hold dividend-paying stocks and MLPs for the long run. For these investors, sustainable distribution growth drives price appreciation over time.
Momentum can only derail returns if investors sell at an inopportune time. Conversely, selling at opportune times—namely, when our favorite stocks trade at elevated valuations—turns paper gains into real ones and provides a store of dry powder to take advantage of any buying opportunities that emerge. That’s not to suggest that you should sell your winners outright; however, taking a partial profit can help to rebalance your portfolio and lock in gains.
Conventional wisdom holds that dividend-paying stocks must sell off when interest rates rise because inflation erodes the value of these disbursements to shareholders.
Although this rationale makes sense for bonds and other securities that pay a fixed coupon, equities offer exposure to improvements in the underlying business and the potential for dividend growth—a value proposition that fixed-income vehicles can’t match.
Real world experience likewise undercuts this argument.
Case in Point: The Alerian MLP Index in 2013 generated a 27.6 percent total return, overcoming a more than 70 percent jump in 10-year Treasury yields.
Last year wasn’t an anomaly. Since the Alerian MLP Index launched in 1996, this basket of 50 popular publicly traded partnerships has posted a positive annual return on six occasions when interest rates ticked higher. In fact, the lone exception occurred in 1999, when the Alerian MLP Index gave up less than 8 percent of its value.
Even more damning, the Alerian MLP Index has posted an average total return of 13.3 percent during the 12 years that interest rates fell, lagging the mean gain of 17 percent when rates climbed.
Need more proof that MLPs aren’t bond substitutes? R-squared is a statistical measure that quantifies the degree to which different data sets correlate with one another.
Over the past two years, the Alerian MLP Index has exhibited zero correlation to movements in the 10-year Treasury note’s yield. If we extend our study to the past decade, the R-squared increases to a mere 0.048.
In contrast, the Alerian MLP Index’s correlation to the S&P 500 comes in at 0.365 for the past two years and 0.443 for the past decade.
No matter how you slice it, MLPs’ total returns have tracked the stock market more closely than interest rates.
However, movements in interest rates are important to the extent that they affect partnerships’ cost of capital and expected returns on investment. Borrowing money at 10 percent to finance a project returning 20 percent a year, for example, is twice as profitable as borrowing at 3 percent to earn 8 percent.
And most MLPs have used the past five years of low interest rates to term out debt while cutting interest costs and limiting dependence on credit lines. As a result, even marginal names have limited near-term refinancing needs, giving them the flexibility to push off bond offerings when market conditions become less favorable.
BreitBurn Energy Partners LP (NSDQ: BBEP), for example, recently pulled a $400 million note offering on which it would have paid an 8.5 percent coupon. With no debt maturing until 2017, the upstream MLP enjoys ample flexibility to play the waiting game.
In contrast, the market’s appetite for midstream bond issues remains healthy. Enterprise Products Partners LP’s (NYSE: EPD) 7.034 percent bonds maturing Jan. 15, 2068 yield 3.423 percent to maturity.
Unless the global economy picks up stream and investors rotate into equities, MLPs’ cost of debt capital appears unlikely to increase significantly in the near term.
What about oil prices? The implications for midstream operators largely will depend on individual companies’ geographic footprints, their contract terms and what kind of assets they own—the growth prospects for oil-gathering operations, for example, depend on drilling activity.
And although Brent crude oil best encapsulates supply and demand conditions in the global market, North American price differentials reflect local takeaway constraints and the transportation costs involved in delivering the hydrocarbons to end-markets.
These regional price differentials remain the key to identifying where the opportunities reside in the midstream segment. The same logic applies to natural gas and natural gas liquids (NGL), a group of hydrocarbons that includes ethane, propane, butane and natural gasoline.
Our forecast calls for the spread between Brent and West Texas Intermediate (WTI) crude oil to widen, potentially driving further downside in US prices. In the near term, the key for midstream operators will be how well regional price differentials hold up; elevated spreads imply increasing demand for takeaway capacity.
Lower price differentials imply less demand for new assets—and greater competition among midstream companies for existing business when contracts expire.
Boardwalk Pipeline Partners LP’s (NYSE: BWP) 80 percent distribution cut provides an object lesson in what can happen when an MLP’s “long-term contracts” expire in unfavorable market conditions. In this case, surging natural-gas production in the Marcellus Shale reduced demand for the firm’s long-haul pipelines.
Meanwhile, Boardwalk Pipeline Partners’ general partner, Loews Corp (NYSE: L), made no effort to offset this headwind via asset acquisitions or divestments.
With natural-gas prices range-bound between depressed and ultra-depressed levels over the past several years, the market largely has come to grips with the risks in this segment of the midstream universe.
A flurry of major pipeline announcements to transport natural gas and NGLs from the Marcellus Shale to end-markets in the South, Northeast and Midwest suggests that depressed prices at Leidy and other trading hubs in Pennsylvania will abate once this much-needed capacity comes onstream.
Meanwhile, NGL prices appear to have found support after surging production led to precipitous declines in the price of ethane and propane. Although we expect the US ethane market to remain oversupplied for at least the next three years, expanded export capacity should provide support for propane and butane prices.
Crude oil remains the x factor. Although break-even rates vary between operators within each basin, prolonged weakness in oil prices would prompt independent producers to allocate their capital expenditures to their core acreage—properties that generate the best internal rates of return. Widespread hedging likewise will insulate cash flow for a time, forestalling a reduction in production growth.
At this point, investors should keep an eye on the following risk factors:
The across-the-board collapse in energy prices that occurred in late 2008, coupled with prolonged weakness in natural-gas and NGL prices, has prompted midstream operators to pursue contracts that limit their exposure to these uncertainties.
Agreements where the customer pays a fixed fee to reserve pipeline capacity have grown especially popular; in these instances, the midstream operator gets paid regardless of whether the shipper uses its allotted volumes.
These guarantees explain why Enterprise Products Partners LP (NYSE: EPD) still managed to grow its distribution in late 2008 and early 2009. In general, we expect the midstream companies that we cover to deliver third-quarter results that involve few surprises.
Rather than panic, now is the time to dig into midstream companies on an individual basis and identify potential risks that could curb growth or jeopardize the distribution.
Kinder Morgan Energy Partners LP (NYSE: KMP), for example, often takes flack for its CO2 division’s exploration and production operations and their exposure to oil prices.
But when you view this exposure within the context of the company as a whole, the potential risk appears less daunting.
For one, management’s cash prow projections assume an average oil price of $96.14 per barrel in 2014—roughly $16 higher than prevailing prices and $6 below the mean price in the first half of the year.
Moreover, a $10 per barrel change in the average price of WTI on the year affects the segment’s earnings by 1.25 percent; in other words, results would decline by a mere 4 percent if oil prices averaged $66.14 per barrel. (This math only applies to 2014.)
Investors must also remember that the consolidation of Kinder Morgan Energy Partners and El Paso Pipeline Partners LP (NYSE: EPB) into Kinder Morgan Inc (NYSE: KMI) gives the firm an array of options to unlock shareholder value and offset weakness in a specific business line.
For example, if Kinder Morgan Inc were to acquire an existing MLP, the firm could monetize some of its existing assets by dropping them down to the new partnership under its wing.
We have yet to see any counterparty defaults that affect midstream companies, though Quicksilver Resources’ (NYSE: KWK) woes have raised questions about throughput volumes on Crestwood Midstream Partners LP’s (NYSE: CMLP) gathering systems in the Barnett Shale.
However, we have seen project delays and cancellations, primarily in Canada’s oil sands, where environmental opposition has stalled the development of several major pipelines.
Last month, for example, Statoil (Oslo: STL, NYSE: STO) announced plans to defer its Cornerstone project. Fortunately, the national oil company fully compensated its midstream partner, Model Portfolio and International Portfolio holding Pembina Pipeline Corp (TSX: PPL, NYSE: PBA), for its costs. The midstream operator has also booked additional growth projects that more than offset this loss.
Cornerstone likely won’t be the last midstream project to be canceled or delayed if oil prices remain low for an extended period.
Chevron Corp (NYSE: CVX), for example, has threatened to walk away from plans to export liquefied natural gas from Canada’s West Coast, a decision that would eliminate potential growth opportunities for midstream companies.
Investors panicking about the retrenchment in crude-oil prices should remember that this pullback occurred during a period of elevated refinery turnarounds; with the global crude-oil market balanced precariously, these seasonal outages have a more pronounced effect than in previous years.
At the same time, we expect OPEC, led by Saudi Arabia, to eventually cut production and bolster crude oil prices.
However, investors should expect much more volatility in crude-oil markets going forward.
We’ll continue to keep a close eye on how North American midstream operators prepare for these challenges and position themselves to take advantage of the ample growth opportunities in today’s market.
Here are some of the risk factors that we’ll monitor in coming quarters and use to guide our Portfolio moves.
Revisiting these considerations with each earnings season and throughout the quarter can give you the confidence to take advantage of the pullbacks that inevitably will come.
Targa Resources Partners LP’s unit price failed to bounce back to the same extent as other master limited partnerships (MLP) in part because of unwarranted skepticism surrounding its acquisition of Atlas Energy LP (NYSE: ATLS) and Atlas Pipeline Partners LP (NYSE: APL).
These stocks have underperformed over the past 18 months, reflecting Atlas Energy’s reliance on upstream MLP Atlas Resource Partners LP (NYSE: ARP) for a big chunk of its cash flow and disappointing utilization rates on Atlas Pipeline Partners’ gathering and processing assets in the Eagle Ford Shale.
Not only did Atlas Pipeline Partners arguably overpay when it acquired these underperforming assets from Teak Midstream, but management also over-promised on distribution growth, destroying much of its credibility with investors.
Before Targa Resources Partners closes these acquisitions, Atlas Energy will spin off all its non-midstream assets in a newly created entity, eliminating this concern.
At the same time, Atlas Pipeline Partners’ gathering and processing assets in the Permian Basin have continued to deliver the goods and will mesh nicely with Targa Resources Partners’ existing assets in the region.
We also expect Targa Resources Partners’ fractionation capacity in Mont Belvieu, Texas, and capacity to export propane and butane to enable the MLP to get more out of Atlas Pipeline Partners’ assets in the Eagle Ford Shale by offering prospective customers an end-to-end solution.
Worries that Atlas Pipeline Partners’ exposure to natural gas liquids (NGL) prices will change Targa Resources Partners’ risk profile also appear overblown; the acquirers’ propane and butane export capacity provides a natural hedge against this risk. Moreover, further downside for NGL prices appears limited at this juncture.
Targa Resources Corp (NYSE: TRGP), which owns the general-partner interest in Targa Resources Partners, has further sweetened the deal by agreeing to forego $77.5 million in incentive distribution rights for four years after the transaction closes.
Moody’s Investors Service Moody’s affirmed Targa Resources Partners Ba1 credit rating following the deal’s announcement, citing opportunities for “significant organic growth and synergy” that more than offset execution risk.
The ratings agency also indicated that the MLP could achieve investment-grade status if the firm keeps its debt to less than 4 times cash flow (estimated at 3.3 times after the deal closes) and grows its percentage of fee-based revenue (currently 60 percent of margin).
We suspect that Targa Resources Partners also lagged during yesterday’s rebound because the market has assumed that the recently announced acquisition suggests that the MLP plans to remain independent.
The stock soared earlier this year when the Wall Street Journal reported that Energy Transfer Equity LP (NYSE: ETE) was in negotiations to acquire the MLP and its general partner, Targa Resources Corp (NYSE: TRGP).
Although this transaction ultimately fell through, Targa Resources Partners’ dock space and NGL fractionation capacity on the Gulf Coast are difficult to replicate and would fit well with in the Energy Transfer family or with Kinder Morgan Inc (NYSE: KMI).
Even if another takeover offer fails to materialize, Targa Resources Partners has proved its ability to drive sustainable distribution growth. In July 2014, the MLP accelerated its rate of sequential distribution growth to $0.0175 per unit from $0.015 in the previous two quarters.
And management suggested that the acquisition will enable the MLP to grow its distribution by 11 percent to 13 percent annually. Achieving this goal will depend on Targa Resources Partners effectively hedging its exposure to commodity prices, judiciously allocating capital to the best growth projects and obtaining higher rates on Atlas Pipeline Partners’ expiring contracts.
Investors usually sell the acquirers’ shares when mergers are announced; however, Targa Resources Partners’ units finished in the green on the day it unveiled its proposed takeover of Atlas Energy and Atlas Pipeline Partners.
Nevertheless, the stock has still given up more than 30 percent of its value from its mid-June high, giving investors an outstanding buying opportunity. We’re adding Targa Resources Partners to the aggressive segment of our MLP Portfolio as a buy up to $62 per share.
We checked in on the majority of our midstream holdings when we reviewed the MLP Portfolio’s second-quarter results in August. We also touched on some of these names last week, when we issued an Alert highlighting our favorite names to buy on a pullback.
Investors should revisit these articles for additional color on our top picks in the midstream segment; all these names remain worthwhile purchases as long as they trade under our current buy target
Here’s when to expect the next round of distribution declarations. I’ve placed an asterisk where payout increases are likely:
The majority of our Portfolio holdings have recovered some of the ground lost late last week and earlier this week.
However, three names stand out as particularly good buys right now.
North of the border, AltaGas (TSX: ALA, OTC: ATGFF) and Pembina Pipeline Corp (TSX: PPL, NYSE: PBA) still trade at favorable prices, in part because of weakness in the Canadian dollar.
Both rely almost entirely on fee-generating businesses and have reached a scale where they can do deals with anyone in Canada’s energy patch.
AltaGas and Pembina Pipeline also deserve credit for taking advantage of their lofty stock prices earlier this year to issue equity capital; they can now deploy the proceeds from these deals in a lower-cost environment.
AltaGas rates a buy up to US$48 in our International Portfolio, while Pembina Pipeline Corp rates a buy up to US$42 in our Model Portfolio.
These Canadian stocks are subject to 15 percent withholding if held in taxable accounts, which you can recover by filing a Form 1116 with your US taxes. There is no withholding of dividends for either stock if held in an IRA or other tax-deferred account.
NuStar Energy LP (NYSE: NS) continues to make all the right moves under new CEO Bradley Barron, which bodes well for its general partner, MLP Portfolio holding NuStar GP Holdings LLC (NYSE: NSH).
Earlier this week, NuStar Energy announced that the MLP had signed a letter of intent to form a joint venture with an affiliate of Petróleos Mexicanos (Pemex) taht will develop pipelines and storage capacity that will facilitate the flow of US-produced propane and butane to Mexico.
The two partners would jointly fund the construction of these assets, with NuStar Energy overseeing the construction process and the operation of this infrastructure.
Management indicated that this project, tentatively slated to come onstream in 2016, would reduce the cost of transporting these hydrocarbons to Mexico; today, our neighbor to the South receives US propane and butane volumes primarily via seaborne vessels.
NuStar Energy deserves credit for leveraging its existing footprint and expertise to ink one of the first joint-venture agreements between US and Mexican energy companies.
This announcement serves as yet another notice of NuStar Energy’s turnaround story, a process that began when NuStar Energy divested its interest in cyclical businesses in favor of organic expansion projects at its South Texas pipeline system, which supports customers in the prolific Eagle Ford Shale.
The MLP in the second quarter completed the first expansion to its South Texas pipeline system, bringing the capacity to 135,000 barrels per day. Management expects to complete the second phase, which will increase the capacity to 200,000 barrels per day, in the second quarter of 2015.
NuStar Energy also more than tripled the capacity of its docks in Corpus Christi, enabling customers to move crude-oil volumes across the Gulf of Mexico to refineries in Louisiana.
This valuable asset also puts the company in pole position to take advantage of potential condensate exports. (See Condensate Conundrum.) In fact, management noted that the firm has started to work on modifications to its pipeline that would segregate minimally processed condensate from other volumes.
We also like the MLP’s agreement with Occidental Petroleum to reactivate and reverse an idled pipeline that will transport NGLs to the oil and gas company’s propane export facility in Ingleside, Texas. NuStar Energy expects this project to come onstream in the second quarter of 2015.
Management indicated that it would continue to focus on organic growth opportunities afforded by its existing asset base while eyeing complementary acquisitions in the Eagle Ford Shale. Constructing or acquiring oil-gathering lines to supply its South Texas pipeline network would be one option.
The Niobrara Shale in the Rockies is a basin that the MLP would consider entering. In 2012, NuStar Energy held an open season for its Niobrara Falls project, which consisted of a new crude-oil pipeline that would run from the Colorado to the MLP’s existing refined-products pipeline that runs from McKee, Texas, to Denver. The project contemplated reversing and converting the latter pipeline to crude-oil service.
A lack of shipper interest scotched the project two years ago, but rapidly growing production in the Niobrara Shale could make this pipeline more viable.
Management has also considered adding rail capabilities at its crude-oil terminals in Vancouver and eastern Canada.
But the progress in NuStar Energy’s pipeline segment must overcome near-term weakness in its terminal segment, where a crude-oil market in contango–spot prices are lower than volumes for future delivery–has weighed on demand from traders.
In particular, management highlighted weakness at its West Coast facilities and reduced profit sharing at its terminals in St. James, La., because of the tightening spread between Light Louisiana Sweet crude oil and West Texas Intermediate.
Management’s forecast calls for its storage segment to generate flat adjusted operating earnings relative to year-ago levels. Thus far, the MLP hasn’t encountered problems renewing expiring storage contracts, though rate increases have been harder to come by.
NuStar GP Holdings, which owns a 2 percent general partner interest in NuStar Energy and 12.9 percent of the MLP’s outstanding common units, sports a distribution yield of 5.6 percent.
Buying the general partner gives us exposure to NuStar Energy’s turnaround story–and any premium in a potential takeover. Buy NuStar GP Holdings LLC up to $45 per unit.
Elliott and Roger on Jul. 27, 2017
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