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In addition to eroding investors’ returns, the indiscriminate selling of energy-related master limited partnerships (MLP) has increased the Alerian MLP Index’s yield to more than 9.5 percent. Meanwhile, 70 of the publicly traded partnerships tracked in our MLP Ratings yield at least 10 percent—usually an indication that the distribution could be at risk.
A higher cost of equity capital represents a major headwind for names seeking to fund near-term growth projects and earn an economic return on investment. Many master limited partnerships disburse the bulk of their cash flow to unitholders via quarterly distributions, an approach that forces them to rely on issuing stock and bonds to fund growth projects.
Our graph tracking aggregate quarterly MLP equity issuance over the past 15 years plots the US energy landscape’s evolution, with the total deal value and volume ballooning from 2010 to 2014 to support the shale oil and gas boom and take advantage of robust investor demand. In 2015, the total value of MLP equity issuance ($11.05 billion) came in at 58 percent of last year’s level.
Payout cuts announced by former MLP Kinder Morgan (NYSE: KMI) and Teekay LNG Partners LP (NYSE: TGP) underscore the dangers associated with constrained access to debt and equity markets.
Although Kinder Morgan raised enough capital via an offering of convertible preferred shares to cover its 2016 debt maturities and had ample capacity on its credit facility to fund planned capital expenditures, the prospect of a credit rating downgrade from Moody’s Investors Service prompted the company to slash its dividend by 75 percent to conserve cash flow for debt service and growth projects.
The blue-chip midstream company faced pressure from its tight dividend coverage, near-term debt maturities and expiring hedges in its oil-producing carbon dioxide segment. The stock’s elevated dividend yield meant that issuing equity to fund growth projects wasn’t feasible.
Teekay LNG Partners’ 80 percent distribution cut came as more of a surprise because of the partnership’s long-term contracts and reliable cash flow.
This decision didn’t stem from a deterioration in the MLP’s underlying business and cash flow; rather, the distribution cut reflects a commitment to funding its growth projects—primarily new tankers to ship liquefied natural gas (LNG) and an LNG import terminal in Bahrain—in the most efficient way possible.
Such a dramatic distribution cut ensures that Teekay LNG Partners will be able to fund its planned growth projects internally for at least the next three years, without tapping the public market.
During a conference call to discuss the distribution cut, management warned that “the investor base has changed [in the MLP market]” and “what is happening now is going to take longer to repair than it did in 2008 and 2009.” The executive team also indicated that Teekay LNG Partners would increase the proportion of its cash flow earmarked for distribution to common unitholders when the equity market recovers.
The unexpected distribution cut resulted in a vicious selloff that roughly halved Teekay LNG Partners’ stock price in a single day, underscoring the premium that the market pays for cash flow disbursed to unitholders relative to income that’s reinvested. On the plus side, the stock did catch a bid after this initial plunge, as investors realized that the MLP’s underlying cash flow remains sound.
But the payout cuts announced by Kinder Morgan and Teekay LNG Partners have several important implications for MLP investors:
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.
But the equity market isn’t closed completely. Whereas as Teekay LNG Partners’ elevated yield prompted the MLP to slash its distribution and retain cash flow instead of funding its growth plans by issuing equity, EQT Midstream Partners LP (NYSE: EQM), Shell Midstream Partners LP (NYSE: SHLX) and Valero Energy Partners LP (NYSE: VLP) issued units in November and didn’t suffer a major selloff.
All three stocks slipped nominally lower after these announcements, but rallied in subsequent trading sessions. These MLPs’ relatively low costs of equity capital represent a huge competitive advantage in these uncertain times.
Elliott and Roger on Oct. 29, 2018
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