When crude-oil prices collapsed after OPEC announced that it would maintain output instead of ceding market share to growing North American production, much of the talk among blue-chip master limited partnerships (MLP) focused on their resilience in the face of lower commodity prices and the opportunity to drive consolidation.
Challenging market conditions set the stage for several blockbuster acquisitions in the midstream space, with exploration and production companies looking to raise capital by monetizing their midstream infrastructure. Meanwhile, MLPs that own desirable assets but face funding issues or headwinds in legacy business lines have paired up with stronger partners.
As we predicted in MLP Takeover Talk, large-capitalization names have accounted for most of the major deals over the past 12 months. Not only do these blue chips have the scale to complete large transactions and unlock synergies, but they also need to generate significant amounts of incremental cash flow to grow their distributions—especially if they pay onerous incentive distributions to a general partner.
These pressures intensify in a market where depressed commodity prices, reduced drilling activity and heightened counterparty risk raise questions about future growth prospects and the sustainability of current cash flow. (We discuss these risks and a handful of opportunities in MLP Strategy Update.)
In this environment, names with tight distribution coverage and deteriorating fundamentals will catch the urge to merge to shore up their payouts.
We also asserted that MLPs which own refinery-facing logistics assets could leverage their resilient cash flow and lower cost of equity capital—huge competitive advantages in the current environment—to pursue third-party acquisitions.
Both these predictions have panned out thus far. Here’s a quick rundown of the major third-party deals announced in the midstream space over the past 12 months:
However, the upheaval in the US energy patch has ushered in an uptick in transactions where the general partner consolidates the MLP(s) under its auspices.
These deals reduce the organization’s cost of capital by eliminating burdensome incentive distribution rights (IDR), a part of the partnership agreement that entitles the general partner to a progressively larger cut of any incremental cash flow. All these transactions have also effectively cut the distribution paid to the limited partnerships’ common unitholders.
When Kinder Morgan announced agreements to acquire El Paso Energy Partners LP and Kinder Morgan Energy Partners LP in August 2014, some investors wondered whether this unexpected transaction amounted to a repudiation of the MLP structure.
Williams Companies’ proposed acquisition of Williams Partners LP—a deal that was ultimately scuttled after the former accepted Energy Transfer Equity’s takeover bid— prompted similar questions about whether MLPs have an inherent flaw.
After failing to attract a buyer, Crestwood Equity Partners LP (NYSE: CEQP) opted to consolidate Crestwood Midstream Partners LP—a deal that sent investors scurrying for the exit, especially those who owned the stock in the hopes that a third-party takeover offer would emerge.
Targa Resources Corp (NYSE: TRGP) likewise resorted to this strategy, earlier this week announcing an agreement to purchase Targa Resources Partners LP (NYSE: NGLS), the ailing MLP in which it owns the general-partner interest and incentive distribution rights that generate the bulk of its cash flow.
Does this flurry of transactions sound the death knell for MLPs with general partners?
As usual, easy generalizations of this nature paper over a much more complex reality and play to investors’ worst impulses; the same can be said for the cheerleading that touted these securities’ high yields and tax advantages without discussing the merits of their underlying businesses.
First and foremost, the five MLPs involved in these transactions all ran relatively tight levels of distribution coverage and have experienced varying degrees of deterioration in their underlying cash flow from volumetric and counterparty risk as well as expiring hedges.
Kinder Morgan Energy Partners had a long track record of pushing the envelope on distribution growth—a sharp contrast to rival blue-chip Enterprise Products Partners LP (NYSE: EPD), which has grown its distribution at a steady, if unspectacular, clip and reinvested any retained cash flow into its business.
Kinder Morgan Energy Partners and Williams Partners’ onerous incentive distribution rights put them at a significant disadvantage relative to Enterprise Products Partners, Magellan Midstream Partners LP (NYSE: MMP) and other blue chips that bought out their general partners during and in the aftermath of the financial crisis and Great Recession.
As we explained in More Thoughts on the Kinder Morgan Mega-Deal and Its Implications, Kinder Morgan Energy Partners went public 23 years ago and disbursed 45.9 percent of its cash flow to its general partner; excluding potential IDR waivers, the MLP would have needed to add about $88.5 million worth of incremental cash flow to grow its distribution by 10 percent.
The significant amounts of incremental cash flow that these established MLPs must generate to move the needle on distribution growth represent a considerable headwind, especially in a challenging market. Removing this burden frees up more cash flow for servicing debt and lowers the hurdle rate for organic growth opportunities and future acquisitions.
Kinder Morgan Energy Partners had some exposure to commodity prices through its carbon dioxide division, which supplies the gas to third-party oil producers and the MLP’s own upstream operations. Lower price realizations and expiring hedges will reduce this segment’s cash flow, a weakness that will need to be offset by other growth projects.
Williams Partners has also dealt with deterioration in its gathering and processing business, which faces volumetric headwinds in some areas and includes contracts that entail exposure to the prices of natural gas and natural gas liquids (NGL).
Crestwood Equity Partners continues to contend with shrinking volumes on its legacy gathering systems in the Barnett Shale, a mature play that should continue to lose share to the Marcellus Shale. The partnership covered 97 percent of its distribution in the third quarter, but we remain concerned about the firm’s elevated debt levels and volumetric and counterparty risk. In short, we don’t see any reason to take a flyer on this name and its 20 percent yield.
Targa Resources Partners’ initial guidance for next year had called for the MLP, which owns gathering and processing assets in several basins as well as Gulf Coast fractionation and propane export capacity, to maintain its payout and cover 90 percent to 95 percent of its distribution.
Targa Resources Corp’s proposed acquisition of Targa Resources Partners would effectively reduce unitholders’ quarterly payout by 32 percent based on the companies’ most recent dividend and distribution, though the coverage ratio would improve.
Management also outlined two scenarios for dividend growth over the next three years, the more realistic of which calls for a 10 percent increase next year and modest hikes thereafter.
However, the near-term forecast for natural-gas prices that underpins this guidance looks particularly aggressive relative to our outlook, which we highlighted in the Nov. 1 issue of Energy & Income Advisor.
Although we like Targa Resources Partners’ sizable gathering and processing footprint in the Permian Basin, the firm’s project backlog looks thin. The recently announced joint venture with Sanchez Energy Corp (NYSE: SN) should help to bolster throughput volumes on its gathering and processing systems in the Eagle Ford Shale, though we would have preferred a relationship with a stronger operator.
Targa Resources Corp’s pending purchase of Targa Resources Partners gives the combined company the breathing room to survive a challenging operating environment that’s fraught with volumetric risk and depressed commodity prices. That being said, we don’t see a compelling reason to change our rating on the stock.
MLPs aren’t immune to the upheaval in the US energy patch; reduced drilling activity in the nation’s shale plays will translate into lower production, pressuring throughput on pipelines and other midstream infrastructure.
In this challenging environment, proactive management teams have taken the necessary steps to improve their chances of surviving and thriving during this down-cycle.
At the same time, investors shouldn’t overlook the sponsors and general partners that have demonstrated their commitment to the MLP structure by stepping up to purchase additional equity or drop down assets at favorable multiples.
Anadarko Petroleum Corp (NYSE: APC), for example, transferred its assets in the Permian Basin to Western Gas Partners LP (NYSE: WES) for what amounts to an IOU. And for MLPs that are earlier in their life cycles, the incentive distribution rights paid to their general partners have yet to reach levels where they exert a severe drag on cash flow.
Although the next 12 months will bring more pain to the MLP space—one reason our coverage universe has 25 Buy ratings, 37 Holds and 48 Sells—indiscriminate selling creates opportunities for discriminating buyers to pick up higher-quality names.
Our strategy continues to focus on adding to positions in high-quality names when they trade at “dream prices”–levels that may not mark a bottom but represent attractive long-term values.
Elliott and Roger on Oct. 29, 2020
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