Our goal with Energy & Income Advisor is to identify the sector’s best total-return opportunities, a goal that underpins our recently completed list of our top energy stocks for 2017.
In addition to making judgments about what will do well in the current environment, we also keep in mind what names have a higher likelihood of underperforming to help our subscribers steer clear of potential value traps—one oil-field equipment company, in particular, comes up regularly during our monthly online chats.
The next issue of Energy & Income Advisor will focus on our top 10 (or maybe more) energy stocks for investors to avoid in 2017, a year where equity selection will become increasingly important after successive waves of indiscriminate selling and buying in the sector.
As part of our preparation for this issue, we dug into the five master limited partnerships (MLP) with the heaviest short interest. Many of these names face significant challenges, but one wonders whether the market has already priced in distribution cuts or the potential worst-case scenario.
Here, we take a holistic view of these stocks, examining the bearish case as well as any positive factors that could be in play. If like what you read and want more independent analysis of MLPs, consider subscribing to Energy & Income Advisor or downloading a sample issue to see what we’re all about.
Sunoco LP generated enough cash flow to cover its distribution by 125 percent in the third quarter, a period of seasonal strength. Over the trailing 12 months, distribution coverage came in at 1.09 times. The fuel distributor faces headwinds at its gas stations in Texas, where volumes and cash flow have come under pressure from reduced headcounts in the oil patch and the Mexican peso’s weakness relative to the US dollars.
After acquiring Emerge Energy Services LP’s wholesale fuel business and Denny Oil Co, Sunoco LP’s leverage ratio reached 5.97 times operating cash flow—below the 6.25 times required by its debt covenant. However, the covenant ratio declines in the second quarter of next year. Management has reiterated its commitment to deleveraging the balance sheet, primarily by issuing equity to pay down debt and fund acquisitions.
Questions remain about Energy Transfer Equity LP’s (NYSE: ETE) capacity and willingness to cut Sunoco LP a break on its incentive distribution rights. In March 2016, Reuters reported that a third party had approached Energy Transfer Equity about selling its interest in Sunoco LP.
The fuel distributor’s enterprise value stands at about 9.5 times operating cash flow—roughly in between the multiples that Alimentation Couche Tard (TSX: ATD/B, OTC: ANCUF) paid for The Pantry and CST Brands (NYSE: CST).
Given Sunoco LP’s cumbersome leverage and reliance on acquisitions to drive cash flow growth, the 13.76 percent short interest in the stock is understandable—especially if the partnership issues equity with the stock yielding more than 13.5 percent.
At the same time, this elevated yield suggests that the market has priced in a potential distribution cut. Instead of issuing equity, the MLP could also take a page out of CrossAmerica Partners LP’s (NYSE: CAPL) playbook and pursue sale-leaseback financing on some of its owned gasoline stations to buy itself some breathing room.
Albeit still elevated, short interest in Sunoco LP has backed down from a high of more than 21 percent in October 2016.
Emerge Energy Services LP produces and distributes the crush-resistant silica sand (proppant) that oil and gas producers pump into wells to prop open cracks in the reservoir rock created by hydraulic fracturing.
The MLP generated negative $8.1 million in operating cash flow last quarter, despite a 24 percent upsurge in sand volumes—a trend that reflects accelerating well completion activity and the industry’s discovery that using increasingly large proppant loads enhances production levels.
Despite this sharp rebound in demand for its product, Emerge Energy Services faces balance sheet issues that forced the company’s lenders to reset its debt covenants and shrink its credit facility. The MLP issued $20 million worth of convertible preferred shares as part of a private placement and has targeted $30 million to $40 million worth of equity issuance by the end of this year.
Emerge Energy Services’ weak balance sheet likely sets the stage for more dilution of existing unitholders and could prevent the firm from taking full advantage of the rebound in its industry. The partnership also doesn’t pay a distribution.
Golar LNG Partners LP generated enough cash flow to cover its third-quarter distribution by 1.37 times. After the quarter ended, the MLP completed a transaction with Golar LNG (NSDQ: GLNG) that reset its incentive distribution rights in exchange for new common units.
This deal ensures that Golar LNG will receive the same quarterly distribution as before, while reducing the Golar LNG Partners’ cost of equity capital to facilitate future drop-down transactions.
The charters for three of the MLP’s four LNG (liquefied natural gas) carriers roll off next year; with this shipping market oversupplied in the near term, the partnership likely will receive less cash flow from any replacement contracts.
And Golar LNG Partners’ floating storage and regasification units (FSRU)—offshore vessels that heat LNG to return it to is gaseous state—have also encountered challenges.
The Golar Tundra, which the MLP acquired from its sponsor earlier this year, remains idle because the charterer has yet to complete the accompanying onshore infrastructure in Ghana.
Management indicated that Golar LNG Partners received the first payment for the Golar Tundra from West African Gas, a joint venture between the Nigerian National Petroleum Corp and Sahara Energy Resource. The MLP continues to negotiate a solution that will work for both parties.
Throughput volumes on the Golar Spirit and Golar Winter have also come under pressure from increasing hydropower production in Brazil after an extended drought. The Golar Spirit’s initial contract with Petrobras (Sao Paulo: PETR4, NYSE: PBR) expires in 2018.
Management indicated that Golar LNG could drop down an interest in the Hilli floating LNG vessel, which will liquefy natural gas produced offshore Cameroon for export. But aside from this transaction, the near-term pipeline of asset drop-downs appears thin.
Golar LNG Partners’ sponsor had a fleet utilization rate of 37 percent in the third quarter and posted an operating loss of $11.3 million. With an impending bond maturity in March 2017, the terms of the next drop-down transaction may favor the Golar LNG over Golar LNG Partners.
Valero Energy Partners LP hiked its third-quarter distribution by 5.5 percent sequentially and generated enough cash flow to cover this higher payout by about 1.9 times. Management asserted that the MLP can grow its distribution by 25 percent annually in 2016 and 2017 without completing another drop-down transaction. Valero Energy Partners’ enterprise value also stands at 14 times cash flow, roughly in the middle of the pack.
Why have investors bet so heavily against Valero Energy Partners?
Two factors come to mind: The market hasn’t responded well to MLPs issuing equity this year, even for drop-down transactions. At the same time, Valero Energy Partners pays top dollar for assets operating at peak levels and with little organic growth potential.
Narrowing crack spreads—a measure of a downstream operator’s profitability—could lead to lower refinery utilization rates and reduced throughput on the midstream assets serving these facilities. That said, Valero Energy Partners has minimum volume commitments in place that put a floor under throughput. Excess distribution coverage also helps to limit risk.
NuStar Energy LP (NYSE: NS) covered its flat distribution by 1.02 times in the third quarter.
Throughput volumes on the MLP’s crude-oil pipelines declined by 3.75 percent sequentially and 20 percent year over year, reflecting weakness on its system in the Eagle Ford Shale. Minimum-volume commitments on these pipelines expire in July 2018, 2019 and 2023.
Volumes on NuStar Energy’s refined-product pipelines ticked up 1 percent from year-ago levels, while the terminal segment suffered a 7 percent decline in throughput—again because of weakness at its assets in the Eagle Ford Shale.
The MLP has made a few gestures at growth of late, acquiring a neighboring terminal in Corpus Christi from Martin Midstream Partners LP (NSDQ: MMLP) at a price that management asserts should be accretive to cash flow based on current throughput volumes. This asset also serves the Eagle Ford Shale.
Management guided for $530 million to $550 million in capital expenditures next year, about one-third of which will go toward a long-promised joint-venture pipeline with Mexico’s national oil company that still hasn’t been formalized.
NuStar Energy should be able to maintain its distribution in the near term, but its growth prospects will be challenged until activity levels improve in the Eagle Ford Shale—an area that has fallen out of favor because of its hydrocarbon mix and the varying quality of crude oil extracted from the play.
Elliott and Roger on Mar. 20, 2018
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