This year started on a promising note for master limited partnerships (MLP), with the Alerian MLP Index rallying hard from mid-December 2017 to the end of January. But this momentum has reversed over the past month, sending this basket of 40 prominent publicly traded partnerships close to the low hit at the end of November 2017.
Last week’s installment of Energy Investing Weekly explored the confluence of factors that have contributed to weakness in midstream MLPs, from a rash of distribution cuts and governance-related concerns to the lack of depth in the market for these securities.
At the height of the shale oil and gas revolution, MLPs issued equity regularly to enthusiastic investors who coveted the group’s tax advantages, leverage to growing US hydrocarbon output, and above-average yields in a low-rate environment.
The proceeds from these transactions usually went toward growth projects or asset drop-downs, as MLPs and their sponsors took advantage of investors’ willingness to pay premium valuations for tax-deferred cash flow streams. This sanguine environment enabled many MLPs to disburse the bulk of their cash flow to unitholders via quarterly distributions.
Fast-forward to 2018. The Alerian MLP Index yields 8.2 percent, compared to the Bloomberg US REIT Index’s 4.7 percent yield and the Dow Jones US Total Market Utilities Index’s 3.6 percent yield. Among the energy-related partnerships covered in our MLP Ratings, 47 offer indicated yields that exceed 8.2 percent.
This 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. Equally important, the market has punished MLPs that have issued equity, particularly in instances where the stock is already widely held.
For example, Shell Midstream Partners LP (NYSE: SHLX), which generates the bulk of its cash flow growth via asset drop-downs from Royal Dutch Shell (LSE: RDSA, NYSE: RDS A), gave up almost 10 percent of its value after the MLP announced a $680 million equity offering on Feb. 1.
MLPs have responded to these challenges by curtailing their equity issuance. Although the total number and value of MLP initial and secondary offerings have trended lower in recent years, they have fallen off a cliff in 2018: Year to date, only a few intrepid partnerships have issued equity on the public market.
This reticence to issue common stock—outside of at-the-market deals—suggests that, at least thus far, MLPs have lived up to their commitments to reduce their equity issuance.
However, with US onshore oil and gas production continuing to grow and upstream operators ramping up activity levels in the Permian Basin and capacity-constrained areas, midstream MLPs have ample growth opportunities on their plates. And the backlog of potential drop-down transactions remains robust for the MLPs that rely on this strategy to drive cash flow growth.
Sharp distribution cuts have put Williams Partners LP (NYSE: WPZ) and other MLPs on a sustainable path, shoring up their balance sheets and enabling them to fund the equity portion of their capital expenditures internally.
Others, such as Crestwood Equity Partners LP (NYSE: CEQP), have monetized noncore assets to help to bridge the funding gap and build distribution coverage without stretching their balance sheets.
Meanwhile, Enterprise Products Partners LP (NYSE: EPD) made a big splash last fall with the announcement that the blue-chip MLP would slow its rate of distribution growth to retain more cash flow and reduce its reliance on the equity market.
Reducing the rate of distribution increases would put the blue-chip MLP closer to being able to self-fund the equity portion of its growth capital in 2019—a major point of differentiation. Management asserted that any excess cash flow eventually could be used to buy back stock, depending on the valuation and how this option stacks up relative to other uses of capital.
Publicly traded partnerships have also hit the debt market hard thus far in 2018.
Year to date, energy-related MLPs have issued about $10 billion worth of bonds for purposes other than refinancing—roughly half the amount sold over the entirety of 2015 and 2017. That’s almost as much as the group issued in 2016, though a sharp selloff in energy debt in the first half of that year constrained bond issuance.
Preferred-equity issuance has also increased significantly for the first time since the mid-2000s. Over the past 12 months, MLPs have raised almost $7.9 billion in this market.
Not only can MLPs issue preferred units at lower yields than their common stock—especially in instances where the partnership has burdensome incentive distribution rights (IDR)—but these securities also sweeten the deal for the cabal of funds that focus on this asset class.
For example, Energy Transfer Partners LP’s (NYSE: ETP) common units yield almost 12 percent, but when you factor in IDR payments to its general partner, its cost of equity capital is closer to 20 percent. These expenses make the roughly 6 percent yields on the preferred securities that the MLP issued last year all the more appealing.
And we doubt that MLP-focused portfolio managers were beating down the door to increase their exposure to Buckeye Partners’ common units. However, the potential upside associated with the preferred units prompted Kayne Anderson Capital Advisors and Tortoise Capital Advisors to pony up.
Bottom Line: MLPs may not issue as much equity this year, but they’re still tapping the capital markets to fund growth projects and drop-down transactions. We prefer to focus on names with strong balance sheets, ample distribution coverage, high-quality management teams, and assets that offer exposure to organic growth opportunities.
In our view, these names should be able to grow their payouts while transitioning to a sustainable model that relies more heavily on self-funding growth opportunities.
Although the recent wave of preferred-equity issuance may involve lower costs than selling common equity, investors should pay attention to potential headwinds that might emerge when the coupons move to floating rates or these preferred units convert to common stock.
Elliott and Roger on Dec. 27, 2018
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