A Changing of the Guard in Master Limited Partnerships

Once a month, Elliott Gue and I host a free-ranging online chat with Energy & Income Advisor subscribers that lasts until all questions are answered. Most of these sessions wrap up around dinner time, though the chats that coincide with periods of market turbulence can stretch into the wee hours. These discussions provide useful insights into what readers want and where sentiment stands.

Energy & Income Advisor subscribers can peruse the transcript of the Aug. 29 online chat on the website. One interesting theme emerged during the proceedings: Investors remain skeptical of master limited partnerships (MLP).  

Sane Fears

We understand investors’ pessimism toward MLPs. Including distributions, the Alerian MLP Index has given up 5.6 percent of its value in a year when the S&P 500 has gained 13.1 percent.

To worsen matters, several larger-capitalization MLPs have slashed their payouts over the past few years, shaking investors’ confidence in the space.

For example, Plains All-American Pipeline LP (NYSE: PAA) did the group few favors with its recent distribution cut of more than 40 percent, though a stretched balance sheet and consistent cash flow shortfalls made this move a necessity. Further rankling investors, this reduction came on the heels of a $7.2 billion transaction to eliminate the MLP’s incentive distribution rights—a valuation that reflected a higher quarterly payout.

This news from Plains All-American Pipeline—which followed high-profile distribution cuts by Kinder Morgan (NYSE: KMI), Energy Transfer Partners LP (NYSE: ETP) and Williams Partners LP (NYSE: WPZ)—prompted some readers to ask whether the recent underperformance in our favorite MLPs implied that their payouts would suffer a similar fate.

Some prominent MLPs still need to slash their distributions further to put themselves on a sustainable path after taking on excessive leverage to capture opportunities during the boom years.

Although sentiment toward midstream MLPs remains weak, the doom and gloom gives savvy investors an opportunity to lock in above-average yields on high-quality names that stand to benefit as US onshore oil and gas production takes market share over time.

Many MLPs have already taken their medicine and put themselves on a sustainable path, while Mexico’s growing appetite for US-produced energy commodities and the coming expansion of the Gulf Coast petrochemical complex create opportunities for growth. (See Three Growth Themes for MLP Investors.)

Time for Some Turnover

Every time we hear from a reader doggedly holding on to units of Plains All-American Pipeline, Genesis Energy LP (NYSE: GEL) or one of the many Sell-rated names in our MLP Ratings, we remind ourselves that Energy & Income Advisor isn’t the sole source of insight and analysis on which people make investment decisions.

The reputational damage to the MLP space inflicted by the old guard obscures the emergence of a new guard of higher-quality names with solid balance sheets that can take advantage of this weakness to pursue joint ventures, asset acquisitions and organic growth opportunities.

Plains All-American Pipeline does own quality assets in the Permian Basin that should offer organic growth opportunities in an environment where oil prices remain lower for longer. However, the MLP must also contend with excessive leverage and a murderers’ row of debt maturities in coming years. Healing the balance sheet will take time and could result in more pain for investors.

Not every blue-chip MLP has treated its unitholders so callously. Enterprise Products Partners LP (NYSE: EPD) and Magellan Midstream Partners LP (NYSE: MMP) have continued to grow their distributions while investing in sensible growth projects and not taking on too much risk.

However, investors can also find opportunities to lock in above-average yields on MLPs that haven’t become household names—an attractive proposition at a time when interest rates remain low and much of the utility sector trades at sky-high valuations.

The shakeout underway in the midstream space reminds me of what happened in the utility sector after Enron’s implosion in late 2001. Back then, shares of Dominion Energy (NYSE: D) and other names that moved early to exit riskier operations and shore up their balance sheets recovered relatively quickly; others, like Aquila, faced hurdles that were too high.

This history lesson, coupled with the favorable valuations that usually accompany negative investors sentiment, make a strong case for investors to focus on the “new guard” of MLPs. However, investors should note that this strategy does not necessarily involve recent initial public offerings.

The New Guard

Attending the MLP Association’s annual investor conference last spring crystallized our strategy of focusing on a new guard of master limited partnerships with strong balance sheets and high-quality assets—names that have been unfairly painted with the same brush as Plains All-American Pipeline and other cutters.

These names will be well-positioned to take advantage of growth opportunities that emerge as the short-cycle shale plays with the best economics take market share globally and within the US itself. In this scenario, production will increase in the Delaware Basin and other areas with exposure to multiple hydrocarbon-bearing formations, while drilling and completion activity will weaken in less-competitive basins. For midstream operators in out-of-favor areas, these trends will result in stagnant to declining volumes and diminished cash flow when contracts renew.

Heavy debt loads will also prevent some popular MLPs from pursuing these growth opportunities to the fullest or force them to pursue joint ventures and sell assets to ease their refinancing burdens.

Recovery is coming for the best-in-class MLPs. Investor sentiment toward the midstream space is too gloomy, valuations are far too low, and several volumetric growth stories remain intact. Selectivity will be critical to profiting from this opportunity.

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