Are Pipelines Right for You?

In DividendInvestor, Morningstar's newsletter focused on high-yielding and high-quality dividend payers, we regularly examine different income-producing sectors such as pipelines, REITs, and utilities. (Investors can access a risk-free trial issue of DividendInvestor here.)

In March, DividendInvestor zeroed in on the pipeline industry with analyst Michael Cumming. Michael covers pipelines as well as international oil stocks for Morningstar. He holds an MBA from Emory University as well as the chartered financial analyst designation.

Morningstar DividendInvestor: How have several of the pipelines earned wide-moat ratings?

Michael Cumming: Pipelines offer by far the cheapest way to ship crude and refined oil products and natural gas over long distances. Trains and trucks offer some competition, but pipelines are much less labor-intensive and require relatively little maintenance.

There are significant barriers to entry as well. Acquiring the regulatory approvals and rights of way to build a new pipeline is a long and difficult process, and the large investment required prevents competitors from building new lines without a demonstrated economic need.

However, the vast majority of pipelines have regulatory caps on investment returns, which places the industry at the narrow end of our wide-moat category: modest economic profits, but sustainable for a very long time.

MDI: Would falling energy prices pose a risk to pipeline earnings?

Cumming: Pipelines earn revenue based on the amount of oil or gas transported instead of the price of the hydrocarbons themselves. Demand for energy is relatively inelastic--most people don't drive their cars or run the air conditioner more if energy prices are low--so the volume of oil and gas transported will remain relatively steady over time.

MDI: Should investors be concerned about these firms' policies of paying out almost all of their operating cash flow as distributions?

Cumming: Since the volume of product transported stays relatively stable, pipeline revenue is too. This stability allows pipelines to raise debt or equity in the capital markets anytime they need funding for expansion projects or acquisitions, making retained earnings less important. These companies are very careful to make sure cash flow will cover all expenses and unitholder distributions, and most maintain a reasonable reserve. The last thing these partnerships want to do is cut distributions, a move that would damage the price of the units.

MDI: It's surprising that a sector with such high payout ratios has had such attractive distribution growth. How have these pipeline partnerships created so much value?

Cumming: Acquiring underused or inefficient assets can create a lot of value for these firms. Recent transactions have involved major integrated energy firms selling in-house assets with excess capacity to dedicated pipeline operators, such as  Magellan Midstream Partners’  purchase of pipeline assets from  Shell   last year. The dedicated pipeline operator sells excess capacity to other parties while continuing to provide transportation services to the original owner, thus generating significantly higher revenue. Pipelines can also realize synergies by making the combined operating and maintenance efforts more efficient.

MDI: The yield on pipelines relative to Treasury bonds is near record lows. Does this make the sector unattractive?

Cumming: Low interest rates have caused investors to chase yields in all forms, including pipeline partnerships. But rates aside, demand for pipelines has grown as investors become more comfortable with the structure of master limited partnerships (MLPs) and a lengthening record of stable and growing returns. Of course, the boost that low initial valuations gave to historical returns probably won't be repeated, and the sector may come under pressure as interest rates rise. That said, many of the pipeline companies have growth opportunities that will help offset an increase in rates, and it makes sense for the firms with the best distribution growth prospects to trade at below-average current yields.

MDI: What should investors expect for distribution growth?

Cumming: On average, we expect distribution growth to slow from the robust pace of the past few years. While distributions have grown in excess of 5% for some companies recently, we expect most to fall in the 2%-4% range, with top performers at 5% or slightly higher. We think most pipelines are fairly valued to slightly overvalued, but internal projects can still generate 1%-2% growth in cash flows. The cash-flow impact of acquisitions will vary widely based on the size of the deal and price paid. Acquisition multiples are up substantially--the attractive economics of a pipeline aren't a secret anymore, and financial buyers (including Warren Buffett's  Berkshire Hathaway (BRK.B)) have become a factor. But since deal financing is raised externally, the industry’s investors can control what the MLPs are allowed to pay.

MDI: What are some of the risks for pipelines?

Cumming: The biggest risks that pipelines face involve regulation. Pipelines held by MLPs do not pay income taxes and could be severely affected if that special tax status were changed or taken away. Most pipelines can be susceptible to adverse rulings regarding the rates of return allowed by regulators. Environmental regulation can be costly for pipelines, and spills or leaks are always a concern. Some pipelines companies, like  Valero LP , derive a large percentage of their revenue from one customer. In this case, Valero LP will diversify its customer base away from parent  Valero Energy (VLO) with its acquisition of  Kaneb Pipe Line Partners .

While most pipelines do not own the oil that passes through the pipes, some (like  Plains All American (PAA)) take title to the oil, a business that can be abused by rogue traders. Controls are generally in place to avoid serious losses, but the practice is very capital-intensive and earns very slim margins.

MDI: Most of the pipelines get a C grade for corporate stewardship. Is that something investors should be concerned about?

Cumming: All of the pipeline companies that are organized as MLPs get dinged because limited partners have little say in the management of the operation. Aside from this mark, several would earn a B grade. It should be noted that C is considered average, so governance at these companies is not a big concern. By the way,  Kinder Morgan Energy Partners  earns a B even with the penalties for MLPs.

MDI: What are your favorite pipelines right now?

Cumming: My favorite pipeline is  TransCanada (TRP), the largest natural-gas carrier in Canada. It owns some of the most vital gas pipelines in Canada and is well positioned to benefit from new sources of gas, including imports of liquefied natural gas and proposed pipelines from gas sources in Alaska and the Mackenzie Delta region. The company recently announced plans to convert one of its underused pipelines to carry oil from the Alberta oil sands into the Midwestern United States. Success in one or more of these projects should ensure TransCanada's cash flow for years to come.

Among the U.S.-based MLPs that we have talked so much about, my favorite right now is  Buckeye Partners . Last year, Buckeye announced acquisitions of two big pipeline systems that fit nicely with its own systems and competencies. The company should be able to increase utilization of these assets, which will allow it to increase distributions to unitholders. As for two others that I like, Magellan's record of distribution increases should continue, while  Enterprise Products Partners (EPD) looks poised to build on its dominant position in the Gulf Coast.

MDI: Are there any pipelines you would avoid?

Cumming: I don't see any that I would be emphatic about avoiding, but I would be cautious with  Williams (WMB) and  El Paso , both of which are still struggling to recover after the energy-trading business collapsed around Enron. I'm also less than enthusiastic about MLPs with poor records for increasing cash distributions, such as  Northern Border Partners . There are certainly pipelines available with better growth prospects.

MDI: Great interview--thanks, Michael.

This article is from a recent issue of Morningstar DividendInvestor, our monthly newsletter dedicated to helping investors find high-dividend stocks with superior long-term return potential. To review a risk-free trial issue of DividendInvestor and receive three free investing reports, click here.