Finding True Value in Master Limited Partnerships
A roadmap to identifying the best investments in midstream energy.
There's no question in our minds that there is tremendous value in midstream master limited partnerships. Stock prices have fallen roughly 50% this year, yet for the vast majority of stocks we cover cash flows and distributions have not suffered to nearly this extent. While concerns over capital market access and distribution security are real, we think fear has created some excellent opportunities. But sifting through our list of 5-star MLPs to find the right opportunity can be daunting, so we've created a short primer to guide your thinking.
First off, with numerous MLPs in 5-star territory, one needs to consider other factors beyond the star rating to find the business offering the best risk/reward profile. This may also help one consider how large to size one's investment. After all, our Consider Buying price is the point at which you should consider buying units, but "consider" implies deliberation, in our view. In addition to our fair value uncertainty ratings and fair value estimates, we suggest MLP investors weigh these factors.
Consider Commodity Price Exposures
MLPs that gather and process natural gas tend to be more exposed to commodity price movements than traditional pipeline MLPs. The difference in the price of natural gas and natural gas liquids (NGLs), known as a frac spread, can make or break processing margins, and because NGLs tend to be priced off crude oil, processing margins have dropped close to zero in recent weeks. While MLPs can hedge out most of their exposure, it's difficult to impossible to hedge all exposures. However, we see opportunity in fee-based gatherers and processors such as Western Gas Partners (WES) and Quicksilver Gas Services (KGS), which have sold off along with other gas gatherers and processors but are significantly more insulated from commodity prices.
Look for Good Coverage
MLPs with high distribution coverage have a better ability to weather the tough market. That's why we looked favorably on Energy Transfer Partners' (ETP) third-quarter decision to maintain rather than raise its distribution. By holding the distribution at second-quarter levels, Energy Transfer was able to increase its distribution coverage and retain the additional cash to help fund future growth. While traditionally MLPs targeted a 1.1x coverage ratio, in this market we are looking for MLPs that cover distributions by 1.4x or better.
Along the same lines, we think liquidity may be the greatest advantage for an MLP in this market. Having cash on hand or available through credit lines gives MLPs a cushion against the unexpected. Liquidity also can allow an MLP to continue its growth plans, and we continue to think that MLPs with strong balance sheets will be the likely buyers if the industry consolidates. As we recently noted, investment-grade MLPs that can raise capital are doing so, and we think this is a mark of prudence.
The Winner's Circle
So which MLPs make the grade by avoiding undue commodity exposure, maintaining strong distribution coverage, and working from a secure liquidity position? We've picked five names that we think do an exceptional job of balancing distribution stability with distribution growth. Any one of these, in our view, presents a compelling risk/reward proposition.
Energy Transfer Partners (ETP)
With a successful debt offering adding to the company's liquidity position and several years' worth of major projects just recently entering service, we think Energy Transfer will be able to maintain its growth momentum. We would not be surprised if Energy Transfer slowed or halted distribution growth in 2009, but we would expect to see any nondistributed cash deployed to fund growth projects, generating solid returns in years ahead.
Magellan Midstream Partners (MMP)
Weak demand for refined products, particularly gasoline, has hurt Magellan's throughput volumes this year, but we don't think cash flows are likely to suffer nearly as much as throughput. Investments in storage assets and terminals plus an inflation-adjusted pipeline tariff should continue to enable Magellan's steady growth.
Enterprise Products Partners (EPD)
Enterprise has $2.2 billion in available liquidity and stable, fee-based assets stretching across the entire midstream energy value chain. Its cash position should allow Enterprise to continue its investment program without tapping equity markets in 2009, and it also puts Enterprise on our short list of potential industry consolidators.
Kinder Morgan Energy Partners (KMP)
While the majority of Kinder's cash flows stem from predominately fee-based pipeline transportation contracts, nearly a quarter of Kinder Morgan's cash flows are derived from oil production through its CO2 business. We've long admired Kinder's very conservative hedging program that locks in selling prices for up to five years, creating a predictable, stable cash flow stream.
Plains All American Pipeline (PAA)
As the largest operator of crude oil transportation and storage assets in the United States, Plains All American is in a great position, in our view, to benefit from falling oil prices. When oil is cheaper on the spot market than in the future, producers and traders are willing to pay premium prices to store oil at Plains' Cushing facility. We think this market dynamic will continue to benefit Plains over the next several quarters.
Bonus Round--General Partner MLPs
We feel compelled to mention that, in our view, among the most attractive MLP investments available to investors today are general partner MLPs. Three of the MLPs in our winner's circle--Energy Transfer Partners, Magellan Midstream Partners, and Enterprise Products Partners--have publicly traded general partners-- Energy Transfer Equity (ETE), Magellan Midstream Holdings (MGG), and Enterprise GP Holdings (EPE)--and each of these general partner MLPs have in recent weeks traded at or above the yield of their underlying MLP.
This just doesn't make much sense to us, and it smells like an opportunity. General partner MLPs hold incentive distribution rights (IDRs) in their underlying MLP, and these IDRs provide general partners with an increasing claim on cash payouts over time: As an MLP increases its distribution to limited partners, its general partner will see its share of total cash distributions increase. Thanks to this incentive structure, we can work out the distribution math and know that, for instance, if Magellan Midstream Partners increases its distribution by 8%, its general partner, Magellan Midstream Holdings, will be able to raise its distribution by about 15%. In exchange for faster distribution growth, we'd expect to see MGG trade at a lower yield.
So what does it mean that a general partner and its underlying MLP are trading at or near the same yield? To us, it means that the market is penalizing the perceived riskiness of general partners' cash flows to such an extent that the growth premium we'd expect to see is canceled out. But if we're confident in the underlying MLP's cash flows and in its ability to grow its distribution over time--a confidence we have in all five of our winner's circle picks--then what we see in the market is an opportunity to buy distribution streams growing 1.5 to 2.0 times faster than those of the underlying MLP at the same price--or, in other words, free growth.
Jason Stevens does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.