Evaluating the Gathering-Processing MLP Model
We explore key investment considerations for gathering-processing MLPs.
While master limited partnerships have been around for decades, their popularity has surged over the past five years. Investor interest and appetite for yield created an incentive for midstream MLPs with commodity price exposures to launch public offerings, resulting in a rash of initial public offerings of MLPs that gather and process natural gas (G&P MLPs). G&P MLPs fill the economic niche between upstream producers of natural gas and the long-haul pipeline operators that move gas from producing regions to end-user markets. In good times this appears to be an attractive niche, but commodity price swings can lead to very volatile cash flows for gatherer-processors. As the commodity boom earlier this decade turned to bust, many G&P MLPs were happy to simply maintain distribution payments, while others were forced to cut. G&P yields spiked above 25% (the median yield in our G&P coverage universe), and while they have since recovered handsomely, they still offer a roughly 5% premium to Treasuries and a small premium to other midstream sub-classes. So, what factors should a less-risk-averse investor consider before investing in a G&P MLP?
A Cyclical Business
Make no mistake about it, gathering and processing natural gas is an inherently cyclical business. First of all, G&P MLPs can only gather gas that exploration and production companies produce. Of course, producers prefer to drill only when gas prices provide an adequate return on investment. The break-even gas price varies widely depending on the geology of a given resource play, but in general, newer horizontal drilling techniques in unconventional resource plays like shale formations or tight sands generate better rates of return. Two of the most promising emerging shale plays in the U.S., in terms of drilling economics and estimated reserves, are the Marcellus shale in the Northeast and the Haynesville shale in Louisiana and east Texas. These plays can still provide economic returns with gas prices around $4 per thousand cubic feet, which bodes well for G&Ps that have a strong presence in these areas. For G&Ps with assets in other regions, it is challenging to maintain, much less grow, gathering volumes when producers allocate capital to more attractive plays. For this reason, we tend to favor G&P MLPs with exposure to multiple producing regions.
The next piece of the value chain is processing. In order to meet long-haul pipeline specifications, natural gas must be processed and treated to remove natural gas liquids (NGLs) and impurities such as sulfur and carbon dioxide. NGLs include ethane, propane, butane, and other heavier hydrocarbon chains used for a variety of purposes. For example, ethane is used by the petrochemical industry to make plastics, and propane is used for heating, primarily in the Northeast. G&Ps make money by processing gas to extract the NGLs under a variety of contract structures. Generally speaking, the higher the natural gas liquids price relative to the natural gas price, the more profitable it is to process gas. We should point out that NGL prices tend to track crude oil prices, historically averaging around 60% of the price of crude. Also, ethane increasingly serves as a substitute for crude-based naphtha as a petrochemical feedstock, which we think will help maintain a floor under processing margins long-term, given a more limited supply outlook for crude oil. That said, processing margins are quite volatile at times.
A historical look at ethane margins below illustrates just how volatile a G&P's unhedged cash-flow stream can be. In 2005, ethane margins went sub-zero as natural gas prices spiked relative to crude, thanks to Hurricanes Katrina and Rita. Within a few years, ethane margins spiked above $0.70 per gallon in the commodity bubble of 2008 before again dipping below zero during the credit crisis, as crude fell below $40 per barrel on concerns of sustained weak economic activity. While we expect both crude and natural gas prices to rise in coming years, which is generally positive for G&Ps, we think commodity prices--and processing margins--will remain volatile.
Cyclicality in the financial markets also impacts G&Ps from a cost of capital standpoint. Like other MLPs, G&Ps pay out almost all cash flow in distributions and thus rely on frequent trips to the capital markets to fund growth. During the throes of the market panic in late 2008, equity yields surpassed 25% and the median option-adjusted spread to Treasuries for G&P debt in our coverage vaulted above 1,400 basis points. G&Ps were slammed by a double-whammy: low commodity prices crimped cash flows, and lack of access to capital threatened future growth. Most G&Ps were happy to simply maintain their distributions as investors priced in distribution cuts almost across the board. Some, such as Crosstex (XTEX) / (XTXI), were forced to cut the distribution, inflicting further pain on unit prices and debt spreads. This, in turn, made growth capital even more expensive, spawning a vicious cycle. For these reasons, we think it's paramount that a G&P management team emphasizes solid distribution coverage ratios, a reasonable debt load, and excess liquidity to remain prepared for the unexpected.
How Gatherer-Processors Manage Commodity Exposure
The first line of defense against fickle commodity prices is a fee-based contract structure. Fees per unit gathered or processed eliminate direct commodity exposure, and often have built-in inflation escalation clauses. Management teams and investors alike have placed an increasing focus on fee-based cash flows in recent years, a trend we expect to continue. Two G&P MLPs that went public more recently, Quicksilver Gas (KGS) and Western Gas (WES), have essentially 100% fee-based cash flows. These MLPs tend to trade at lower yields than peers with direct commodity exposure, especially in periods of uncertainty. Chesapeake Midstream, which plans to go public imminently, also operates under a fully fee-based model. In spite of their fee-based contracts, each of these players receives the vast majority of its volumes from its upstream sponsor, which creates significant volumetric and credit risk. We consider a solid base of fee-based cash flows to be a very important trait in a potential G&P investment.
The other major way G&Ps manage their commodity exposure is by hedging. G&Ps will often sell a portion of their expected NGL volumes (or crude as a proxy) forward for up to three or four years using a variety of derivatives. This sacrifices some upside potential in order to eliminate some downside exposure to future price swings, promoting a more stable distributable cash flow profile. We think Copano (CPNO) is particularly savvy with its hedging strategy, and note that the firm's gross margins net of hedging held up fairly well through the abysmal commodity price environment of late 2008 and early 2009.
Gatherer-Processor Growth Strategies
While building and buying growth are both viable strategies, we tend to prefer the former for a few reasons. First, organic growth promotes strategic extensions to a G&P's footprint that can add synergies to its network. Some of the most successful G&P MLPs have demonstrated that vertical integration along the midstream or downstream value chains can be a winning formula when executed purposefully. A good example is MarkWest (MWE), which has combined gathering, processing, fractionation, and even segments of pipelines to build integrated midstream solutions for producers in the Woodford and Marcellus shales. In the Haynesville shale, Regency (RGNC) has had similar success by establishing a strong, early presence with a long-haul pipeline joint venture. This, in turn, has provided Regency a platform to further ramp up its gathering and compression operations in the area, adding volumes that ultimately feed its pipeline to collect multiple rents on the same gas molecules. Organic growth also tends to be less risky than acquisitions, and typically provides more attractive returns on invested capital.
That said, acquisitive growth remains a viable strategy for some G&P MLPs, especially those with large sponsors. DCP Midstream Partners (DPM), for instance, has spent 90% of its growth capital on acquisitions since its 2005 IPO. This includes several drop-downs from general partner DCP Midstream LLC, one of the largest G&P operators in the U.S., and we fully expect the general partner to drop down additional assets over time. What's more, DCP Midstream Partners' general partner has helped finance drop-downs by purchasing equity in the partnership, and has even provided commodity price guarantees in conjunction with a drop-down--both examples of how a powerful sponsor can drive growth in challenging times. Another drop-down story is Targa Resources Partners (NGLS), which has by now pretty much tapped out its parent company's stash of midstream and downstream assets. We like the fee-based cash flows and growth potential of Targa's downstream business, which enhance Targa's cash-flow profile, add scale, and differentiate its asset mix from that of other pure-play G&Ps.
Putting It All Together: Our Favorite Gatherer-Processor MLP
Considering the asset bases, cash-flow profiles, growth potential, and management teams across our G&P coverage, we think MarkWest stands out from the pack. MarkWest's growth prospects look the rosiest to us thanks largely to its dominant position in the Marcellus shale, where the partnership's Liberty joint venture provides a full suite of midstream services to several major producers. We also expect that MarkWest will benefit from production growth in other emerging resource plays including the Haynesville shale, Granite Wash, and Woodford shale. MarkWest's fee-based cash flows continue to edge up toward 50% of total cash flows, which, though lower than several other G&Ps, makes MarkWest's distribution increasingly dependable over time. Moreover, MarkWest is one of the only G&Ps (along with Copano) that does not pay incentive distribution rights, which lowers the company's effective cost of capital and allows it to boost quarterly distributions more quickly over time, all else equal. Finally, we think MarkWest's management team is among the best in the space as illustrated by its quick action to establish a first-move advantage in the Marcellus, its ability to find joint-venture partners to take on attractive but very capital-intensive projects, and MarkWest's consistently high scores on customer satisfaction surveys.
That said, we feel the G&P space is fully valued at the time of writing and would generally not be buyers without a greater margin of safety. Investors should remember that macro events, particularly commodity prices and access to capital, can trump firm-specific events or management decisions in this space. We think that less-risk-averse investors could consider G&P MLPs again when the relatively paltry 1.3% yield advantage over investment-grade pipeline MLPs widens once again.
Avi Feinberg does not own shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.
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