These Income Generators Are Losing Energy

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. Midstream energy companies have been very much in the news recently. I'm here today with Josh Peters; he is editor of Morningstar DividendInvestor. He has recently made some moves in the master limited partnership space in its portfolio. We're going to talk about what he sold, why, and how investors should think about this space?

Josh, thanks for joining me today.

Josh Peters: Good to be here, Jeremy.

Glaser: Let's talk a little bit about why this has been in the news so much recently. Why have MLPs, in particular, been under such intense focus?

Peters: They're tremendous vehicles for income in an environment where interest rates are pretty low and other types of stocks, in general, are not offering relatively rich yields. If you go into MLPs, it's very common to find yields of 5%, 6%, 7%, or 8% in some cases, but at the same time you don't want to just take those yields for granted. And I think that it's a mistake to assume that just because an MLP is operating pipelines or storage terminals, assets that you think of as having very long useful lives and throwing off a lot of cash, that the distribution is going to be safe and just grow like clockwork.

One of the most notable events in this space here recently, which we've discussed before, was the blowup, and I think that's the right word--blowup--of Boardwalk Pipeline Partners, not too long ago. That was the type of event that should certainly make MLP investors go back to their holdings, go back to those names that they're interested in and scrutinize the asset quality as well as the financial strength of the partnerships that they own.

Glaser: When you went back and looked at your portfolio, what did you find? Why did you decide to make some moves?

Peters:  There were basically two names that I sold out of, though one of them has two securities associated with it. The first was Energy Transfer Equity, symbol ETE, which was one of the best-performing MLPs last year, with really an outstanding total return. Over time the Energy Transfer family has become more complicated. For a while, it looked like the partnership was starting to simplify itself and consolidate some of the intertwining operations among its various subsidiary partnerships: Energy Transfer Partners, Sunoco Logistics Partners, and Regency Energy. This kind of proliferation of partnerships here makes things kind of complicated.

And they're in the process of hopefully receiving full approval to add liquefied natural gas export capacity, which is a development that promises to provide a lot of steady cash flow for them in the future if the projects are executed successfully and they start up in kind of that 2020 time frame. And it's definitely a growth name. Yielding less than 3%, you're expecting lots and lots of growth from Energy Transfer Equity. And as a general partner, you hope that the incentive arrangements it has with these subsidiary partnerships will allow it to provide that growth.

But I wasn't real enthused by the valuation as the units really skyrocketed in value. Once the price crossed a point where it no longer yielded even as much as 3%, I became inclined to sell. But this is also an organization that relative to some of the other partnerships is known as being very aggressive. As an acquirer, it's very aggressive in terms of its organizational complexity and it's very aggressive in terms of distribution policy, frequently paying out a little bit more cash than the partnerships actually generate from their operations.

I didn't feel like that was the best position to be in. The combination of a pretty fair to full type of valuation--even considering all that growth--as well as the complexity and the aggressiveness of that business, I felt like it was time to let that go.

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Glaser:  How about your other sales?

Peters: The other two were both of the Kinder Morgan entities, or I should say two of the four in this case. This is another one where there's multiple securities associated with the same organization. There is Kinder Morgan Incorporated, KMI, which is at the top of the heap as the general partner for both Kinder Morgan Energy Partners, KMP, and El Paso Pipeline Partners, EPB. There is also a separate entity called Kinder Morgan Management, KMR. It doesn't really manage anything. It's just a tax-efficient way for investors to gain access to KMP. Essentially it bypasses all of the unfriendly tax complications that you get with partnerships.

KMP is a name that I've owned literally since day one in DividendInvestor. I made it one of my first six purchases back on Jan. 10, 2005, and for most of the time since then it had been a good performer. It churned a lot of growth in the distribution, and the unit price had followed that up. But there were always elements of Kinder that shared this sort of theme of aggressiveness. And in particular, Kinder has long made a practice of paying out essentially 100% of the cash that its operations generate on an ongoing basis.

You could say it's certainly a very well-diversified portfolio and has a lot of economically resilient characteristics. But is 100% or 1.00 times coverage really appropriate when inside that portfolio you know you have assets that may be decreasing in value or decreasing in their cash flow capacity, while hopefully some others are increasing? And in particular, Kinder Morgan Energy Partners gets about a quarter of its cash flow from not the pipeline business, but an oil-production business in Texas, which is very profitable. But if you pay out all of the cash that an oil-production business generates, eventually the barrels of oil that were in the ground before are gone and the cash flow dries up.

So, I felt like the combination of very tight coverage just as a matter of policy for the Kinder organization as well as that exposure to oil production--eventually the production of oil will decline unless they're constantly acquiring new reserves, which in turn means raising more money from the debt and the equity markets in order to fund that--this was something that I wasn't comfortable with anymore. And the time had really passed for Kinder to outgrow some of these issues and adopt a more conservative approach. That's easier when you're still smaller and growing quickly, but now it's such a large organization that it takes gigantic projects or gigantic acquisitions to even move the needle a little bit.

I felt like the story had kind of played itself out.

Glaser: What are you doing with these proceeds? Are you putting them into another energy name? Are your holdings going to be in cash? How do you think about what to do with them?

Peters: For the time being, I have been holding the proceeds in cash, but my goal is to get those funds reinvested. I'm continually evaluating and scrutinizing new investment opportunities outside our portfolios as well as looking at some of the existing names that we own in the Harvest as possible bolt-on buys to deploy that capital that's been raised.

But in particular, one of the nice side effects of having sold both KMP and ETE from our Harvest portfolio is that our weighting, our exposure to the overall midstream energy group, has dropped quite a bit. Historically, we've gotten a lot of our portfolio value, even more of our income, from these MLPs. I like the idea that we're going to have a little bit better diversification, redeploy some of that capital into some other industries going forward.

I think that's going to make for a healthier overall portfolio, but by no means am I abandoning MLPs. The ones that I still own really distinguish themselves not just with good growth potential and good yields, but also more conservative financial practices and higher coverage ratios. That's Magellan Midstream Partners, AmeriGas Partners, and Spectra Energy Partners.

Glaser: Josh, thanks for the update on your portfolio today.

Peters: Thank you too, Jeremy.

Glaser: For Morningstar, I'm Jeremy Glaser.

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