For a list of MLPs, check out The Energy Report's new MLP Directory.
The Energy Report: Some of our readers may not know how MLPs work. Please give us an overview of the sector and some advantages and disadvantages of investing in MLPs.
Michael Blum: Master limited partnerships are high-yielding publicly traded entities, which trade on major exchanges similar to a corporation. The difference is that MLPs are structured as partnerships; they don't pay corporate taxes at the partnership level and investors avoid double taxation. Investors receive cash distributions instead of dividends.
To be eligible as an MLP, the partnership has to receive at least 90% of its income from what's called qualifying sources (natural resources, real estate rents and dividend income). For practical purposes, MLPs are involved mostly in the energy sector—of the 91 publicly traded MLPs, 71 are involved in energy. Most energy MLPs provide midstream services (i.e., they handle various commodities for a fee). Many MLPs operate pipelines and storage facilities, so they generate pretty stable cash flows with little direct commodity risk.
MLPs distribute available cash flow—cash left over after paying debt service, maintenance, etc.—at the end of each quarter to their unit holders. Therefore, MLPs have pretty high yields, averaging between 6%–8%.
TER: Explain the tax advantages.
MB: The basic value proposition for an MLP investor is a low double-digit annual total return consisting of a 6%–8% yield with 3%–5% annual distribution growth and certain tax-deferred advantages. Investors are required to pay tax on only 20% of that distribution, typically. The rest of the tax is deferred until the investor sells the security, which could be many years in the future. From a tax perspective, it can be very efficient for investors.
TER: Does that mean that MLPs are long-term investments?
MB: Yes, I would consider them long-term investments; they certainly own long-lived assets. About 70% of MLPs are owned by retail investors, and retirees own them for the income.
TER: Recent healthcare legislation will tax dividends for people making more than $200K/year but will not affect MLP distributions. I suppose this makes MLPs even more attractive.
MB: Yes, the recent 3.8% tax on interest dividends, annuities, etc., which also includes families earning more than $250K. This will not impact MLPs in terms of their distributions. On a relative basis, yes, the MLPs become more attractive.
TER: What are the risks?
MB: MLPs present some additional tax-filing burdens that you don't find with C-Corp investments. MLP investors receive K-1s instead of 1099s because they're partners in a partnership–not corporate shareholders. MLPs also have relatively low liquidity in terms of trading volume, so they're not easy to trade in and out of if you want to take large positions. Large MLP positions shouldn't be held in IRAs or tax-free accounts because they generate unrelated business taxable income (UBTI), which triggers tax consequences if it exceeds $1,000 per year.
In terms of actual investment risk, there are some legislative risks. For example, many of these are oil and gas companies and current, proposed legislation could impact them. MLPs are also very reliant on access to capital markets; when those markets become stressed, the MLPs tend to trade poorly.
TER: So, were MLPs a bad place to invest in the 2008 market crash?
MB: Everywhere was a bad place to be in 2008, including MLPs. But if you just owned MLPs for income, about 80% maintained or increased their distributions during that period. MLP prices declined precipitously in line with the market. From that perspective, it was not a great place to be.
TER: But unit holders still received distributions. Are you saying that MLPs are pretty much bulletproof in terms of economic downturns?
MB: Nothing's bulletproof, but certainly most MLPs that own pipeline assets have very stable cash flows and have—over many different economic and commodity-price cycles—been able to maintain and even grow their distributions. Some MLPs have more commodity price risk, and some of those were forced to cut or eliminate distributions during the last downturn.
TER: You said there is a legislative risk. Is there an MLP lobby?
MB: The National Association of Publicly Traded Partnerships (NAPTP), a trade association, represents publicly traded limited partnerships. They lobby on behalf of the MLP sector; and, historically, have made a good case for leaving MLPs' tax status intact.
TER: In your research, you said a lot of an MLP's performance is determined on a macro level. Moody's recently downgraded Greece's credit to junk and oil prices are projected to be relatively soft through 2010 and into early 2011. How will that affect the MLP sector?
MB: We have a relatively cautious near-term outlook on MLPs for those reasons. The correlation between high-yield credit spreads and MLPs is quite high. Because MLPs are yield products, they move in sympathy to yield spreads. MLPs pay out most of their cash flows in the form of quarterly distributions, yet they're growing by acquisitions and new pipeline and asset investment. They must have access to debt and equity markets to fund those investments. MLPs are very sensitive to happenings in the equity and credit markets. Credit spreads are continuing to widen due to Eurozone issues, which could put more pressure on MLP prices. Commodity prices also play a role, as some MLPs have direct commodity exposure. Generally speaking, MLPs move in sympathy with commodity prices because they are energy companies; so, weaker oil prices imply lower MLP prices.
TER: Given that many MLPs are energy companies, will the Gulf of Mexico (GOM) spill impact the sector?
MB: Very little. Only a handful of MLPs have direct exposure to the Gulf.
TER: You follow a number of segments within the MLP sector: large- and small-cap pipelines, upstream, propane and shipping. Please provide an overview of these sectors and the investment opportunities there.
MB: Let's start with pipeline MLPs. There are different types of pipeline MLPs—crude oil; natural gas; natural gas liquids (NGLs), which are produced in association with natural gas, and refined product pipelines. They all have different characteristics but, in general, they generate mostly fee-based cash flows. Sometimes they're driven by volumes, but often they're regulated with automatic adjusters for inflation. Generally, pipeline MLPs are the lowest risk; sometimes their growth is more modest, but still relatively healthy at 3%–5%.
Gathering and processing MLPs collect and process—remove impurities—and separate the NGLs. The natural gas is then pipeline-ready, and is shipped via larger pipelines to consuming markets. NGLs are shipped on a separate pipeline grid for their markets. NGLs include ethane, propane, butane, isobutene and natural gasoline; and each has its own distinct market. Ethane is used by the petrochemical industry to make plastics. Propane is also used in that industry, primarily as heating fuel for homes. The others are used in the refining and gasoline-production industries. Gathering and processing MLPs have higher yields and more risk, as they have more direct exposure to commodities and natural gas production trends.
Upstream MLPs are traditional oil and gas producers actively drilling for oil and gas. Upstream MLP properties differ in that the reserves they own are typically mature, low-decline assets. . .the boring stuff. They make good MLP assets because they throw off relatively predictable cash flows. Upstream MLPs also have the most commodity exposure and, typically, the highest yields; however, they do hedge for several years out to mitigate that commodity price exposure.
Propane MLPs distribute propane via propane-delivery trucks to residential tanks. Companies are able to adjust their margins as propane prices change, so there's not much direct commodity exposure; so propane MLPs have been pretty defensive investments in downturns. The main risk is weather; these MLPs are dependent on cold winters.
Shipping MLPs cover domestic and international shippers—oil, liquefied natural gas (LNG), etc. Local shippers ship refined products and crude oil only around local markets, up and down rivers and between states.
TER: It seems like they were created as a way to invest in infrastructure.
MB: Yes, Congress created MLPs with these special rules to encourage energy infrastructure investment. Over the last five to seven years, there's been a multi-billion dollar buildout in natural gas pipelines. The MLPs have been spending most of that capital and building most of those pipelines. So, in terms of attracting private capital to build the U.S. pipeline infrastructure, it's worked.
TER: Have you seen corresponding growth in the number of MLPs over the last few years?
MB: Tremendous growth. In 2000, there were 18 energy MLPs and the sector's market cap was $16 billion. Today, there are 71 energy-related MLPs with a combined market cap of about $180 billion.
TER: Can you explain the difference between general and limited partners?
MB: MLPs are structured with a general partner and limited partners. The general partner controls and manages the MLP and, typically, owns a 2% equity interest. The limited partners provide capital. General partners own incentive distribution rights; that is, they're entitled to an increasing percentage of incremental cash flow as they raise the distribution to limited partners at incremental rates. This provides incentive for the general partner to raise distribution levels to limited partner unit holders. Almost all MLPs have a general partner. In recent years, some MLPs formed without general partners and incentive distributions rights (IDRs). Or some MLPs eliminated their general partner or IDRs.
TER: Basically, it's like a managing partner. What's the maximum they can own?
MB: I don't think there's any maximum; most own only a 2% interest, but the incentive distribution rights entitle the general partner to receive up to 50% of incremental cash flow. They start out at 2%, then, when the distribution reaches a certain level, the general partner is entitled to 15% of the incremental cash, then 25%, and then 50%. Most general partners own a large percentage of limited partner units, as well; so they are aligned with the limited partner unit holders from that standpoint.
TER: In a recent research report, you wrote: "For investors that are more cautious in their macro outlook we would focus more on the large-cap defensive pipeline names." You named the following companies in your research: Enterprise Products Partners L.P. (NYSE: EPD), Kinder Morgan Management, LLC (NYSE:KMR), Magellan Midstream Partners L.P. (NYSE:MMP), Sunoco Logistics Partners L.P. (NYSE:SXL). Tell us about those names.
MB: During periods when there's more risk aversion, the investment-grade pipelines tend to outperform on a relative basis. Enterprise Products Partners is the largest MLP in the sector. It has a franchise position in pipeline and storage, and fractionation in the NGLs market. We think EPD can grow distribution about 6% annually for the next several years. A lot of that has to do with where its assets are located, as well as some expansion projects it's pursuing. EPD is expanding a pipeline out of the developing Haynesville shale and its NGL assets at Mont Belvieu, Texas, which is the premier market and pricing point for NGLs. EPD is very well-positioned and cash flows are very stable, in our opinion.
TER: What constitutes an investment-grade MLP?
MB: There are only 13 investment grade-rated MLPs, which are primarily the large-cap pipeline MLPs. The rest of the MLPs are non-investment-graded or "junk." The yields on these MLPs are higher because there's more perceived risk and, as a result, their cost of financing is higher for both debt and equity. To the extent that an MLP can move from non-investment-grade to investment-grade, that should improve its valuation and capital cost. It's a big advantage.
TER: Alright, what's the yield from Enterprise Products?
MB: 6.6%.
TER: How long will that continue?
MB: In general, we forecast the stock should continue to yield somewhere around 6%–7%, with roughly 6% annual distribution growth. We think that's sustainable for several years.
TER: What about Kinder Morgan?
MB: Kinder Morgan is another one of the franchise MLPs in the sector. It has a large natural gas pipeline business, a refined product pipeline segment and a terminal storage business, wherein they store and handle various materials for a fee, as well as an oil production company. The cash flows are also relatively stable. Kinder Morgan Energy Partners, L.P. has two securities, Kinder Morgan Energy Partners (KMP) and Kinder Morgan Management (KMR). KMR pays a stock dividend instead of a cash distribution. As a result, KMR, which pays the stock dividend, does not generate a K-1. It eliminates a lot of tax-filing requirements that some investors don't want to deal with. We think the distribution there is secure and is probably going to grow around 4%. We prefer KMR to KMP because it priced more attractively and the distribution is based on the same assets and underlying cash flow stream.
TER: Magellan?
MB: Magellan Midstream Partners is a refined product pipeline and storage company. Again, stable cash flows, very strong balance sheet, in our opinion. What attracts us to Magellan is its acquisition prospects. The oil majors such as Chevron Corp. (NYSE:CVX), Exxon Mobil Corp. (NYSE:XOM) and ConocoPhillips (NYSE:COP) and others have announced plans to sell some of their midstream assets in the U.S. as a way to raise cash. We think the MLPs and Magellan in particular, due to the elimination of its IDRs, are well-positioned to acquire some of those assets. This should lend itself to higher distributions in the future.
TER: What's the yield on Magellan?
MB: The yield at present is 6.4%.
TER: And Sunoco?
MB: Sunoco is also in the refined product and crude oil pipeline and storage business. What's unique there is the company has a lot of organic opportunities. It has assets in the Gulf Coast and Northeast that are in growth markets. As a result, SXL is spending money to expand its asset base. Therefore, you can point to visible 10%+ distribution growth for the next couple of years. You've got a stable yield at 6.5% with 10%+ growth in distributions. We think that'll enable the partnership to outperform.
TER: Are there some other companies you would like to talk about in that space?
MB: The other one I might mention is Energy Transfer Partners. The company is principally a natural gas pipeline company. It has a number of interstate pipelines and also a large Texas intrastate pipeline system. What's unique about Energy Transfer is that management has done a really good job of positioning the company in many of the emerging natural gas shale plays in the U.S., such as the Barnett, Haynesville, Fayetteville and Woodford. ETP has many of the new pipelines that are delivering supply out of these new basins. Going forward, the partnership has a number of pipeline projects that are coming into service in 2011. So, as those come into service, we think you're going to see a step up in cash flows and, therefore, increases in the distribution. That stock has a very healthy yield right now of 8%.
TER: What are some of the smaller-cap MLPs that you like?
MB: I would first highlight a gathering and processing MLP, Regency Energy Partners L.P. (NASDAQ:RGNC). This company is going through a transformation. It originally owned mostly gathering and processing assets. Through acquisitions and organic expansion, RGNC added significant pipeline and compression assets—all of which are fee-based. It now generates roughly 70% fee-based cash flows and is only 30% exposed to gathering and processing. The partnership hedges its commodity exposure, so there is very little volatility in cash flows. Over time, we think this company has a good chance of becoming an investment-grade credit-rated company by virtue of adding the fee-based cash flows, strengthening the balance sheet and growing in absolute size. If it does achieve investment grade, we think you'll see a revaluation where the MLP will be revalued like a pipeline MLP, such as Kinder Morgan or Enterprise. Right now, it's yielding about 7.8%; but the thesis is that, at some point, that becomes a 6%- to 6.5%-yielding stock.
TER: Who decides if an MLP is investment grade?
MB: It's all up to the rating agencies but, in general, you have to have a certain size and scope, your cash flows have to be of a certain stability and your balance sheet has to be of certain metrics. From a size perspective, I think it's $250 to $350 million in EBITDA. From a balance sheet perspective, it means having a debt-to-EBITDA ratio of 4x or less; and from a cash flow-stability perspective, probably 70%+ fee based. By the end of 2011, we think Regency will meet all those requirements, but its rating will still be up to the rating agencies.
TER: Another one you seem to like is Blueknight Energy Partners L.P. (OTCPK:BKEP), a small-cap pipeline MLP.
MB: This is what we would call a 'speculative outperform-rated stock.' This is a turnaround story. The parent company of the MLP was originally a company called SemGroup Corporation, a private oil trading company in Tulsa, Okla. They had an MLP called SemGroup Energy Partners L.P. (OTC:SGLP). The parent company went bankrupt and was the MLP's primary customer. Control of SemGroup Energy Partners was acquired by Vitol, a global energy trading company, and the name of the MLP was changed to Blueknight Energy. The company's assets are crude oil storage and pipeline and asphalt storage. It's a relatively a low-risk, fee-based business. Right now, the MLP is not paying a distribution and, in our view, has too much debt. Our thesis is that Vitol will recapitalize the company by year-end. In doing so, Blueknight would reinstate additional distribution at $1.25 per unit, which should cause the stock to rebound nicely.
TER: What about some upstream MLP names like Encore Energy Partners (NYSE:ENP) and Legacy Reserves (NASDAQ:LGCY)?
MB: I'll start with Legacy. Legacy was created from a third-generation, family owned oil and gas business located in the Permian Basin in West Texas, which is one of the oldest oil-producing basins in the country. The two families took their Legacy business and put it into this MLP. The advantage is that these families have been operating in the Permian Basin for many years, so they know all of the well and oil-reserve owners in the region. Over time, they've been able to make acquisitions in the Permian Basin to grow cash flows. LGCY is mostly an oil company, so it's tied to the oil price. The partnership hedges about 70% of its cash flow for the first year out, and then decreasing levels going forward. Overall, we believe it's a well-managed, disciplined company with very attractive assets for this asset class.
Encore Energy Partners is interesting. Its general partner parent company was acquired by another publicly traded oil and gas company called Denbury Resources Inc. (NYSE:DNR), which has since announced plans to sell Encore. We think a number of MLPs, private equity firms and others will be interested in it. Encore has very attractive long-lived assets, mostly oil in the Permian Basin and Rocky Mountains. There's potential upside tied to a takeout of the MLP.
TER: How does a gathering and processing MLP differ from an upstream MLP? And what are some of your picks in the gathering and processing space?
MB: An upstream MLP is an actual oil and gas producer, whereas the gathering and processing company gathers the gas from the wellheads, processes it and strips out the NGLs, which are produced along with natural gas to ensure it meets pipeline-transport specifications. Some of our favorites? One we talked about already is Regency. Another would be Targa Resources Partners L.P. (NYSE:NGLS), which has gathering assets in several basins in North Texas, West Texas and South Louisiana. Over time, the volume on those assets has proven to be relatively steady even in what's been a difficult gas-price environment. Targa also has NGLs, pipeline and storage and fractionation assets, which lends a fee-based nature to some of its cash flows. So it's a better mix of overall cash flows and provides some growth opportunities (e.g., the partnership is expanding one of its fractionation facilities in the Gulf Coast right now).
TER: Fractionation?
MB: The NGLs are separated from the natural gas at a processing plant. They're in a mixed form. They're called mixed NGLs or Y grade. They're then transported to a fractionation facility where they're separated into the individual purity components. The ethane, propane butane, etc. are then sold to their individual markets. It's all part of the NGLs energy-value chain.
TER: Your research talks some about Energy Transfer Equity, L.P. (NYSE:ETE) Tell us about that one.
MB: Energy Transfer Equity is the general partner of Energy Transfer Partners. To make it even more confusing, it recently acquired the general partner interest of Regency Energy Partners as well. ETE now owns two general partner interests in MLPs. A general partner is attractive because its growth rate in cash distributions is 2x or greater than that of the underlying MLP, typically. You get a lower yield; but, in many cases, your total return could be higher than owning the underlying MLP. Also, in many instances, the management team owns a large percentage of the general partner, so your interests are more aligned if you own the general partner units. ETE is interesting because, on the one hand, Energy Transfer Partners, one of the MLPs it controls, has some future growth prospects tied to new pipelines going into service. On the other hand, Energy Transfer's management is very active in the acquisition market. The team plans to use Regency, potentially, as a vehicle for acquisitions. If it's successful, you could see cash-flow growth accelerate at ETE.
Michael J. Blum is a managing director and senior analyst at Wells Fargo Securities covering energy master limited partnerships. He began his Wall Street career in 2000 at First Albany Corp. as an associate analyst covering alternative energy securities and joined Wells Fargo in 2001. Since 2003, he has been following master limited partnerships and integrated natural gas securities at Wells Fargo. Before joining the sell side, he spent a year as the investor relations manager for a publicly traded internet startup during the dot-com boom. Michael has been recognized twice as a Wall Street Journal "Best On The Street" winner, ranking in two categories in 2010: No. 3 for the oil and gas producers sector and No. 5 for oil equipment, services, and distribution; he also ranked No. 4 for oil equipment, services, and distribution in 2007. In 2010, Michael was ranked as the No. 1 MLP analyst in the Greenwich Associates survey of institutional investors. In 2009, Michael was named the No.1 oil and gas pipelines analyst by Forbes magazine and was ranked as the No. 3 analyst for the master limited partnership sector in a survey conducted by Institutional Investor magazine. Michael graduated magna cum laude from the University of Pennsylvania with a BA in English literature and a minor in economics.
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DISCLOSURE:
1) Jim Patrick of The Energy Report conducted this interview. He personally and/or his family own the following companies mentioned in this interview: None.
2) The following companies mentioned in the interview are sponsors of The Energy Report: None.
3) Michael Blum: I personally and/or my family own shares of the following companies mentioned in this interview: None. I personally and/or my family am paid by the following companies mentioned in this interview: None.
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ENP: Risks to the units trading below our range include a dependence on acquisitions to fuel growth and partially offset the depletion of reserves, the inability to hedge at favorable prices, and rising interest rates.
EPD: Risks to EPD trading in our range include weakness in the petro-chem industry, low or negative frac spreads, and a decline or delay in deepwater GoM production.
ETE: Risks to ETE trading in the range include (1) unsuccessful execution of an acquisition or an organic growth project; (2) potential conflicts of interest; (3) competition in the Texas-Louisiana natural gas market; and (4) a decline in natural gas prices.
ETP: Risks to ETP achieving our valuation range include: (1) execution risk related to integrating acquisitions and completing organic growth projects; (2) negative outcome from third-party litigation; (3) competition in the Texas-Louisiana natural gas market; and (4) abnormally warm weather.
KMP: Risks to the units trading in our valuation range include (1) delays/cost overruns on expansion projects and (2) rising interest rates.
KMR: Risks to the units trading in our valuation range include (1) a final resolution to the SFPP rate case, (2) delays/cost overruns on expansion projects, and (3) rising interest rates.
LGCY: Risks to the units trading below our range include a sustained decline in crude oil prices and dependence upon acquisitions to fuel growth.
NGLS: Risks to the units trading below our valuation range include a slower-than-forecasted rate of dropdown acquisitions, a decline in commodity prices, and rising interest rates.
RGNC: Risks to the units trading below our valuation range include a slower-than-forecasted rate of dropdowns, a decline in commodity prices, and rising interest rates.
SXL: Risks to the units trading below our valuation range include customer concentration, refinery turnarounds, and rising interest rates.
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Visit The Energy Report’s MLP Insights to learn more.
The Energy Report: Some of our readers may not know how MLPs work. Please give us an overview of the sector and some advantages and disadvantages of investing in MLPs.
Michael Blum: Master limited partnerships are high-yielding publicly traded entities, which trade on major exchanges similar to a corporation. The difference is that MLPs are structured as partnerships; they don't pay corporate taxes at the partnership level and investors avoid double taxation. Investors receive cash distributions instead of dividends.
To be eligible as an MLP, the partnership has to receive at least 90% of its income from what's called qualifying sources (natural resources, real estate rents and dividend income). For practical purposes, MLPs are involved mostly in the energy sector—of the 91 publicly traded MLPs, 71 are involved in energy. Most energy MLPs provide midstream services (i.e., they handle various commodities for a fee). Many MLPs operate pipelines and storage facilities, so they generate pretty stable cash flows with little direct commodity risk.
MLPs distribute available cash flow—cash left over after paying debt service, maintenance, etc.—at the end of each quarter to their unit holders. Therefore, MLPs have pretty high yields, averaging between 6%–8%.
TER: Explain the tax advantages.
MB: The basic value proposition for an MLP investor is a low double-digit annual total return consisting of a 6%–8% yield with 3%–5% annual distribution growth and certain tax-deferred advantages. Investors are required to pay tax on only 20% of that distribution, typically. The rest of the tax is deferred until the investor sells the security, which could be many years in the future. From a tax perspective, it can be very efficient for investors.
TER: Does that mean that MLPs are long-term investments?
MB: Yes, I would consider them long-term investments; they certainly own long-lived assets. About 70% of MLPs are owned by retail investors, and retirees own them for the income.
TER: Recent healthcare legislation will tax dividends for people making more than $200K/year but will not affect MLP distributions. I suppose this makes MLPs even more attractive.
MB: Yes, the recent 3.8% tax on interest dividends, annuities, etc., which also includes families earning more than $250K. This will not impact MLPs in terms of their distributions. On a relative basis, yes, the MLPs become more attractive.
TER: What are the risks?
MB: MLPs present some additional tax-filing burdens that you don't find with C-Corp investments. MLP investors receive K-1s instead of 1099s because they're partners in a partnership–not corporate shareholders. MLPs also have relatively low liquidity in terms of trading volume, so they're not easy to trade in and out of if you want to take large positions. Large MLP positions shouldn't be held in IRAs or tax-free accounts because they generate unrelated business taxable income (UBTI), which triggers tax consequences if it exceeds $1,000 per year.
In terms of actual investment risk, there are some legislative risks. For example, many of these are oil and gas companies and current, proposed legislation could impact them. MLPs are also very reliant on access to capital markets; when those markets become stressed, the MLPs tend to trade poorly.
TER: So, were MLPs a bad place to invest in the 2008 market crash?
MB: Everywhere was a bad place to be in 2008, including MLPs. But if you just owned MLPs for income, about 80% maintained or increased their distributions during that period. MLP prices declined precipitously in line with the market. From that perspective, it was not a great place to be.
TER: But unit holders still received distributions. Are you saying that MLPs are pretty much bulletproof in terms of economic downturns?
MB: Nothing's bulletproof, but certainly most MLPs that own pipeline assets have very stable cash flows and have—over many different economic and commodity-price cycles—been able to maintain and even grow their distributions. Some MLPs have more commodity price risk, and some of those were forced to cut or eliminate distributions during the last downturn.
TER: You said there is a legislative risk. Is there an MLP lobby?
MB: The National Association of Publicly Traded Partnerships (NAPTP), a trade association, represents publicly traded limited partnerships. They lobby on behalf of the MLP sector; and, historically, have made a good case for leaving MLPs' tax status intact.
TER: In your research, you said a lot of an MLP's performance is determined on a macro level. Moody's recently downgraded Greece's credit to junk and oil prices are projected to be relatively soft through 2010 and into early 2011. How will that affect the MLP sector?
MB: We have a relatively cautious near-term outlook on MLPs for those reasons. The correlation between high-yield credit spreads and MLPs is quite high. Because MLPs are yield products, they move in sympathy to yield spreads. MLPs pay out most of their cash flows in the form of quarterly distributions, yet they're growing by acquisitions and new pipeline and asset investment. They must have access to debt and equity markets to fund those investments. MLPs are very sensitive to happenings in the equity and credit markets. Credit spreads are continuing to widen due to Eurozone issues, which could put more pressure on MLP prices. Commodity prices also play a role, as some MLPs have direct commodity exposure. Generally speaking, MLPs move in sympathy with commodity prices because they are energy companies; so, weaker oil prices imply lower MLP prices.
TER: Given that many MLPs are energy companies, will the Gulf of Mexico (GOM) spill impact the sector?
MB: Very little. Only a handful of MLPs have direct exposure to the Gulf.
TER: You follow a number of segments within the MLP sector: large- and small-cap pipelines, upstream, propane and shipping. Please provide an overview of these sectors and the investment opportunities there.
MB: Let's start with pipeline MLPs. There are different types of pipeline MLPs—crude oil; natural gas; natural gas liquids (NGLs), which are produced in association with natural gas, and refined product pipelines. They all have different characteristics but, in general, they generate mostly fee-based cash flows. Sometimes they're driven by volumes, but often they're regulated with automatic adjusters for inflation. Generally, pipeline MLPs are the lowest risk; sometimes their growth is more modest, but still relatively healthy at 3%–5%.
Gathering and processing MLPs collect and process—remove impurities—and separate the NGLs. The natural gas is then pipeline-ready, and is shipped via larger pipelines to consuming markets. NGLs are shipped on a separate pipeline grid for their markets. NGLs include ethane, propane, butane, isobutene and natural gasoline; and each has its own distinct market. Ethane is used by the petrochemical industry to make plastics. Propane is also used in that industry, primarily as heating fuel for homes. The others are used in the refining and gasoline-production industries. Gathering and processing MLPs have higher yields and more risk, as they have more direct exposure to commodities and natural gas production trends.
Upstream MLPs are traditional oil and gas producers actively drilling for oil and gas. Upstream MLP properties differ in that the reserves they own are typically mature, low-decline assets. . .the boring stuff. They make good MLP assets because they throw off relatively predictable cash flows. Upstream MLPs also have the most commodity exposure and, typically, the highest yields; however, they do hedge for several years out to mitigate that commodity price exposure.
Propane MLPs distribute propane via propane-delivery trucks to residential tanks. Companies are able to adjust their margins as propane prices change, so there's not much direct commodity exposure; so propane MLPs have been pretty defensive investments in downturns. The main risk is weather; these MLPs are dependent on cold winters.
Shipping MLPs cover domestic and international shippers—oil, liquefied natural gas (LNG), etc. Local shippers ship refined products and crude oil only around local markets, up and down rivers and between states.
TER: It seems like they were created as a way to invest in infrastructure.
MB: Yes, Congress created MLPs with these special rules to encourage energy infrastructure investment. Over the last five to seven years, there's been a multi-billion dollar buildout in natural gas pipelines. The MLPs have been spending most of that capital and building most of those pipelines. So, in terms of attracting private capital to build the U.S. pipeline infrastructure, it's worked.
TER: Have you seen corresponding growth in the number of MLPs over the last few years?
MB: Tremendous growth. In 2000, there were 18 energy MLPs and the sector's market cap was $16 billion. Today, there are 71 energy-related MLPs with a combined market cap of about $180 billion.
TER: Can you explain the difference between general and limited partners?
MB: MLPs are structured with a general partner and limited partners. The general partner controls and manages the MLP and, typically, owns a 2% equity interest. The limited partners provide capital. General partners own incentive distribution rights; that is, they're entitled to an increasing percentage of incremental cash flow as they raise the distribution to limited partners at incremental rates. This provides incentive for the general partner to raise distribution levels to limited partner unit holders. Almost all MLPs have a general partner. In recent years, some MLPs formed without general partners and incentive distributions rights (IDRs). Or some MLPs eliminated their general partner or IDRs.
TER: Basically, it's like a managing partner. What's the maximum they can own?
MB: I don't think there's any maximum; most own only a 2% interest, but the incentive distribution rights entitle the general partner to receive up to 50% of incremental cash flow. They start out at 2%, then, when the distribution reaches a certain level, the general partner is entitled to 15% of the incremental cash, then 25%, and then 50%. Most general partners own a large percentage of limited partner units, as well; so they are aligned with the limited partner unit holders from that standpoint.
TER: In a recent research report, you wrote: "For investors that are more cautious in their macro outlook we would focus more on the large-cap defensive pipeline names." You named the following companies in your research: Enterprise Products Partners L.P. (NYSE: EPD), Kinder Morgan Management, LLC (NYSE:KMR), Magellan Midstream Partners L.P. (NYSE:MMP), Sunoco Logistics Partners L.P. (NYSE:SXL). Tell us about those names.
MB: During periods when there's more risk aversion, the investment-grade pipelines tend to outperform on a relative basis. Enterprise Products Partners is the largest MLP in the sector. It has a franchise position in pipeline and storage, and fractionation in the NGLs market. We think EPD can grow distribution about 6% annually for the next several years. A lot of that has to do with where its assets are located, as well as some expansion projects it's pursuing. EPD is expanding a pipeline out of the developing Haynesville shale and its NGL assets at Mont Belvieu, Texas, which is the premier market and pricing point for NGLs. EPD is very well-positioned and cash flows are very stable, in our opinion.
TER: What constitutes an investment-grade MLP?
MB: There are only 13 investment grade-rated MLPs, which are primarily the large-cap pipeline MLPs. The rest of the MLPs are non-investment-graded or "junk." The yields on these MLPs are higher because there's more perceived risk and, as a result, their cost of financing is higher for both debt and equity. To the extent that an MLP can move from non-investment-grade to investment-grade, that should improve its valuation and capital cost. It's a big advantage.
TER: Alright, what's the yield from Enterprise Products?
MB: 6.6%.
TER: How long will that continue?
MB: In general, we forecast the stock should continue to yield somewhere around 6%–7%, with roughly 6% annual distribution growth. We think that's sustainable for several years.
TER: What about Kinder Morgan?
MB: Kinder Morgan is another one of the franchise MLPs in the sector. It has a large natural gas pipeline business, a refined product pipeline segment and a terminal storage business, wherein they store and handle various materials for a fee, as well as an oil production company. The cash flows are also relatively stable. Kinder Morgan Energy Partners, L.P. has two securities, Kinder Morgan Energy Partners (KMP) and Kinder Morgan Management (KMR). KMR pays a stock dividend instead of a cash distribution. As a result, KMR, which pays the stock dividend, does not generate a K-1. It eliminates a lot of tax-filing requirements that some investors don't want to deal with. We think the distribution there is secure and is probably going to grow around 4%. We prefer KMR to KMP because it priced more attractively and the distribution is based on the same assets and underlying cash flow stream.
TER: Magellan?
MB: Magellan Midstream Partners is a refined product pipeline and storage company. Again, stable cash flows, very strong balance sheet, in our opinion. What attracts us to Magellan is its acquisition prospects. The oil majors such as Chevron Corp. (NYSE:CVX), Exxon Mobil Corp. (NYSE:XOM) and ConocoPhillips (NYSE:COP) and others have announced plans to sell some of their midstream assets in the U.S. as a way to raise cash. We think the MLPs and Magellan in particular, due to the elimination of its IDRs, are well-positioned to acquire some of those assets. This should lend itself to higher distributions in the future.
TER: What's the yield on Magellan?
MB: The yield at present is 6.4%.
TER: And Sunoco?
MB: Sunoco is also in the refined product and crude oil pipeline and storage business. What's unique there is the company has a lot of organic opportunities. It has assets in the Gulf Coast and Northeast that are in growth markets. As a result, SXL is spending money to expand its asset base. Therefore, you can point to visible 10%+ distribution growth for the next couple of years. You've got a stable yield at 6.5% with 10%+ growth in distributions. We think that'll enable the partnership to outperform.
TER: Are there some other companies you would like to talk about in that space?
MB: The other one I might mention is Energy Transfer Partners. The company is principally a natural gas pipeline company. It has a number of interstate pipelines and also a large Texas intrastate pipeline system. What's unique about Energy Transfer is that management has done a really good job of positioning the company in many of the emerging natural gas shale plays in the U.S., such as the Barnett, Haynesville, Fayetteville and Woodford. ETP has many of the new pipelines that are delivering supply out of these new basins. Going forward, the partnership has a number of pipeline projects that are coming into service in 2011. So, as those come into service, we think you're going to see a step up in cash flows and, therefore, increases in the distribution. That stock has a very healthy yield right now of 8%.
TER: What are some of the smaller-cap MLPs that you like?
MB: I would first highlight a gathering and processing MLP, Regency Energy Partners L.P. (NASDAQ:RGNC). This company is going through a transformation. It originally owned mostly gathering and processing assets. Through acquisitions and organic expansion, RGNC added significant pipeline and compression assets—all of which are fee-based. It now generates roughly 70% fee-based cash flows and is only 30% exposed to gathering and processing. The partnership hedges its commodity exposure, so there is very little volatility in cash flows. Over time, we think this company has a good chance of becoming an investment-grade credit-rated company by virtue of adding the fee-based cash flows, strengthening the balance sheet and growing in absolute size. If it does achieve investment grade, we think you'll see a revaluation where the MLP will be revalued like a pipeline MLP, such as Kinder Morgan or Enterprise. Right now, it's yielding about 7.8%; but the thesis is that, at some point, that becomes a 6%- to 6.5%-yielding stock.
TER: Who decides if an MLP is investment grade?
MB: It's all up to the rating agencies but, in general, you have to have a certain size and scope, your cash flows have to be of a certain stability and your balance sheet has to be of certain metrics. From a size perspective, I think it's $250 to $350 million in EBITDA. From a balance sheet perspective, it means having a debt-to-EBITDA ratio of 4x or less; and from a cash flow-stability perspective, probably 70%+ fee based. By the end of 2011, we think Regency will meet all those requirements, but its rating will still be up to the rating agencies.
TER: Another one you seem to like is Blueknight Energy Partners L.P. (OTCPK:BKEP), a small-cap pipeline MLP.
MB: This is what we would call a 'speculative outperform-rated stock.' This is a turnaround story. The parent company of the MLP was originally a company called SemGroup Corporation, a private oil trading company in Tulsa, Okla. They had an MLP called SemGroup Energy Partners L.P. (OTC:SGLP). The parent company went bankrupt and was the MLP's primary customer. Control of SemGroup Energy Partners was acquired by Vitol, a global energy trading company, and the name of the MLP was changed to Blueknight Energy. The company's assets are crude oil storage and pipeline and asphalt storage. It's a relatively a low-risk, fee-based business. Right now, the MLP is not paying a distribution and, in our view, has too much debt. Our thesis is that Vitol will recapitalize the company by year-end. In doing so, Blueknight would reinstate additional distribution at $1.25 per unit, which should cause the stock to rebound nicely.
TER: What about some upstream MLP names like Encore Energy Partners (NYSE:ENP) and Legacy Reserves (NASDAQ:LGCY)?
MB: I'll start with Legacy. Legacy was created from a third-generation, family owned oil and gas business located in the Permian Basin in West Texas, which is one of the oldest oil-producing basins in the country. The two families took their Legacy business and put it into this MLP. The advantage is that these families have been operating in the Permian Basin for many years, so they know all of the well and oil-reserve owners in the region. Over time, they've been able to make acquisitions in the Permian Basin to grow cash flows. LGCY is mostly an oil company, so it's tied to the oil price. The partnership hedges about 70% of its cash flow for the first year out, and then decreasing levels going forward. Overall, we believe it's a well-managed, disciplined company with very attractive assets for this asset class.
Encore Energy Partners is interesting. Its general partner parent company was acquired by another publicly traded oil and gas company called Denbury Resources Inc. (NYSE:DNR), which has since announced plans to sell Encore. We think a number of MLPs, private equity firms and others will be interested in it. Encore has very attractive long-lived assets, mostly oil in the Permian Basin and Rocky Mountains. There's potential upside tied to a takeout of the MLP.
TER: How does a gathering and processing MLP differ from an upstream MLP? And what are some of your picks in the gathering and processing space?
MB: An upstream MLP is an actual oil and gas producer, whereas the gathering and processing company gathers the gas from the wellheads, processes it and strips out the NGLs, which are produced along with natural gas to ensure it meets pipeline-transport specifications. Some of our favorites? One we talked about already is Regency. Another would be Targa Resources Partners L.P. (NYSE:NGLS), which has gathering assets in several basins in North Texas, West Texas and South Louisiana. Over time, the volume on those assets has proven to be relatively steady even in what's been a difficult gas-price environment. Targa also has NGLs, pipeline and storage and fractionation assets, which lends a fee-based nature to some of its cash flows. So it's a better mix of overall cash flows and provides some growth opportunities (e.g., the partnership is expanding one of its fractionation facilities in the Gulf Coast right now).
TER: Fractionation?
MB: The NGLs are separated from the natural gas at a processing plant. They're in a mixed form. They're called mixed NGLs or Y grade. They're then transported to a fractionation facility where they're separated into the individual purity components. The ethane, propane butane, etc. are then sold to their individual markets. It's all part of the NGLs energy-value chain.
TER: Your research talks some about Energy Transfer Equity, L.P. (NYSE:ETE) Tell us about that one.
MB: Energy Transfer Equity is the general partner of Energy Transfer Partners. To make it even more confusing, it recently acquired the general partner interest of Regency Energy Partners as well. ETE now owns two general partner interests in MLPs. A general partner is attractive because its growth rate in cash distributions is 2x or greater than that of the underlying MLP, typically. You get a lower yield; but, in many cases, your total return could be higher than owning the underlying MLP. Also, in many instances, the management team owns a large percentage of the general partner, so your interests are more aligned if you own the general partner units. ETE is interesting because, on the one hand, Energy Transfer Partners, one of the MLPs it controls, has some future growth prospects tied to new pipelines going into service. On the other hand, Energy Transfer's management is very active in the acquisition market. The team plans to use Regency, potentially, as a vehicle for acquisitions. If it's successful, you could see cash-flow growth accelerate at ETE.
Michael J. Blum is a managing director and senior analyst at Wells Fargo Securities covering energy master limited partnerships. He began his Wall Street career in 2000 at First Albany Corp. as an associate analyst covering alternative energy securities and joined Wells Fargo in 2001. Since 2003, he has been following master limited partnerships and integrated natural gas securities at Wells Fargo. Before joining the sell side, he spent a year as the investor relations manager for a publicly traded internet startup during the dot-com boom. Michael has been recognized twice as a Wall Street Journal "Best On The Street" winner, ranking in two categories in 2010: No. 3 for the oil and gas producers sector and No. 5 for oil equipment, services, and distribution; he also ranked No. 4 for oil equipment, services, and distribution in 2007. In 2010, Michael was ranked as the No. 1 MLP analyst in the Greenwich Associates survey of institutional investors. In 2009, Michael was named the No.1 oil and gas pipelines analyst by Forbes magazine and was ranked as the No. 3 analyst for the master limited partnership sector in a survey conducted by Institutional Investor magazine. Michael graduated magna cum laude from the University of Pennsylvania with a BA in English literature and a minor in economics.
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DISCLOSURE:
1) Jim Patrick of The Energy Report conducted this interview. He personally and/or his family own the following companies mentioned in this interview: None.
2) The following companies mentioned in the interview are sponsors of The Energy Report: None.
3) Michael Blum: I personally and/or my family own shares of the following companies mentioned in this interview: None. I personally and/or my family am paid by the following companies mentioned in this interview: None.
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1) All views expressed in this research report accurately reflect my personal views about any and all of the subject securities or issuers discussed; and
2) No part of my compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed by me in this research report.
- Wells Fargo Securities, LLC maintains a market in the common stock of Energy Transfer Partners, L.P., Enterprise Products Partners L.P., Kinder Morgan Energy Partners, L.P., Kinder Morgan Management, LLC, Legacy Reserves, L.P., Regency Energy Partners, L.P., Targa Resources Partners, L.P.
- Wells Fargo Securities, LLC or its affiliates managed or comanaged a public offering of securities for Encore Energy Partners, L.P., Energy Transfer Partners, L.P., Enterprise Products Partners L.P., Kinder Morgan Energy Partners, L.P., Legacy Reserves, L.P., Regency Energy Partners, L.P., Sunoco Logistics Partners L.P., Targa Resources Partners, L.P. within the past 12 months.
- Wells Fargo Securities, LLC or its affiliates intends to seek or expects to receive compensation for investment banking services in the next three months from Encore Energy Partners, L.P., Energy Transfer Equity, L.P., Energy Transfer Partners, L.P., Enterprise Products Partners L.P., Kinder Morgan Energy Partners, L.P., Legacy Reserves, L.P., Regency Energy Partners, L.P., Sunoco Logistics Partners L.P., Targa Resources Partners, L.P.
- Wells Fargo Securities, LLC or its affiliates received compensation for investment banking services from Encore Energy Partners, L.P., Energy Transfer Equity, L.P., Energy Transfer Partners, L.P., Enterprise Products Partners L.P., Kinder Morgan Energy Partners, L.P., Kinder Morgan Management, LLC, Legacy Reserves, L.P., Regency Energy Partners, L.P., Sunoco Logistics Partners L.P., Targa Resources Partners, L.P. in the past 12 months.
- Encore Energy Partners, L.P., Energy Transfer Equity, L.P., Energy Transfer Partners, L.P., Enterprise Products Partners L.P., Kinder Morgan Energy Partners, L.P., Kinder Morgan Management, LLC, Legacy Reserves, L.P., Regency Energy Partners, L.P., Sunoco Logistics Partners L.P., Targa Resources Partners, L.P. currently is, or during the 12-month period preceding the date of distribution of the research report was, a client of Wells Fargo Securities, LLC. Wells Fargo Securities, LLC provided investment banking services to Encore Energy Partners, L.P., Energy Transfer Equity, L.P., Energy Transfer Partners, L.P., Enterprise Products Partners L.P., Kinder Morgan Energy Partners, L.P., Kinder Morgan Management, LLC, Legacy Reserves, L.P., Regency Energy Partners, L.P., Sunoco Logistics Partners L.P., Targa Resources Partners, L.P.
- Energy Transfer Equity, L.P., Energy Transfer Partners, L.P., Regency Energy Partners, L.P. currently is, or during the 12-month period preceding the date of distribution of the research report was, a client of Wells Fargo Securities, LLC. Wells Fargo Securities, LLC provided nonsecurities services to Energy Transfer Equity, L.P., Energy Transfer Partners, L.P., Regency Energy Partners, L.P.
- An affiliate of Wells Fargo Securities, LLC has received compensation for products and services other than investment banking services from Blueknight Energy Partners, L.P. in the past 12 months.
- Wells Fargo Securities, LLC received compensation for products or services other than investment banking services from Energy Transfer Equity, L.P., Energy Transfer Partners, L.P., Regency Energy Partners, L.P. in the past 12 months.
- Wells Fargo Securities, LLC or its affiliates has a significant financial interest in Blueknight Energy Partners, L.P., Energy Transfer Equity, L.P., Legacy Reserves, L.P., Sunoco Logistics Partners L.P., Targa Resources Partners, L.P.
- Wells Fargo Securities, LLC, is acting as financial advisor to Denbury Resources Inc in the announced exploration of strategic alternative surrounding its ownership interest in Encore Energy Partners, LP.
ENP: Risks to the units trading below our range include a dependence on acquisitions to fuel growth and partially offset the depletion of reserves, the inability to hedge at favorable prices, and rising interest rates.
EPD: Risks to EPD trading in our range include weakness in the petro-chem industry, low or negative frac spreads, and a decline or delay in deepwater GoM production.
ETE: Risks to ETE trading in the range include (1) unsuccessful execution of an acquisition or an organic growth project; (2) potential conflicts of interest; (3) competition in the Texas-Louisiana natural gas market; and (4) a decline in natural gas prices.
ETP: Risks to ETP achieving our valuation range include: (1) execution risk related to integrating acquisitions and completing organic growth projects; (2) negative outcome from third-party litigation; (3) competition in the Texas-Louisiana natural gas market; and (4) abnormally warm weather.
KMP: Risks to the units trading in our valuation range include (1) delays/cost overruns on expansion projects and (2) rising interest rates.
KMR: Risks to the units trading in our valuation range include (1) a final resolution to the SFPP rate case, (2) delays/cost overruns on expansion projects, and (3) rising interest rates.
LGCY: Risks to the units trading below our range include a sustained decline in crude oil prices and dependence upon acquisitions to fuel growth.
NGLS: Risks to the units trading below our valuation range include a slower-than-forecasted rate of dropdown acquisitions, a decline in commodity prices, and rising interest rates.
RGNC: Risks to the units trading below our valuation range include a slower-than-forecasted rate of dropdowns, a decline in commodity prices, and rising interest rates.
SXL: Risks to the units trading below our valuation range include customer concentration, refinery turnarounds, and rising interest rates.
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Wells Fargo Securities, LLC's research analysts receive compensation that is based upon and impacted by the overall profitability and revenue of the firm, which includes, but is not limited to investment banking revenue.
STOCK RATING
1=Outperform: The stock appears attractively valued, and we believe the stock's total return will exceed that of the market over the next 12 months. BUY
2=Market Perform: The stock appears appropriately valued, and we believe the stock's total return will be in line with the market over the next 12 months. HOLD
3=Underperform: The stock appears overvalued, and we believe the stock's total return will be below the market over the next 12 months. SELL
SECTOR RATING
O=Overweight: Industry expected to outperform the relevant broad market benchmark over the next 12 months.
M=Market Weight: Industry expected to perform in-line with the relevant broad market benchmark over the next 12 months.
U=Underweight: Industry expected to underperform the relevant broad market benchmark over the next 12 months.
VOLATILITY RATING
V = A stock is defined as volatile if the stock price has fluctuated by +/-20% or greater in at least 8 of the past 24 months or if the analyst expects significant volatility. All IPO stocks are automatically rated volatile within the first 24 months of trading.
As of: 6/25/2010:
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