The following discussion published at Seeking Alpha regarding investment opportunities in midstream energy distribution companies is a useful reference for investors looking for income and energy participation.  

Midstream MLPs Crashing, Present Opportunity

by: Prudent Speculations posted on: October 10, 2008 | about stocks: EPD / ETE / GLP / KMP / NSH / OKS / TPP / XTEX

As we all know, the entire market has been crashing in recent weeks.  The price action in the MLP sector has been no different.  However, unlike many sectors that have been crashing, the businesses of Midstream MLPs are very defensive in nature.  Midstream MLPs can be characterized as having stable cashflows that are backed up by either fees based on the volumes of oil, gasoline or natural gas moved through pipelines or hedges that are used to stabilize the fairly stable cash flows of processing plants. 

Under even a severe recession people will still need to drive to work, heat their homes and turn on their lights.  Midstream MLPs will continue to serve this need by transporting the energy we need to survive.  This idea was recently confirmed by the management of Crosstex Energy LP (Nasdaq:XTEX) on October 2 during their conference call to discuss the impacts of Hurricane Ike.  Below is management’s statement on the matter:

We think that we have a great set of assets in a diverse area in the best of producing areas and those assets are going to continue to perform well. We’re still serving a necessary piece of the industry. We’re getting gas to market. The market is going to continue to demand this gas supply with a link to the source. So we feel good about that.

The one Achilles heel of midstream MLPs is that they are highly dependent on the capital markets to finance growth projects.  But midstream MLPs are not dependent on capital markets to operate their assets.  This was recently confirmed by management of Crosstex.  Here is what Crosstex’s management said about this issue.

We think Wall Street is doing a poor job of distinguishing between companies that need capital to execute a growth plan versus those that need capital to survive. We are clearly in the former group.

Once pipelines, processing plants or storage tanks are in place the amount of capital required to operate them is very low.  Most midstream MLPs continue to have significant amounts of their credit lines undrawn but they will nonetheless likely be deferring growth projects in the current environment as the long-term credit markets are no longer functioning.  Nevertheless, there will continue to be a large need for new midstream infrastructure in the United States, as significant new infrastructure is needed to support the production growth of the North American shale plays.

Midstream MLP cash flows fall into one of two groups.  Fee based contracts and price based contracts.  While both groups are defensive in nature, some types of midstream assets produce cash flows that are more secure than others are.  Pipelines with fee-based contacts are oil pipelines, gasoline pipelines and large interstate or intrastate natural gas pipelines.  These fee based contracts charge based on the volume of product that they transport, not the price.  These fees are raised every year based on the Producer Price Index.  These companies can be considered the toll roads of America’s energy infrastructure.  

Oil and refined product pipelines have a little economic exposure as the consumption of gasoline has dropped between 3%-4% over the last year.  Whether this trend continues now that gasoline prices have dropped is unknown but a recession certainly will not help gasoline consumption.  Fortunately, the annual rate increases have more than made up for the slight drop in volume.  Under normal circumstances, rate increases result in steadily increasing cash flows.  Under these circumstances rate increases are keeping cash flows stable for oil and gasoline pipelines. My favorite pick in this area is NuStar GP Holdings LLC (NYSE:NSH) with a 10% yield.  Under normal circumstances, I would expect NSH to be able to grow distributions at 20% per year for the next few years.

Intrastate natural gas pipelines are the most stable type of asset in the midstream MLP universe.  Natural gas consumption is still rising as the United States slowly migrates towards generating more of its electricity from natural gas and less from coal.  There is a shortage of this type of pipeline in many areas of the United States as natural gas is essentially trapped in producing basins with a lack of pipeline capacity to transport it out.  Interstate natural gas pipelines also have annual rate increases based on the producer price index so this type of asset should continue its cash flow growth even during a severe recession.  My favorite pick in this area is Energy Transfer Equity (NYSE:ETE) with a 12.5% yield.  Under normal circumstances, I would expect ETE to grow its distribution 20% per year for the next few years.

The final area within fee based contracts is storage assets.  Oil or gasoline storage cash flows are very similar to that of oil or gasoline pipelines.  Natural gas storage cash flows are similar to those of natural gas pipelines.  Storage assets also have rates that adjust for inflation.  Even during the best of economic times, storage assets typically have little growth.

The third type of assets are natural gas gathering and processing assets.  These assets have some commodity exposure as cash flows are tied to the price of natural gas or natural gas liquids.  Gathering pipelines charge a percent of the value of the natural gas they move, as a result they are long natural gas.  While processing plants burn some natural gas (methane) to extract the natural gas liquids (propane, butane, isobutane etc.), which they keep and sell, processing plants must then purchase the amount of natural gas (methane) they burned during the processing.  So processing plants are long natural gas liquids and short natural gas.  The pricing of natural gas liquids is highly correlated with oil prices.  Midstream MLPs hedge the cash flows of gathering and processing assets with derivatives for what is typically a rolling three-year period.  If gas and oil prices are significantly lower three years from now, these assets will continue to be profitable, as the costs of operation are very low but they will be less profitable than they are today.  My favorite pick in this area is Markwest Energy Partners (NYSE:MWE) with a 14.8% yield.  Markwest Energy Partners has been guiding for 15% to 20% distribution growth over the next 12 months.

Recently Warren Buffett purchased preferred shares of General Electric (NYSE:GE) and Goldman Sachs (NYSE:GS) that yield 10%.  The median Midstream MLP yield is somewhere around 12%.  Given their general stability, I view MLPs as better defensive holdings when compared to these two companies.  Typically, midstream MLPs retain a portion of the distributable cash flow to ensure stable distributions and most MLPs only distribute between 70% to 90% of their available distributable cash flow to ensure that they have this margin of safety.  In addition, it is important to remember that if inflation picks up in the future MLPs may do much better than Buffett’s GE or Goldman preferred shares as MLPs have the ability to pass any inflation through to the rates they charge, whereas Buffett’s preferred shares have fixed dividends.

So, you are probably asking if midstream MLPs are so stable and defensive why are their yields so high and why have unit prices declined with the rest of the market? Citigroup Global Markets addressed this question in a recent report on October 8.  Here is Citigroup’s statement on the subject:

This type of volatility in a sector with defensive characteristics leads us to believe that fundamentals and valuations are being completely ignored in the near term as fear and forced liquidations by distressed hedge fund investors seem to be the primary drivers of recent unit price performance.

Wachovia Capital Markets and Lehman Brothers (now owned by Barclays) have also reached the same conclusion.  Jim Cramer has also recently recommended Kinder Morgan Energy Partners LP (NYSE:KMP) and Enterprise Products Partners LP (NYSE:EPD) as defensive stocks that pay high dividends in comparison to their underlying asset value.  On October 8, Kinder Morgan Energy Partners raised its distribution 3%, suggesting that MLPs truly are defensive investments in difficult times.  Here is what the firm’s Chairman and CEO Richard Kinder had to say about the business environment.

While no company is 100 percent immune to external conditions, KMP continues to demonstrate that our diversified portfolio of stable assets is capable of generating consistently strong cash flow even in extremely difficult market conditions

ONEOK Partners LP (NYSE:OKS), TEPPCO Partners LP (NYSE:TPP), Enterprise Products Partners LP (NYSE:EPD) and Global Partners LP (NYSE:GLP) have all raised their distributions and made similar comments in the past week. 

As I write this there have only been five midstream MLPs to announce distributions so far this quarter and all have increased their distributions.  In the coming days I expect announcements of distribution increases and similar comments from virtually all midstream MLPs as the economic downturn should have little effect on cash flows in the sector.

This article has 8 comments! Add yours below…

This article has 8 comments:

• David Van
  Knapp

  Oct 10 08:37 AM

  My Website

  Terrific article and explanations. Thank you. Report abuse

• Beabaggage

  Oct 10 08:46 AM

  Also consider KYE, diversified closed end fund– you get all these and more, some Canroys and at a discount to market. just raised div to .54 from .53 last quarter. so yield is major now plus the discount to NAV.
  Own/Long KYE plus a few of it’s components. Seems a safer bet to me, potential appreciation and great yields. Report abuse

• NHSkier

  Oct 10 08:55 AM

  What about ETP? That was one of Yale Endowment Fund’s largest holdings last year. Report abuse

• CT
  Programmer

  Oct 10 10:57 AM

  Great article. I have both EEP and OKS and I think they are solid investments. Unfortunately, like you said in the current market valuations are out the window and both the good and the bad are being sold off heavily by hedge funds and panicked investors. If you buy in, expect that the price will continue to drop. So I’d buy immediately prior to the cutoff date to receive a dividend. Who knows when anything will hit bottom, but at current valuations these companies are a steal, even if they’ll go lower in the short term. And they’ll be the first to recover once the “all clear” whistle is blown. At least with them you get paid generously in the meantime to wait for some semblance of normalcy. Also note that MLP dividends have special tax handling both within and without an IRA, but nothing a normal tax-prep software program can’t handle. But I recommend reading up on MLP’s and their tax implications before investing. Avi Morris has some good blogs regarding MLP’s on Seeking Alpha (seekingalpha.com/autho…). Report abuse

• MurphMan

  Oct 10 11:07 AM

  How can one determine if a given MLP’s compensation is fee based or price based….are all the ones mentioned in this article fee based? Thanks! Report abuse

• Emerald

  Oct 10 11:10 AM

  Good article. Nothing like steady cash flow in a sea of uncertainty. Note: Long, EPD, TPP, LINE, NGLS,KMP, BBEP, ERF, PVX, PWE. Bought more this week due to fire sale prices as hedge funds dump to raise cash for rdemptions. Even if market stays down for two years or more, cash flows keep coming! Report abuse

• John Egan

  Oct 10 11:10 AM

  A stock is only defensive if it protects your equity. If the market misunderstands and undervalues these MLPs, then they aren’t defensive. I’m saying that as a purchaser of three MLPs just two days ago. I just got stopped out on two this morning.
  jegan Report abuse

• AlanHHI

  Oct 10 03:15 PM

  PIcking point on KMP, which I am long. They raise their distribution almost every quarter, and indeed raised the distribution 3% form 2nd quarter 08 to third quarter 08. However, the raise from 3rd quarter 07 to 3rd quarter 08 was 16%, which is quite representative of what they have been doing over the last several years. Otherwise, great article. Report abuse

Tags: peak oil energy investments

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