I own several midstream energy master-limited partnerships (MLPs), which have gone from being seemingly safe income plays to being as hard hit as other more obviously risky plays due to the present market meltdown. But that doesn't mean that the companies themselves have become any riskier. What it does mean is that you may have to pay closer attention to their balance sheets than you might have previously. Having done that, I have one that I think presents an opportunity here. But first, a little background.
Insiders were (and still are in some cases) active buyers in these firms, which transport oil, gas and related liquids from where they are produced (downstream) to where they are refined and consumed (upstream). Terminalling and storage of these commodities are also usually a part of the business mix of most midstream MLPs.
It takes a lot of capital to build out the infrastructure that is the backbone of MLPs' business. The MLPs then generate revenues based on the volume of product put through their infrastructure. The price fluctuations of the underlying commodity being transported do not generally affect their revenue. They are not in business to speculate in commodity prices. They just move the stuff.
With so many new sources of gas and oil being found with advanced exploration methods, MLPs have been busy connecting the new production sites to their existing arteries. The build-out bodes well for MLPs to increase their capacity, and therefore their revenues.
The sound fundamentals of both increasing supply and demand of oil and gas moving through pipelines made the 6% to 8% indicated yields of MLPs appear attractive to me, and others looking for some yield. With increasing volumes leading to increased payouts, capital gains in the mid to high single digits also appeared reasonable to expect.
Sure, midstream MLPs aren't the sexiest positions around, but I make it a point of presenting insider-inspired investment ideas for all investor types. MLPs seemed a better place for yield than the financial sector for sure.
That is still the case, but the antics of the smartest guys in the room have lowered the safety net for MLPs as well. They have fallen anywhere from 15% to 25% in recent weeks. The discount is, unfortunately in this case, logical. As we now know, the overpaid hot shots in our once-respected financial institutions screwed up so royally that they have seized up credit markets, and also economic growth. A recession (which I suspect we are already in) leads to less energy consumption on the margin, and less volume of oil and gas consumed, which means lower revenues for MLPs.
The price of oil and gas has already slid in expectation of the slowdown, and exploration and production firms have duly announced reductions in drilling budgets, given the less attractive price. So it's not a matter of MLPs having liquids no one wants in their pipelines. The producers will be putting less volume in the pipelines to begin with.
Reduced volumes are not the only bearish fallout from the present crisis. Being capital intensive businesses forced to pay out most of their cash flow at the end of each quarter, MLPs need to tap capital markets frequently. That is a much tougher and/or expensive thing to do now that both credit and equity markets are in a tumult.
The capital-raising risk for MLPs is a much more vexing one than that of reduced volumes. It is less quantifiable, and, to the extent that an MLP has not saved a little something in the bank for this extraordinary rainy day, potentially more devastating.
As a rule of thumb, smaller midstream MLPs have always represented higher-risk bets, and have needed to offer higher yields to compensate for that fact. With relatively smaller infrastructure to generate revenues from, they have far less room for error when it comes to down time due to unpredictable events -- like hurricanes. This is not lost on capital markets, and if a small MLP also needs to raise money in the coming months, they may not get favorable terms -- if they get them at all.
Assessing Your Investment and Finding the One
So if you're going to stick with your MLP bets here, make sure they have capital on hand to withstand this downturn, and a broad portfolio of assets, as well. This generally means sticking with larger midstream MLPs, and taking your lumps in the smaller ones.
For investors tempted to buy into smaller MLPs right now, make sure you're being compensated for any risk, as they may have a tough time accessing capital in the near term. A low-to-mid-teen indicated yield is what you should expect in a smaller MLP, and that still may not be sufficient if the MLP has a large note coming due soon.
Enterprise Products Partners LP
is one of the larger players in the space that will survive this downturn, but even its quality shares have fallen nearly 15% since the beginning of September. EPD now yields just over 8%, which is historically high for this security.
While the indicated yield could yet move higher before this financial catastrophe is over, any further decline in EPD should not be the result of fears of being rejected in the capital markets. Enterprise can wait until October 2009 to hit up the market for more funding. That's when a $500 million note comes due.
In the meantime, Enterprise has reduced its distribution growth for about 7% last year, to 6% so far this year. This has allowed the firm to amass over $200 million in retained cash in the first two quarters of this year. It is not unreasonable to expect Enterprise to double that cash figure in the second half of this year.
The firm also has a $1.75 billion revolving facility with a consortium of banks, with no one bank responsible for more than $85 million of the facility. That's a broad enough lender base to make me feel comfortable that the revolver won't evaporate if and when more banks hit the skids.
Enterprise made a decision to reduce its distribution growth earlier this year in order to prefund infrastructure projects. Whether by luck or forethought, it was the right move.
If you are wondering if you should stick with your own beaten-down midstream MLPs--or buy into more of them--just make sure their balance sheets are in order to weather the storm which could well get worse before subsiding.
At the time of publication, Moreland was long Enterprise Products Partners, although holdings can change at any time.
Jonathan Moreland is director of research and publisher of the weekly publication InsiderInsights, founder of the Web site InsiderInsights.com and the director of research at Insider Asset Management LLC. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. While he cannot provide investment advice or recommendations, Moreland appreciates your feedback;
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