Infrastructure Shortage Should Hasten M&A Activity In The MLP Sector

Submitted by Investing Daily as part of our contributors program.

Doom to boom: That sums up the massive January momentum shift in performance of master limited partnerships (MLP).

The Alerian MLP Index is again pushing new all-time highs in the 430 range following a stunning 11 percent one-month gain.

The primary catalyst for recovery was the reversal of negative factors that affected the fourth quarter of 2012.

For one thing, the 12th-hour deal reached to avert a US government fiscal cliff produced investment taxes that were far more benign than expected.

But it still raised the top rate for capital gains and dividends going to just 20 percent.

That makes MLPs much more attractive, particularly for upper-bracket investors. And, perhaps more importantly, it at least temporarily set to rest worries about legislation that could eliminate MLPs’ tax advantages.

The deal on the cliff still brought austerity that will impact growth in 2013. Some 77 percent of taxpayers have seen their taxes rise this year, mostly due to higher Social Security levies.

And there’s more to come as spending cuts kick in, either by the so-called sequester or as the result of another deal in Washington.

But the odds that Congress will refuse to raise the debt ceiling and cause the US government to default are now quite low. And the austerity we’ll get is far more benign than what would have resulted from going over the fiscal cliff.

As I’ve written many times before, the biggest danger to MLPs’ four-year-plus bull market is that management will stop demanding long-term contracts before building. That’s hardly where we are now.

But the sector does face one significant headwind this year: a North American shortage of energy midstream infrastructure that’s created vast differentials in regional pricing of oil and gas.

The infrastructure shortage is hugely bullish for MLPs over the long term because it means more demand for pipelines and related assets.

Ironically, the short-term the picture is far less clear-cut. Pricing differentials are inhibiting producers’ profitability and hence their willingness to sign long-term contracts for new capacity. This, in turn, is discouraging new building, at least for the near term.

The solution is getting larger. MLPs with scale and scope are the preferred providers for giant energy companies that can afford to plan beyond the current cycle. The bigger an MLP gets the better its access to the really big and lucrative contracts.

That’s what’s behind the sector mergers I’m seeing (See MLPs Set to Consolidate). One potential takeover target in the space is Inergy Midstream LP (NYSE: NRGM).

Inergy Midstream LP weighs in at a market capitalization of just USD1.75 billion. General partner (GP) Inergy LP (NYSE: NRGY) owns 74.4 percent of the limited partnership (LP), which is its only real asset. It would presumably have to be part of any deal. Given its market value of USD2.9 billion, that likely means a total price of USD4 billion to USD5 billion.

Inergy Midstream’s USD425 million acquisition of the COLT Crude Oil Logistics Hub takes its Marcellus Shale midstream operation to the Bakken Shale for the first time.

The new assets include an oil rail terminal as well as storage and pipeline facilities. Rail has emerged as a critical midstream asset in the Bakken, owing to the lack of interstate pipeline access at this time.

Inergy Midstream’s ability to make such a large acquisition is a major plus, and the purchase is expected to be accretive to earnings.

The MLP was forced to pay 6 percent to issue debt maturing in eight years to complete the deal. That’s still low enough to ensure the deal is accretive to earnings. By way of contrast, however, Enterprise Products’ eight-year debt has a yield of maturity of just 2.7 percent.

Fourth-quarter and full year 2012 results were solid, as the company’s assets continued to grow and produce. Fourth-quarter cash flow rose 8 percent, while distributable cash flow surged 14 percent to USD29.5 million. That produced a distribution coverage ratio of roughly 1-to-1.

Storage revenue was flat, reflecting overall market weakness and gas surpluses. Sales at the Hub services and Salt divisions declined but more than made up for by increases in Transportation services and Oil-related operations, as overall revenue rose 7.7 percent.

On the whole these results suggest a healthy company capable of growing on its own, even if market conditions remain weak. And project additions should keep growth going in 2013 for the distribution.

The prospect of faster growth as part of a larger enterprise, however, may make a generous merger offer too good to refuse for general partner Inergy LP. And the company has several assets that could entice a suitor. For more of my favorite MLP picks, see my free report.

This article was written by Roger Conrad.