By: Roger Conrad
The third quarter of 2012 was marked by a recovery in energy prices from the lows made in May and June. The extent to which that helps any energy producers will depend on the structure of price hedges. And exposure to natural gas liquids prices and “frac” spreads is something of a wild card, as these markets are much smaller and more difficult to hedge.
By and large, however, the resilience of energy prices should prove to be a major plus for the maintaining the pace of new energy midstream projects, particularly in oil. Meanwhile, MLPs continued to enjoy a very low cost of capital, for both equity and debt.
Predictably, new equity issues during the quarter routinely triggered short-lived selloffs for MLPs. Enterprise Products Partners LP’s (NYSE: EPD) USD473 million offering in late September didn’t do too much damage, sending the unit price down from USD54 and change to USD53 and change. Other MLPs took more dramatic hits when they went to market, however, including Energy Transfer Partners LP (NYSE: ETP).
My view is that selling in the wake of equity issues is usually a good time to buy an MLP, as raised funds are almost always invested in accretive enterprises. But investors should continue to expect this kind of action when companies come to market.
As for debt capital, Enterprise Products’ debt maturing in January 2068 currently trades at a yield to maturity of less than 4.5 percent. That’s emblematic of a market that’s appears still ready, willing and able to accept any and all debt that’s backed by energy midstream assets.
Low cost of capital means even very conservative and therefore lower margin projects can be highly lucrative. The most encouraging thing is that most MLP managements are still not succumbing to the temptation to relax project standards to boost revenue, or to lever up.
Rather, management is still locking in cash flows with long-term contracts and keeping balance sheets relatively clean.
Even MLPs with larger amounts of debt have very low obligations relative to their size. Enterprise Products, for example, has a total of USD1.2 billion in bond issues maturing in 2013. That amount, however, is equal to just 2.5 percent of the company’s market capitalization. It’s covered nearly three times over by the available credit on the company’s USD3.5 billion tranche that matures in September 2016. And it’s at coupon rates between 5.65 percent and 6.375 percent, or roughly twice the yield to maturity on Enterprise Products’ 10-year debt.
The upshot is refinancing that USD1.2 billion is going to translate into considerable savings for Enterprise Products next year. And even if credit conditions should tighten sharply, management still has more than enough wherewithal to retire those obligations and refinance them later when conditions improve.
That’s an extraordinarily nice position for a company to be in, particularly when it operates a business that held revenue steady even during 2008, when oil prices fell from well over USD150 a barrel to barely USD30.
I fully expect solid industry conditions and low financing rates to shine through with strong distribution coverage and continued growth for MLPs as third-quarter numbers come in.
Several MLPs in my coverage universe did post distributable cash flow (DCF) in the second quarter that lagged their current payouts, namely Buckeye Partners LP (NYSE: BPL), Kinder Morgan Energy Partners (NYSE: KMP), Legacy Reserves LP (NSDQ: LGCY), Linn Energy LLC (NSDQ: LINE), PVR Partners LP (NYSE: PVR), Regency Energy Partners LP (NYSE: RGP) and Vanguard Natural Resources LLC (NYSE: VNR).
MLPs over time must generate enough DCF to at least cover their distributions. One quarter of inadequate coverage is excusable, provided management has laid out a clear course for improved coverage going forward. And that was the case for all of these MLPs last quarter.
Buckeye, for example, was heavily impacted by the weather and its impact on throughput of petroleum products.
Kinder Morgan Energy Partners’ distribution increases are well funded by energy midstream projects that began generating revenue in the second quarter and will ramp up a lot further in the third. The same is true for Regency and PVR, which was hit by lower royalties from coal produced on its lands.
Legacy, Linn and Vanguard, meanwhile, were nicked by the volatility in natural gas liquids prices in the first half of 2012, markets which are much more difficult to hedge than oil and natural gas. But all have new production coming on line that should more than close any revenue gap in the second half of the year.
The key for all of these MLPs, of course, is putting up numbers that indicate management’s guidance for recovery is still on track. Preferably, that will mean DCF coverage of better than 1-to-1 in the third quarter and the promise of further gains ahead.
But the key will be the assumptions behind maintaining and increasing the current distribution rate going forward, and whether or now any have changed. For more fourth-quarter MLP picks, check out my free report.