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Uncovering Value in MLPs
03/28/2014 10:00 am EST
Energy sector specialist Elliott Gue, editor of Energy & Income Advisor, helps unravel the complexity of master limited partnerships—highlighting two favorites for growth and income potential.
Steve Halpern: We’re here today with Elliot Gue, editor of Capitalist Times and the Energy & Income Advisor. How are you doing today, Elliot?
Elliot Gue: Good, good. How are you? Thanks for having me on the program.
Steve Halpern: My pleasure. Today we’re going to be discussing master limited partnerships, specifically, recent IPOs in the sector. First, let’s look at the structure of these investments for our listeners who might not be familiar, and you note that MLPs are usually comprised of two entities. Could you explain that?
Elliot Gue: Sure, well MLP, or a master limited partnership, is typically comprised of a limited partner, or LP, and a general partner, or GP.
Now, when you buy an MLP you’re typically buying a stake in the limited partnership and what that means is that you’re entitled to receive regular distributions, which represent a share of the cash flows generated by that business.
But with the limited partner, you, typically, have no interest in the actual management of the MLP so, in other words, you’re not making decisions or voting on decisions like, “shall we make this acquisition?” or to go ahead with a new pipeline construction project, or to go ahead with new oil storage terminal.
That management path is undertaken by the GP, or the general partner. Now what’s really important about this relationship is that the LP—which is, basically, you and me who buy the MLP—we pay a fee to the general partner in exchange for managing and helping to grow those assets over time.
That fee is called an Intensive Distribution Right (or IDR) and, typically, those IDRs rise—the share of IDR rises as the underlying distributions of the LP to the MLP increases. The reason it works that way is it’s basically incentivizing the general partner to make decisions that allow the underlying LP to grow its payout to new holders or shareholders.
It’s typically a very good relationship, particularly in the earlier years of a partnership’s existence because it’s designed to encourage growth and yield, and MLPs—most people buy master limited partnerships for that yield.
The average MLP in the US yields a little over 6%, which, of course, is many times what the S&P yields right now, so it’s typically a very good relationship but you have to watch it very carefully because at some point in the future, you can get into a situation where the general partner is taking too large a fee as an IDR out of that LP which affects their ability to grow distributions going forward.
Steve Halpern: As you pointed out, in order to attract investor attention, these MLPs offer particularly high yields in the first few years. What specific factors do you look at to determine if these distributions will be maintained and continue?
Elliot Gue: Right. Well, most master limited partnerships, or MLPs, are involved in what we call the midstream energy business. Basically, the energy business is divided up into three parts; you have upstream, which is actual oil and gas production. There are handfuls of about a dozen MLPs in that segment.
Then you have the midstream, which is really transportation and storage, so it’s owning things like pipeline, like natural gas storage caverns like oil terminals and tankers. That would be midstream, transportation, and storage.
Then you have downstream, which is usually refining. There’s just a couple of MLPs involved there. About 80% are involved in that midstream area, 80%, 90%. Now that area is typically very stable business.|pagebreak|
Typically, for example, the pipeline owner doesn’t care whether the oil moving through their pipeline is trading at $150 a barrel or $50 a barrel. They’re typically paid a capacity reservation fee which is simply a payment made by the shipper on that pipeline just to guarantee access to capacity, so it’s paid regardless of where oil is trading.
When I’m looking at distribution stability for an MLP, I first look at what business they’re involved in. The safest MLPs are typically involved in that midstream area.
Upstream MLPs, you want to look at how fully have they hedged their production income in coming years, but that does involve a little bit more commodity price activity and within that midstream side, I want to see what their contract coverage is.
In other words, they own a pipeline which has a 15 or 20 year commitment from a group of major companies like Exxons and Chevorons of the world to ship and pay a minimum capacity reservation fee, or do they have a shorter term contract which the tariffs are adjusted every two or three years.
If it’s the latter, you do have some risk because, for example, in recent years in the US, some natural gas pipelines have not been full because the US has been experiencing a sort of glut of natural gas and older pipelines that might been contracted 15 or 20 years ago, when they were in very high demand, now when they are up for re-contracting they’re not in as much demand anymore and the owner can’t receive as high a fee for using that pipeline.
I like to look at the length of those contracts, what portion of a commitment they have in terms of a capacity reservation fee.
The final thing I would look at is the gathering and processing aspect of the business. Gathering is owning small diameter pipelines, processing is taking raw natural gas and removing natural gas liquids like propane, ethane, and butane.
Depending on what kind of contracts the MLP has governing this business, they can have exposure to either natural gas or natural gas liquid pricing, so I want to look very closely at how those contracts are structured.
In some cases they use what’s called a percent of proceeds arrangement which means the MLP charges—MLP is basically paid for processing natural gas by receiving a portion of the natural gas and natural gas liquids that are produced and that does introduce a little bit at a commodity price risk.
Steve Halpern: From listening to your description, it’s clear that these are relatively complex vehicles; but luckily for us, our listeners, you’ve done the difficult work in reading through the prospectuses and the S-1 registration statement and analyzing these companies so maybe you’d share a couple of names briefly with our listeners that are high quality ideas that have come to the forefront of your research.|pagebreak|
Elliot Gue: Well, absolutely. I think one of the interesting things about MLPs is that they are a little bit complex in terms of each one being a little bit different and that does allow you, by digging into information like the S1 registration statement to identify names that are a little bit under the radar screen that just aren’t getting enough attention from investors.
In fact, one company that I profiled recently is called Marlin Midstream Partners LP. The symbol is (FISH). It’s a relatively new IPO. It went public towards the end of last year and it’s a very small company.
It’s a very small MLP and it didn’t really get a whole lot of attention or a whole lot of analyst coverage and, in the very beginning, if you went to a lot of—and this common with MLPs—if you went to a lot of brokerage web sites or a lot of financial Web sites like Yahoo! Finance and you typed in the symbol FISH it would indicate that the MLP paid zero yield.
And that’s only because the MLP hadn’t yet paid its first distribution so I think a lot of investors wrongly assumed that the company doesn’t pay a dividend or a distribution at all. Reality is almost 7.7% right now pays out about 35 cents a quarter.
I think investors are starting to catch on to that now that it’s made its first couple of distributions. They are involved in the midstream energy business. It’s a little bit higher up on the risk side because it being a small name but they do have some decent contracts covering their business and their two main businesses are a series of natural gas related transportation and processing assets located in Eastern Texas.
This is an area that’s seen a decline in drilling activity in recent years because it’s an area that produces primarily natural gas. However, in the very specific area in which Marlin Midstream operates, they’ve actually seen drilling activity be pretty strong. It’s actually up about 6% year over year and that just means more natural gas traveling through their processing plants and their storage facilities.
One other thing that is even more interesting business for them is their oil trans loading facilities—basically these are facilities for moving oil from trucks on to trains or from small diameter pipelines on the train.
Their two trans-loading facilities are located in Utah and Wyoming and obviously, as many listeners are aware, rail is becoming a much more important means of transporting crude around the US because there just simply aren’t enough pipelines in many parts of the US to handle all of this new oil that’s being produced from regions like the Bakken Shale.
They recently also made an acquisition and are doing some expansions to these oil trans-loading facilities and these particular facilities are in very, very high demand because they’re focused on oil drilling activity and oil prices are quite high.
Another one to look at which is more of a senior MLP which has been around for a long time and went public back in 2002 is a company called Sunoco Logistic Partners LP. The symbol (SXL).
One of the reasons I looked at this is it’s a very good example of how you can make a lot of money buying an MLP IPO. This company went public in 2002.
You can’t imagine a worse time to come public and it went public the very same day that Tyco was down 20 plus % on accounting concerns, and yet, despite that fact, this MLP generated a return of 23% in its first 12 months of trading while the market was down about the same, about 23%.
This company is continuing to grow and we really like the fact that their general partner was recently acquired by Energy Transfer Equity (ETE), which is the general partner also for Energy Transfer Partners (ETP).
They’re very interested in growing the underlying MLP. Most of their assets are associated with crude oil, things like oil product terminals, refine product terminals, oil pipelines, oil gathering systems and again, the key trend to watch here is that Sunoco is benefiting from growth in shale drilling activity.
All this new oil we’re producing from regions like west Texas and the Permian, and North Dakota’s Bakken. There’s just not enough pipeline capacity to handle to transport and store all the oil that’s being produced and so what we’re seeing is a lot of regional gluts develop.
For example, right now, West Texas intermediate crude oil traded to Midland Texas which is in West Texas. It’s trading at almost a $10 a barrel discount to the same exact oil in Cushing, Oklahoma just a few hundred miles away.
The reason for that is that there just aren’t enough pipelines and terminals to move oil from point A to point B and Sunoco does benefit from this because they do have some of the only pipelines out there that are able to handle those movements.
It’s a lot lower yielder than Marlin Midstream because it’s a lot more well-known company but I also think you have to balance that by the fact that it’s likely to grow its distributions in an accelerated pace over the next few years.
So you’re looking at a company which currently yields about 3%—so its lot less than Marlin Midstream at almost 7.7%—but over the last three years it’s grown its distribution and the average annualized pace is over 17% so that distribution is rising very rapidly.
Steve Halpern: Well, we really appreciate you taking the time today. Thank you for joining us.
Elliot Gue: Thanks for having me.
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