Pipeline Potential

06/16/2006 12:00 am EST


Elliott Gue

Editor and Publisher, Energy and Income Advisor and Capitalist Times

"A takeover bid for our portfolio holding Kinder Morgan is throwing the spotlight on the pipeline industry," says Elliott Gue in his The Energy Strategist. Here’s his look at the impact on the sector and the current best opportunities.

"For the most part, companies in the pipeline group are organized as master limited partnerships (MLPs), publicly traded partnerships that are designed to offer a steady stream of income to shareholders. MLPs don’t tend to be fast-moving and watching the group trade can be akin to watching paint dry. Over longer time frames, MLPs offer excellent income and slow-but-steady capital gains potential.

"I have been saying for some time that pipelines don’t get the attention on Wall Street that they deserve. This is likely the result of the fact that they’re not fast-growing companies. With accomplished managers like Richard Kinder bidding for pipelines, the sector is sure to get more attention from investors. A whole slew of pipeline firms with attractive assets would make attractive targets.

"This bodes well for my other pipeline recommendations. Chief among those is midstream gas-processing giant Enterprise Products Partners (EPD NYSE). The company owns a number of natural gas-processing facilities that remove liquids like propane and butane from the natural gas stream, preparing the gas for injection into the US pipeline grid. In addition, Enterprise owns so-called gathering systems that connect individual gas wells to larger pipeline systems.

"On the growth front, Enterprise has two advantages. First, the company’s assets are located in parts of the country where gas-processing and transport demand is growing particularly rapidly. Second, the company has a number of offshore floating production platforms in the Gulf of Mexico; it’s a beneficiary of increased development of reserves in the Gulf.

"Enterprise currently yields more than 7% and has been consistently boosting its payout for years. It is not exactly a fast-mover, but it has little direct exposure to oil and gas prices and can continue to perform well even if oil and gas prices correct this summer. A defensive play, Enterprise remains a buy under 28 in Proven Reserves.

"Another pipeline play is Valero LP (VLI NYSE). This limited partnership’s general partner is controlled by Valero Energy, the largest independent refiner in the US. However, these two companies are totally separate entities. Valero LP’s refined product pipelines carry processed products like gasoline, jet fuel, and kerosene from refiners to third-party pipelines or terminal/storage facilities.

"The key is that these fees are not based on the value of the products shipped, and the LP does not take ownership of the refined products that travel along its pipes. Instead, the fee charged is based on the number of barrels shipped over the pipeline grid. That means that there is little commodity price sensitivity; as long as Valero keeps pumping through the network, the fees keep rolling in.

"But the big attraction of Valero LP is that there’s potential for Valero to keep spinning off more assets to the partnership in coming quarters. Slow-growing, cash-generative assets are ideal for partnerships. Valero also acquired a number of other possible MLP assets in buying competitor Premcor last September. As Valero LP acquired these assets, it’ll make it possible for the company to pay out even higher distributions. Higher income potential is what ultimately drives MLPs; in fact, Valero LP announced yet another distribution increase after reporting earnings in late April.

"A similar story exists for Williams Partners LP (WPZ NYSE) which we hold in our Wildcatter’s Portfolio. The company’s general partner is The Williams Companies, another company with plenty of assets suitable for holding in a partnership. As Williams spins off assets to Williams LP, the MLP’s cash flows should grow quickly, supporting faster-than-average distribution growth.

"Both Williams LP and Valero LP are rated buys. Valero LP is the more conservative play and pays a solid 7% yield. Williams LP is faster-growing partnership but is far riskier and less liquidly traded. In addition, Williams is a play on distribution growth not current income; the MLP currently pays less than 5%, near the low end of the average for the MLP space."

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