Energy Transfer Shows the Power of the General Partner

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This morning Energy Transfer Partners (ETP) agreed to merge with Regency Energy Partners (RGP). Terms included an equity swap whereby RGP holders will receive 0.4066 ETP units and $0.32 in cash for each RGP unit they hold. ETP is also assming RGP’s debt. Energy Transfer Equity (ETE), ETP’s General Partner,  already owns the GP and Incentive Distribution Rights (IDRs) for RGP. However, the IDR’s were only at the 25% split level with respect to RGP, meaning that ETE was receiving 25% of RGP’s Distributable Cash Flow (DCF), whereas ETE is at the 50% splits on its share of ETP’s DCF. Simply put, prior to the merger ETE was getting more of each dollar generated by ETP than it was from RGP. Following the merger, RGP’s DCF will in effect be subject to the same 50% split at ETP’s. ETE has agreed to forego $320 million of IDR distributions over the next five years as a sweetener. It is nonetheless a nice deal for ETE and the relative performance of the stock prices reflects this. ETE is currently up over 4% reflecting its improved cashflow outlook, while ETP is down more than 5%, perhaps in part because of the issuance of additional units. RGP is up because the terms of the transaction represented a premium to RGP’s Friday close. RGP’s projected 2015 distribution yield was 8.9% prior to the transaction compared with 6.6% for ETP, so even allowing for the modest premium the transaction is still accretive to ETP. Importantly though, ETE investors most notably including CEO Kelcy Warren did not have to provide any capital to make this transaction happen; it’s been funded by ETP, as directed by ETE, its GP. The subsequent entity will also have a stronger balance sheet with a lower cost of debt, making future acquisitons easier to execute.

It highlights the advantages of investing in the General Partners of MLPs. They have all the control, and can execute M&A transactions that improve their economics with little or no obligation to provide additional capital. We are invested in ETE, as is Kelcy Warren who owns almost 80 million units of ETE worth around $4.5 billion. He figured this out long ago.

Kinder Morgan Finds Value in a New Pipeline Network

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Master Limited Partnerships (MLPs) have been falling along with the rest of the Energy sector since oil began its plunge last Summer. Following its peak in August, the Alerian MLP Index is down 15.1%. So far it’s down 1.6% in January, typically a strong month as retail investors implement asset reallocations settled on over the Christmas holidays. However, there are some signs of stabilization as the Index was -8.9% for the month by January 13th so has rebounded since then.

We’re in earnings season, a time during which those firms with solid fundamentals and limited direct commodity price exposure can differentiate themselves by reporting their results and providing guidance. Kinder Morgan (KMI), although no longer technically an MLP since their reorganization last year, still derives over half their cashflows from natural gas pipelines and is solidly in the midstream sector. During the conference call following their earnings they went through the coverage of their $2 distribution and although there are many moving parts the distribution coverage looks comfortable even with crude oil substantially lower (into the $20s per bbl) and natural gas down to $1 per MCF. Their direct exposure to crude oil and natural gas prices is limited. They reaffirmed 10% distribution growth through 2020. The stock yields 4.7% on its 2015 dividend.

KMI also made their first investment in the Bakken Shale in North Dakota by acquiring Hiland Partners LP, a privately owned MLP with pipeline assets in a still under-served area, from Continental CEO Harold Hamm. The $3 billion price tag will help fund Hamm’s expensive divorce.

KMI expects to invest an additional $800M in these new assets, expanding their capacity to transport crude oil from North Dakota. At a time when many are worrying about production cutbacks by U.S. shale producers this decision to make a new capital commitment highlights an interesting advantage pipelines retain over other form of crude oil transportation such as rail or truck. Only around half the 1.2 million bpd of output from North Dakota moves by pipeline, so increasing the Double H Pipeline (for example) from 80,000 bpd to 108,000 by next year will help. Pipelines operate at as little as 25% of the cost of rail and truck. While the latter two can offer greater flexibility, once a pipeline is in place its substantial cost advantage makes it a formidable competitor, and the long term commitments required of shippers provide far greater certainty about future cashflows. Some have suggested that E&P firms will press their MLP partners for price cuts on transportation, but they’re more likely to start by cutting use of more expensive rail and trucking assets. Pipelines are also far safer, with proportionately fewer injuries or spills.

The impact of production cutbacks is more likely to be felt by the higher cost transportation networks such as rail and truck. The area of the Bakken served by Hiland’s network has, according to the North Dakota Department of Mineral Resources, an IRR of 10% even with oil as low as $38 bbl. It’s one of the more profitable areas, and likely to keep producing output at current price levels. The Hiland acquisition is expected to be accretive to KMI by 2017. The company isn’t immune to reassessing its backlog of projects though, and although the figure only fell slightly (from $17.9BN to $17.6BN), $785MM of planned capex was shelved, mostly in its CO2 division where they have more direct exposure to the price of oil. So there clearly are some reductions in planned investment because of the drop in oil. These figures offer a measure of their likely magnitude, at least for a bellwether midstream operator.

In other news, Markwest Energy (MWE) increased its dividend by 4.7% YOY. It currently yields 6.2% based on its expected 2015 distribution. MWE owns its General Partner too, so unlike many MLPs there is no drag on distributions to investors from Incentive Distribution Rights. Consequently, all the growth directly benefits MWE investors.

We own both KMI and MWE in our portfolios.

Drilling Down on Oil Production Details

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It’s always interesting digging into the details of what’s happening with oil and gas production. Often there’s useful information provided by the companies themselves. Baker Hughes (BHI) for example publishes a global rig count every month. It covers most oil producing regions, and shows that the global rig count (counting those in use) has barely changed from the Summer. The average for 2014 was 3,578 and December’s figure was 3,570. So far, on a global level, rig use is not down much, although in their earnings call this morning  BHI did warn that operating conditions would be challenging this year because of the drop in oil. Incidental, the U.S. and Canada represent a big chunk of the global. Together, they closed the year at 2,257 rigs so 63% of the global total and slightly above the 2014 average but down 4% from November.

What did jump out at us though was the increase in use in some Middle Eastern countries. Saudi Arabia has been increasing all year, from 89 in January 2014 to 115 in December. The UAE similarly went from 28 to 36. So far, these countries don’t look as if they’re cutting back, as indeed the Saudis regularly remind us.

Another small but interesting nugget came from the Halliburton (HAL) call. They noted that the volume of sand used in fracking was +46% in 4Q14 compared with a year ago. This is consistent with comments from U.S. Silica (SLCA), that more mature wells use greater volumes of sand to maximize production. We think SLCA is attractively priced at current levels, and the indications we see are that their business of providing fracking sand is less vulnerable to falling oil prices than some may think. We are not invested in BHI or HAL.

 

Look For MLP Earnings To Confirm Business Fundamentals

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The General Partners (GPs) of Master Limited Partnerships (MLPs) have in many cases taken quite a drubbing since the Summer when the sell-off in oil picked up steam. Plains GP Holdings (PAGP) for example has fallen 26% over this time. And yet, midstream MLPs have limited direct exposure to commodity prices. Kinder Morgan (KMI) is now a C-corp following the corporate reorganization that simplified their prior structure which had two MLPs controlled by their C-Corp owned GP. While their corporate structure was altered, their business model wasn’t. So KMI still earns 54% of its pre-depreciation earnings from running natural gas pipelines with fully 82% of its 2014 cashflows fee-based rather than driven by commodity prices.

Last week PAGP announced an increase in their quarterly distribution of 9.8% year-on-year, which caused the price of its securities to rally. Other GPs and C-Corps that own GPs will similarly be announcing earnings over the next several weeks. Their results and guidance will reflect the toll-like model that midstream MLPs operate combined with the advantaged economics enjoyed by those that control them. Over the past twelve months some of them have enjoyed stunningly fast distribution growth: Williams Companies (WMB) yields 5.1% and grew last year at 36%; Oneok (OKE) yields 4.7% and grew at 63%. Given the recent indiscriminate selling of energy-related stocks, the earnings announcements of these and related companies will provide a useful reminder about their business fundamentals. It will be an area well worth watching.

Linn Energy is Not Your Father's MLP

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Master Limited Partnerships (MLPs) are best when they’re boring over the short term. Predictably raising your cashflows and distributions leads to long term excitement at the very reasonable cost of being tedious to watch on a daily basis.

In 2014, Linn Energy (LINE) was the antithesis of this. While most MLPs own midstream energy infrastructure assets with their toll model, LINE is engaged in Exploration and Production (E&P) of oil and natural gas. The consequent commodity price exposure makes both their cashflows and stock price highly volatile. This contradicts the point of owning MLPs, which is to extend the holding period indefinitely so as to maximize the tax shield that the deferral of income affords. The best MLPs are those that are stable, boring and whose valuation doesn’t hit either extreme of rich or cheap. Because selling an MLP usually creates a tax bill, greatly impeding overall returns.

LINE fell 67% in 2014 because of its exposure to oil. It was obviously a great sale earlier last year above $30. It may be a great buy now at around $11, given that they’ve done the inevitable and cut their distribution. But timing MLPs isn’t easy, and investing in businesses like LINE requires some timing skills on the part of the investor because it’s not always a good name to hold. This is LINE’s second collapse since their 2006 IPO. In fact, even a buyer in 2008 at the stock’s absolute low is now barely ahead of breakeven following a six year roller coaster.

So buying LINE may be a good trade as it’s fallen so far. But buying and then inevitably selling it is unlikely to be a tax-efficient investment. Boring is better, and after taxes far superior.

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