After four years of shattering records, raising tens of billions of dollars in public offerings and helping to fuel an energy infrastructure boom, midstream master limited partnerships (MLP) are losing favor with investors concerned about the commodities downturn and the risk it's presenting for the space.
Billions of dollars have poured into midstream infrastructure growth in recent years, fueled by the the meteoric rise of oil and natural gas production across the country. A bevy of midstream MLP offerings since 2011 has also been fueled in part by producers choosing to build their own gathering and transportation assets rather than use the costly systems of others.The MLP, which provides the tax benefits of a limited partnership and the liquidity of a publicly traded company, had become a bellwether for investors with its stable high yields and a top choice for capital-hungry producers.
But with oil's staggering fall and persistently low natural gas prices, concerns have emerged about midstream MLPs’ ability to grow. Revenue is in some cases threatened by a lack of committed volumes; commodity price risk is built into certain contracts and high expenses and counterparty credit risks at flagging producers appear to have investors on edge.
"It looks like the party is pretty much over," said Danielle Sandusky, principal at Source Energy Advisors LLC, who has recently explored the trend in writings on her energy information website. "There's some consolidation happening too. You see it with the Energy Transfer and Williams deal (see Daily GPI, Sept. 28), where all the MLPs are trying to shore-up and make sure they're not going to be borrowing indefinitely to make the distributions...It's just really tough to find anyone that looks totally protected from falling production."
A sell-off has occurred in the space and new MLP offerings have stalled. The Alerian MLP index, a leading gauge that includes 50 prominent companies and captures 75% of available market capitalization in the space, has fallen nearly 27% since the beginning of the year.
In the last year, 13 MLPs have trimmed their payouts, or tax-advantaged distributions from available cash flow to unit holders. Since 2009, midstream MLPs have raised more than $100 billion in initial public offerings (IPO). Royal Dutch Shell plc In late 2014 launched Shell Midstream Partners LP in the first such offering to break $1 billion (see Daily GPI, Oct. 29, 2014). Columbia Pipeline Partners LP (CPPL) set a record earlier this year when it raised more than $1.1 billion (see Shale Daily, Feb. 9) .
But concerns have surfaced about contracts between midstream operators and producers. As Sandusky pointed out, some MLPs are touted as "fixed-fee," when in reality the agreements only require a dedication of production from a given area of an operator’s acreage. That could leave the MLP susceptible to a decline in drilling, she said, especially if the producer has no obligation to pay if they don't use midstream assets.
An older contract type, Sandusky said, requires an MLP to take a percentage of proceeds from the sale of hydrocarbons, creating an inherent commodity price risk at the midstream level. Higher expenses on overbuilt systems in declining basins and counterparty stability as credit dries up have also partly prompted a sell-off.
"The exposure has definitely started to come to light," said Sandusky, who formerly worked as vice president of natural gas marketing for Concord Energy LLC and as a trading analyst for Florida Power & Light Co. "But it's kind of painting in broad strokes by talking about the whole category when we say the whole sector has sort of sold-off. But you've still got good fundamentals with some companies and others that are showing their prospects aren't great.
"I think we're going to start to see the companies within the space differentiate from one another."
Another potential strike against MLPs in the coming quarters could come with rising interest rates, said Patrick Rau, NGI's Director of Strategy & Research and a former Wall Street MLP analyst.
"MLPs tend to be highly inversely correlated with U.S. interest rates, and those aren't likely to stay at rock bottom levels forever," he said. "Falling rates have contributed to the extraordinary performance of MLPs over the last few years, but the market is currently pricing in a roughly 80% probability of at least one Fed rate hike over the next year."
Moreover, there remains concern for MLPs in the event that exploration and production (E&P) companies become insolvent. In a note to clients on the topic this week, Deutsche Bank noted that "while these [midstream contracts] are typically senior to most debt, the key takeaway of our call was that it really goes case by case. The main determinant is usually which side (upstream or midstream) has more leverage over the other.
"For example, if an E&P is wholly dependent on one pipe for takeaway, but that pipeline can attract other volumes, the midstream operator would have more leverage over the producer. Clearly, there are multiple scenarios, but the main point is that there is no firm rule here."
To be sure, the midstream MLP sector is diverse with companies involved in gathering oil, gas and liquids, long-haul transportation, storage terminals and refined petroleum products. A look at the Alerian's top-10 constituents shows names with Federal Energy Regulatory Commission-supported, stable long-haul contracts such as Enterprise Products Partners LP (EPD). EPD has a unit price near $30 and a yield of 5.5%. Plains All American Pipeline LP is another strong interstate operator that has performed well on the index with an 8.6% yield and a unit price of more than $30.
"The long-haul pipelines, they've got long-term commitments and there's going to be a need for that service, but everything that got pushed under the MLP umbrella didn't need to be built," Sandusky said. "So those are the ones that over time are going to continue to break down."
Hillary Holmes, a partner at Baker Botts LLP who has represented underwriters in some of the leading midstream MLP IPOs of recent years, including CPPL and Shell Midstream, said the sector's regression is not unexpected. She added that lower growth and distributions are both prudent and warranted in the current environment.
"If you look at [SEC] filings that were made in 2008 and 2009, when we were going through the recession, there was zero MLP IPOs; we hit a huge dip at that time. The decline from the ultimate high to the low in the Alerian right now is comparable to what we experienced with the high in 2007/2008 to the low in 2009/2010," she said. "We're really going through the same thing we went through a few years ago. Obviously for different reasons; one was a global financial recession and here we just have a decline in commodity prices in the energy space."
After the sector's fall during the Great Recession, Holmes said, MLPs, investment bankers and the attorneys that advise them are more aware of what could go wrong. They're paying attention to contracts, distributions and capital discipline, she said.
"Recently, what we've started to pay attention to is how long the contracts are and at what point are they rolling off," she said. "Are they rolling off at a time when the midstream MLP is going to have to renegotiate with the producer, when the producer is strapped for cash or not planning to produce as much? That could make the next contract that the pipeline rolls into look different."
In a report last week, Ernst & Young noted that while other industries made progress toward going public with IPOs or MLP spinoffs, no oil and gas companies participated during 3Q2015. The firm noted that without any clear consensus on a commodities rebound, the industry opted instead to evaluate new sources of capital (see Daily GPI, Oct. 14).
"What does this all look like a year from now, or two or three years from now?” asked Holmes. “That's just so hard to know. It depends on where production goes, where commodity prices go. What I'm hearing from investment bankers is that at some point, everyone is confident this will settle to a new normal," She said the market could also adjust favorably to lower midstream MLP yields if the trend persists, especially with the tax-advantages for investors.
"There was a time when I was doing an MLP offering every single week; it's not that way anymore," she said. "I think people are in a bit of a hunker-down mode, and that's a good thing. It's what we do in energy...If you look in the rearview mirror and compare it to the way it used to be, you'll definitely see that things aren't as good as they were a year ago.
"The way to make it out of the tunnel for the long haul -- like these MLPs are doing -- is to be prudent with distributions and be prudent with growth."