Midstream Mlps & Emerging Shale Opportunities
TWST: Please start with a brief snapshot of your coverage universe.
Mr. Horowitz: In total our coverage universe is a very diverse group of 47 stocks. Approximately two thirds are traditional midstream MLPs and integrated midstream suppliers. This includes partnerships/companies that engage in the gathering, processing, transport, storage and distribution of oil, natural gas, liquefied petroleum (LPG), natural gas liquids (NGLs) and refined petroleum products. Likewise, our midstream coverage also encompasses those partnerships engaged in the distribution of propane and other refined products, as well as marine transportation of petroleum products. The remaining one-third of our coverage is what we call upstream or E&P MLPs and traditional royalty, drilling trusts, which are involved in the production of oil and natural gas. The way to really classify it is to say we cover the heart of the energy value chain, or all the necessary infrastructure for moving hydrocarbons from the wellhead to the burner tip.
TWST: What's your overall view of that market?
Mr. Horowitz: The MLP asset class has dramatically outperformed its peers on a trailing 12 month, TTM, basis. When considering the Alerian MLP Index, AMZ - which is a good representation of the asset class given it reflects the 50 largest MLPs on a market-cap-weighted basis - it is up 25% versus the S&P 500, up approximately 13%. Thinking about the market from a yield perspective, the average MLP yield is 6%, with a current spread to the 10-year Treasury of around 230 basis points. Given that spread is 50-to-75 basis points below the 10-year average spread, outlier adjusted, it suggests the group is fairly valued at present based on current risk to reward, and we agree.
However, when considering investment in MLPs, we take a long-term approach when calculating risk-adjusted, total-return potential. Investors shouldn't get caught up in benchmarking current valuations relative to the historical averages of spreads to the 10-year Treasury. The focus should be on comparing current MLP valuations versus alternatives in today's market. Specifically, the two questions we seek to answer when reconciling current valuations with our models are, one, is the full risk - i.e., financing, execution and integration risk - associated with facilitating cash flow growth accurately reflected? And two, is the full magnitude of intermediate to long-term distribution growth fully factored in? In support of that latter point, I'd highlight that we believe the cost of both debt and equity capital remain extremely attractive on a relative basis, and visibility continues to improve around future cash flow growth with lower associated risk. Thus, as investors put money to work in today's market, considering all viable securities - both equity and debt - one must take into account, one, the sustainability of the underlying fundamentals influencing the asset base and industry; two, market volatility and beta; and three, track record of year-over-year distribution growth and the risk associated with that distribution growth pace continuing. So in short, we believe the MLP asset class remains compelling versus other total-return alternate investments, as many of these same securities lack the magnitude of intrinsic value and lower associated risk of cash flow facilitation inherent in select MLP models.
TWST: How do fluctuations and volatility in commodities prices affect these companies? What do you watch for in terms of gauging that impact or potential impact?
Mr. Horowitz: Commodity price volatility and fluctuations in supply actually have less of an impact on cash flow than perceived. Remember, the vast majority of midstream operators do not take title to the physical commodity, so they are virtually price insensitive. From a volume perspective, several midstream operators run fee-based assets; however, they may have either minimum volume commitments, MVCs, or other contractual provisions that mitigate volume volatility, with the goal to keep quarterly revenue consistent. Additionally, for several long-haul interstate pipeline operators or those involved in terminalling and storage operations, etc., both commodity price risk and volume risk is reduced by capacity reservation or take-or-pay contracts. These contracts generate fees regardless of the actual capacity utilized on the asset or the volume that flows through the asset. Think of these contracts as rent. Producers rent infrastructure capacity via long-term contracts to make sure they have the vital connection to get their production to end users.
That being said, depending on the magnitude of pricing swings it can change producer economics to a great degree, making some plays more or less economic. So we stay focused on canvassing North America, trying to figure out what areas hold the greatest reserve potential which can be exploited at the lowest all-in cost. As a lot of these areas are developed and start garnering more and more attention, typically the infrastructure dollars follow in short order.
TWST: So these companies are a way to play the oil and gas market without being sensitive to the turmoil we often see in the commodities market.
Mr. Horowitz: That's exactly right. These partnerships/companies really provide the backbone of the energy industry, and are crucial to helping mitigate regional pricing differentials and helping us maximize our domestic reserve potential. Investment in energy infrastructure is vital to enhancing our ability to be energy independent.
TWST: Are there particular locations or shale plays that are especially productive or promising right now?
Mr. Horowitz: Absolutely. Shale plays are much more productive versus conventional resource plays, and are on pace to account for about 50% of overall natural gas production in the next five to seven years. That is a big number. Looking at the plays that represent the most opportunity to drive that trend, you have to consider the composition of production, or the breakdown between dry gas, natural gas liquids or NGLs, crude oil, condensate, etc. Over the past year we've seen rigs slowly migrate out of the older gas shales - such as the Barnett, Fayetteville and Woodford - and move into the more liquids-rich plays, such as Granite Wash, Eagle Ford, Marcellus and Cana Woodford. This makes sense given the financial incentive for producers to focus more on oil or liquids relative to dry gas.
Looking forward, we see a lot of opportunity on the horizon, as supply is always shifting. While the Haynesville shale will likely show a large ramp in gas production based on the large backlog of uncompleted wells eventually being hooked up, areas such as the Utica shale in West Virginia/Ohio are starting to get a lot of press. Out West, areas such as the Jonah/Pinedale, Piceance/Uinta basins and San Juan Basin also hold a lot of opportunity for increased gas and NGL production. Additionally, we remain focused on the Granite/Colony Wash, Eagle Ford, Marcellus shale and Woodford plays as it relates to incremental NGL growth. From an oil perspective, in addition to the Granite Wash and Eagle Ford both having an oily component, the West Texas Permian Basin - and associated Avalon/Bone, Spring/Wolfcamp - Niobrara and Williston Basin/Bakken shale continue to draw attention. So you continue to see more and more focus on a lot of these emerging plays, and ultimately that's what's going to drive incremental production and the need for additional infrastructure.
TWST: What are some of the companies you think are best positioned to make the most of those opportunities?
Mr. Horowitz: When you think about best connecting the areas of the most prolific supply with areas of the greatest demand, Enterprise Products Partners (EPD) is at the forefront. They own/operate over 50,000 miles of pipeline that helps transport natural gas, natural gas liquids, crude oil and refined products, in addition to a lot of downstream connectivity into the petrochemical landscape. In our opinion Enterprise runs the most vertically integrated supply chain, has one of the lowest costs of capital of all investment grade-rated MLPs, has a very transparent balance sheet with excellent financial flexibility to pursue growth opportunities and has also demonstrated one of the best track records for enhancing value via distribution growth. Looking forward, we expect Enterprise to grow its cash distribution per unit in the range of 5% to 6% year over year for the next few years. EPD is a name that we think has a lot of intrinsic value, the full extent of which has yet to be realized by the market.
Additionally, we continue to recommend Williams Partners (WPZ). This partnership has a growing geographic scale in all the right places with increasing scope, a sizable pipeline project backlog - $1.3 billion-plus - and a financially flexible balance sheet to pursue strategic opportunities. We remain confident in our forecast for cash distribution per unit growth of 6%-plus on a compound basis over the next few years.
TWST: Are there any other recommendations? Are there any other top picks?
Mr. Horowitz: On the crude oil and refined product side, both transportation and storage, we very much like Plains All American (PAA) and Magellan Midstream Partners (MMP). Both reflect very good geographic distribution of assets, enhanced optionality across the midstream supply chain, excellent balance sheets and top-notch management with a proven track record for enhancing value.
In addition, we like El Paso Pipeline Partners (EPB) and Spectra Energy Partners (SEP). Both have very stable, risk-averse underlying cash flow profiles, great visibility intwo future organic growth initiatives and a lot of upside from potential drop downs from their respective parent corporations. Finally, Energy Transfer Equity (ETE) remains one of our favorite general partners, benefitting via the incentive distribution leverage on underlying limited partner cash flow growth at both Energy Transfer Partners (ETP) and Regency Energy Partners (RGNC).
TWST: How did these equities and the distributions that they pay out to unit holders fare during the downturn, and how are they doing today?
Mr. Horowitz: Throughout that period the MLP model was undoubtedly stress tested, given growing concerns that MLPs were structurally flawed from a capital market access standpoint. Remember, the MLP model is very sensitive to capital market fluctuations, given the reliance on accessing incremental debt and equity to finance growth initiatives, which in turn should drive increasing cash distributions. So during this time, there was lot of uncertainty around which partnerships had the ability to sustain existing cash flow in order to cover their distributions, service debt obligations, etc.
For some smaller-cap partnerships that may have been spread too geographically diverse and/or increased distributions at too rapid of a pace without balancing the need to increase retained cash, the downturn was more painful. There was a fair share of asset divestitures that took place to help deleverage balance sheets. Some partnerships had to cut distributions to enhance liquidity and meet credit obligations, and others worked to amend credit covenants while some were ultimately consolidated by the same parent companies that had spun them out in years prior.
However, this was not the case for all partnerships. Even at the lowest point of the credit crunch during 4Q2008, the structural resiliency of the MLP model and intrinsic value of its assets were validated, as exemplified by a large-cap, investment grade MLP - Enterprise Products Partners LP - completing the first public equity offering of any BBB-rated company. In short order, other large-cap, investment grade partnerships followed suit, augmenting balance sheets and enhancing liquidity. The specific stocks that I mentioned fared better than most because of their geographic diversity, the retention of a larger percentage of their cash flow beyond what they distribute and also better balance sheet management - i.e., no major debt obligations. This group of partnerships came out of that time frame stronger and certainly more flexible from a capital profile perspective. It was these principals, as well as prudence in capital allocation and dedication to enhancing long-term unit holder value with lower associated risk, that helped to better position the MLP asset class to achieve the above-average returns experienced during 2009-2010.
TWST: What about sector-wide estimates on distribution growth? What should investors expect?
Mr. Horowitz: This year we are modeling for the asset class as a whole to generate approximately 4% to 5% year-over-year growth in distributions, which I think based on what we see today will be achievable. We are also anticipating approximately 5% to 10% price appreciation. So in aggregate, we expect the asset class to generate between 10% and 15% total return in 2011.
TWST: How much are investors interested in the space? Is this still considered an alternative asset class or is it becoming more mainstream? Is it more accepted by institutional investors in particular?
Mr. Horowitz: I think the awareness of the asset class has increased significantly over the past several years. The institutional fairway has and continues to widen, especially given the flow of nontraditional funds into the space and the evolution of structured products like ETNs, ETFs, etc. If you consider the total return potential on a risk-adjusted basis for this asset class against comparative asset classes such as REITs, utilities or even fixed income instruments, MLPs look very, very compelling over the long term.
TWST: What are the main risks these companies face?
Mr. Horowitz: There is always going to be the perceived risk of rising interest rates and what impact that could have on the cost of capital. We would point out that when reviewing the past decade average MLP distribution growth has outpaced inflation, as measured by the CPI, by almost three times. This is an excellent point when discussing long-term MLP ownership, especially in a rising rate environment, and certainly supports owning these stocks even if inflation is looming.
Secondly, despite the fact that most midstream operators don't take title to the physical commodity themselves, these are energy stocks. So from a theoretical perspective, instead of being in a $100-plus crude and $4-plus natural gas environment, if we're looking at $50 crude and $2 natural gas, you could argue such a pricing environment may significantly change producer economics by play. Thus, if producers scale back their capital programs, one could infer the magnitude of demand for incremental infrastructure investment may somewhat diminish. Finally, there is always the potential for legislative risk, as it relates to taxation.
TWST: Are you concerned about potential changes in the tax treatment?
Mr. Horowitz: No, we monitor current and proposed legislation closely and don't believe there is anything on the front burner that would really put the current structure into jeopardy.
TWST: Thank you. (MN)
Note: Opinions and recommendations are as of 04/06/11.
Vice President - Energy Equity Research
Raymond James & Associates, Inc.
5847 San Felipe Rd.
Houston, TX 77057
(713) 789-3581 - FAX