Fear is the watch word across the entire energy complex -- this is not news -- but nowhere does it seem as fierce as within the master limited partnership sub-sector.
Many already know the MLP story -- these are companies that own and operate infrastructure here in the U.S. that connect the producers to the customers. The MLP was born in the mid-1980s and there is nothing new today about how they make money or how they are valued. Nothing.
Because of a unique tax structure that exempts the partnerships themselves from paying taxes, MLPs are obligated to pass through the majority of their income on to owners of their units (unitholders). This tax structure was initially granted by the U.S. government to qualifying partnerships in an effort to spur domestic energy infrastructure spending. There are MLPs that fall into three categories: upstream (gathering), midstream (transportation) and downstream (processing).
I will only be discussing the midstream MLPs -- those that transport and/or store oil, gas, natural gas and other refined petroleum products.
Reliable cash flow, and the corresponding healthy, tax-advantaged yields, has made the MLPs an attractive pocket of the energy space for a very long time. But perhaps never so much so as the last few years, with interest rates looking like they will be "lower for longer."
Retirees have been forced to look elsewhere -- away from the traditional allocation to fixed-income investments -- in order to fund the retirement they have been expecting. These are not investors who can tolerate equity-like volatility.
What happens when those who can't tolerate volatility experience volatility? They run for the exits. I believe a good deal of the MLPs' recent problems result from their "change in ownership" during the past couple of years. I do not share the position of many that "lower for longer" will also apply to oil prices, but that's a separate argument.
Master limited partnerships lease their pipes over lengthy contracts -- in some cases more than 20 years -- to producers and refiners who are looking to get product to their customers. Customers can be the refiners themselves (to process the unrefined product) or end-users who consume the finished product (cars, trucks, factories, airplanes). MLPs are able to grow their distribution organically -- by raising prices or laying and leasing out more pipe -- or by acquisition, issuing equity or debt to buy up their competition.
Kinder Morgan (KMI) has been in the news a lot lately, mainly because of the swift nature of its recent stock decline. Why has KMI stock been under such pressure? There are doubts about Kinder's ability to maintain its dividend. On Kinder's most recent conference call, the company disappointed investors by reducing expectations for the growth of its dividend in 2016 to a range of 6% to 10% from 10%. There is an enormous disconnect between growing this year's dividend by 6% into next year and having trouble maintaining the 2015 dividend of $2.04 per share.
Any commentary you read today suggesting that KMI's dividend is in jeopardy should be completely ignored. Is it possible Kinder is only able to grow its dividend at the low end of the 6% to 10% range next year? Absolutely. Is it possible Kinder misses and only grows its dividend by 3% to 4%? If oil stays between $40 to $50 for all of next year, sure. That is nowhere near the same thing as being on the verge of a dividend cut. Kinder Morgan has positive free cash flow per share today, despite their current debt load (which at about 5.8x EBITDA is admittedly on the high side, but not unmanageable).
The fear across the entire MLP space appears to be analogous to the one outlined above, specific to Kinder Morgan. That fear is that these companies will no longer be able to keep up their previous records of growing distributions and, in some cases, may be forced to reduce or eliminate their current distributions -- the latter of which is, again, a little silly. Just because the market is pricing in a distribution doesn't make it so.
MLPs have more cash flow today than they currently pay out. They will have more cash flow than they will pay out in 2016 -- even in a dire commodity price scenario. The growth of their distributions may be at risk in the short term, yes. But MLPs have much more financial flexibility with their balance sheets than many realize. The elimination or deferral of growth projects would simply serve as a short-term cost cut and allow for cushion with current distributions.
Domestic production has started falling -- from a peak of 9.6 million barrels per day (bpd) to just about 9 million bpd today -- and that trend will likely continue into next year as prices remain inequitable for new drilling to come online. Declining production in the U.S. means we don't need as much new infrastructure development right now.
In some cases, it means volumes on existing infrastructure will decline (and certain MLPs will see cash flows decline as a result). But this is a short-term issue that will correct itself in 2016 when the supply and demand come back into balance and support further growth in U.S. production.
MLPs across the board are being treated as though their assets are without value, and their cash flows are on the verge of drying up. Don't let the current price action tell you a story that's not true.