The following commentary was originally sent to Action Alerts PLUS subscribers on Dec. 10, 2015, at 2:34 p.m. ET.
We want to take a moment to discuss Energy Transfer Partners (ETP), a position that has oscillated in whiplash fashion over the past week. However, before discussing ETP specifically, we want to help subscribers understand how master limited partnerships (MLPs) work, why they were such successful investments (in ubiquitous fashion) for many years, and why they have indiscriminately collapsed over the past year and change.
When it comes to the MLP space, the number one thing investors currently care about in this environment is strong balance sheet/liquidity, followed by distribution coverage. But up and until the collapse in oil prices -- which subsequently sent the entire MLP space into a downward spiral -- investors only cared about distribution growth.
For many years, MLPs -- regardless of their vertical (midstream, exploration & production, transportation, etc.), level of commodity sensitivity, corporate structure, quality of management and geographic exposure -- were able to grow their distribution quarter after quarter with an incredible amount of ease. The unremitting rise in oil prices, unbridled expansion in production, and influx of capital (largely via the emergence of highly levered MLP-dedicated funds) provided the partnerships easy access to cheap financing, both from low-rate debt issuances and accretive equity financing. Investors salivated over MLPs, chomping at the bit like rabid dogs for access to IPOs and secondary offerings.
This fanatic demand is reflected in the sheer growth in the aggregate size (in terms of total market capitalization) of the MLP space -- from $86 billion in 2008 to nearly $600 billion as of last year. The number of publicly listed MLPs in the market went from 72 in 2008 to well over 100 by 2014.
In and of itself, the average MLP, regardless of the oil environment, rarely generated enough cash to cover, let alone grow its distribution, as their general partners captured a large, fixed proportion of their cash flow (this is how MLPs are structured). This wasn't an issue, however, as an MLP -- regardless of shape, size or quality -- could easily tap the debt or equity markets and raise the necessary amount of cash to purchase companies trading at half of its valuation (immediate accretion) and/or fund the requisite amount of cash needed to fulfill its distribution growth targets.
When I (Jack Mohr) worked on the Barclays trading floor roughly three years back, it seemed like a new MLP -- or secondary equity offering -- popped up every day, with buy-side clients across the board elbowing for a piece of the allocation (for example, if a hypothetical MLP looked to raise $500 million in equity financing, institutional and hedge fund clients would argue for maximum allocation). Many times, the demand outweighed the supply by absurd amounts -- anywhere from 10:1 to 20:1 to upwards of 40:1.
Without getting too deep into the weeds, once oil started dropping, the entire economic model (and investor confidence) collapsed. With oil prices trading 60% lower, near seven-year lows, investors fleeing the space in droves (weighed down by highly-levered MLP funds which have had to unwind in dramatic fashion, dumping shares on the market), MLPs simply do not have the currency to fund their distribution. Banks are no longer willing to issue debt, unless the MLP is willing to borrow at absurdly high rates. The market for equity financing has all but dried up as well. Even if an MLP tries to issue shares, they are doing so at prices 50%+ off their highs, which makes the transaction dilutive.
So why the heck do we own ETP? The partnership is truly distinct from its brethren. For starters, it is a natural gas pipeline company, a rare area within energy experiencing demand. Pipelines are full for the most part, with ETP acting as a "toll collector," getting a simple cut from every unit of volume that flows through the system. It has no direct commodity exposure nor volume exposure.
ETP's near 13% yield implies a significant cut to its distribution (for context, within the MLP space, a 9% yield essentially implies no distribution growth). This assumption is likely a product of guilt by association, following Kinder Morgan's (KMI) announcement this week that it is cutting its distribution. But we think this link is unfair as ETP is different from KMI in two respects including:
- Lower leverage: debt/EBITDA at ETP's underlying entities is at least a turn lower than KMI (ETP is at 4.5x, SXL is 3.4x, WPZ is 4.4x while KMI is nearly 6.0x);
- ETP's more diverse structure provides it with flexibility to manage growth and funding needs of its various entities (while a single company -- KMI -- has less flexibility).
ETP requires just $1 billion of additional equity next year with less required in 2017. Potential options to bridge that gap include an IPO of Philadelphia Energy Solutions, selling a stake of Lake Charles LNG or another asset, deferring some spending on its Rover project, or electing to take cash to redeem SXL units. Plus, the general partner -- Energy Transfer Equity (ETE) -- has emphatically stated it would support ETP if necessary.
All in all, we advise approaching ETP with caution as we expect continued volatility in the near term. Long term, however, we view the current price and yield as a steal.