High yields, tax advantages and distribution growth are three major attractions of master limited partnerships (MLP). Now there’s a fourth: A nascent but growing wave of industry mergers.
To complete a merger, the acquiring company must offer something compelling. That’s usually a buyout price significantly above the target’s pre-deal market value, handing the owners a short-term capital gain.
MLP mergers’ biggest benefits, however, flow over the long term, as the combined company gains scale and therefore enhanced financial power and reach. Not every industry benefits from increased size.
Like utilities, however, MLPs typically own complementary assets that operate more efficiently and profitably with the benefit of enhanced scale. As a result, merged companies are typically more profitable, as well as better able to weather industry ups and downs.
Durability is an increasingly important factor in 2013. North America is in the middle of an oil and gas boom, with the Energy Information Administration projecting the US will overtake Saudi Arabia as the world’s largest oil producer by 2020.
If that forecast proves even half right, robust demand for energy midstream infrastructure like pipelines is here to stay for years to come. The problem is it doesn’t exist yet, and that’s left a large amount of oil basically stranded, and therefore selling at extremely discounted prices. In fact, oil in some parts of North America was recently quoted as much as $40 a barrel less than benchmark West Texas Intermediate Crude (WTI).
Discounted oil cuts into producers’ profitability, particularly in combination with tepid economic growth in the US. And as a result, we’ve seen several companies cut back capital spending plans this year from what they were doing last year.
Energy midstream MLPs’ cash flow isn’t directly tied to energy prices. But curtailed projected oil output has affected the business by making it more difficult to secure contracts with producers, particularly smaller and more aggressive ones.
Last year, for example, ONEOK Partners LP (NYSE: OKS) shelved plans to build a major oil pipeline linking the prolific Bakken fields of the upper Midwest with Gulf Coast refineries. The MLP has since been able to replace the project in its development pipeline and still projects robust cash flow and distribution growth. And it’s actually comforting to see management remain conservative by not building until there’s guaranteed revenue at the end of the line.
The ONEOK example, however, is a pretty clear indication that the energy midstream business does face some headwinds in coming months. And smaller MLPs that are more dependent on fewer projects and assets are at rising risk to seeing growth plans rolled back and may even lose existing contracts if the North American economy really slows this year.
The answer is to merge. MLPs have been prolific acquirers of assets as well as builders in recent years. Now a growing number of management teams are eyeing other MLPs as targets.
Kinder Morgan Inc’s (NYSE: KMI) takeover of the former El Paso Corp last year was a blockbuster that fired up distribution growth at its Kinder Morgan Energy Partners (NYSE: KMP) unit. This week, the partnership itself announced a major deal–acquiring Copano Energy LLC (NSDQ: CPNO) in a $5 billion deal including assumed debt.
Copano unitholders get 0.4653 units of Kinder Morgan for every Copano unit they formerly held. That’s an immediate 23.5 percent premium to the MLP’s price before the deal was announced. And unitholders stand to gain even more over the long term as part of a larger and stronger Kinder.
As for Kinder owners, the deal as structured is expected to be immediately accretive to distributable cash flow, and to add at least 10 cents per unit starting in 2014. That’s mainly thanks to the consolidation of ownership in the Eagle Ford Gathering venture, which is currently split between Kinder and Copano.
The Eagle Ford Shale, which is situated in Texas, is one of the most explosive areas for energy development in North America. The venture provides gathering, transport and processing services to producers in the region, which unlike the Bakken is not locked away from global energy markets. And there’s considerable potential for further expansion going forward.
Overall, Copano holds roughly 6,900 miles of gas pipelines in Texas, Oklahoma and Wyoming, with 2.7 billion cubic feet per day of throughput capacity. Processing facilities are capable of handling 385 million cubic feet of capacity.
Those figures are a drop in the bucket compared to Kinder’s assets. And despite solid recent performance, that small size makes Copano considerably more exposed to sector pressures than Kinder is. Combining forces eliminates that risk and positions both MLPs to grow faster as well.
Predictably, several specialist law firms have announced they may contest the deal, with several focusing their fire on Copano’s board. But in an environment of uncertain energy prices and drilling activity in the near term–as well as significant upside over the long term–getting larger with mergers is an elegant solution to keeping MLPs’ momentum moving forward.
The upshot: Not only is the Kinder Morgan/Copano deal likely to win needed regulatory and shareholder approvals by management’s third-quarter 2013 target date. But it’s nearly certain we’ll see many more such deals in the coming months.
As I’ve written many times in the past, I have one rule for buying prospective takeover targets: I only own what I wouldn’t mind holding if no deal appears.
That’s kept me away from betting on the majority of merger activity in corporate America. But it’s also saved a lot of heartache from holding weaklings that either never attracted a suitor or did so at a subpar price.
The nice thing about MLP takeover bets is, with few exceptions, revenue and distributions are reliable and generous. As long as the underlying business remains solid, you get paid to wait, often richly, until in the end there’s an offer they can’t refuse.