Is the MLP Business Model Busted?

The energy sector’s bear market is starting to feel reminiscent of 2008. As each selloff causes share prices to hit new lows, investors wonder whether they’re finally seeing a capitulation, only to watch their favorite stocks fall into a deeper swoon a few weeks later.

Perhaps the true capitulation will come when the last investor stops wondering if they’re finally seeing a capitulation.

The one thing we know about crucial commodities such as crude oil is that low prices will eventually cause supply and demand to come back into balance. And odds are it will happen within the next 12 to 24 months.

In contrast to the last downturn, this time around it’s taking far longer for low prices to be the cure for low prices.

Although we’re more than a year into the energy sector’s downturn, U.S. crude oil production continued to ramp up through April, to a new all-time high, as producers focused on the assets with the highest returns, found ways to cut costs, and defer an eventual reckoning amid a global price war. And that’s pushed the eventual rebound out by another nine to 12 months.

Right now, the consensus forecast is for oil to trade at an average of $52.70 per barrel next year. To put things in perspective, during the third quarter, global oil demand was running at a rate of 95.3 million barrels per day, while global oil supply was increasing at a rate of 96.9 million barrels per day, which is a supply overhang of 1.6 million barrels per day.

Next year, the gulf between consumption and production is projected to decline to an average of around 570,000 barrels per day. And we could see the market move into undersupply by the end of 2016 if low prices boost demand, as they have done recently.

As value-oriented investors, we’ve tried to take advantage of the downturn in the energy sector by re-recommending our favorite master limited partnerships (MLPs) when their share prices seemed unfairly beaten down, while picking up a new one after it had already gotten pummeled.

And each time, we’ve suffered a new mauling. That’s to be expected in a bear market. And to a great extent, we’ve been willing to tolerate such downside in the expectation that we’ll be rewarded when the cycle inevitably turns.

But as the economist John Maynard Keynes once observed, markets can remain irrational longer than you can remain solvent.

And given the news over the past two weeks, we now have more existential considerations. In the wake of Kinder Morgan Inc.’s (NYSE: KMI) collapse in share price and subsequent dividend cut, the question is which of its midstream peers might be forced to follow suit with a similar cut, or even a restructuring.

Though Kinder Morgan’s fall from grace may seem obvious in hindsight, the fact is that while some skeptics got it right, the majority got it wrong. Indeed, based on data from Bloomberg, sentiment among Wall Street analysts remained overwhelmingly bullish–at 16 “buys,” five “holds,” and no “sells”–up until last week.

In analyzing the wreckage, it’s important to learn the right lessons. The biggest lesson is that as the bear market intensifies, access to capital is tightening. And that has big implications for the MLP business model in this environment.

At the same time, the main characteristics of that business model that have been touted for years remain largely true. These entities consist primarily of stable, fee-generating midstream assets that provide steady cash flows while being somewhat insulated from commodities prices.

Even now, Kinder Morgan’s underlying business underscores this. Next year, the company is projected to grow EBITDA (earnings before interest, taxation, depreciation and amortization) by 8%, to $7.8 billion, which will throw off more than $5 billion in distributable cash flow (DCF).

Kinder is still mostly a natural gas pipeline company (60.1% of trailing 12-month revenue), and its CO2 business, which is the one segment that has direct exposure to commodities prices accounts for just 12.4% of revenue.

The problem for Kinder and its midstream peers is that the business model the firm helped pioneer requires significant external financing for future growth projects. That funding is typically comprised of a mix of debt and equity.

In the past, that allowed Kinder, which is a C-corp. but continued to operate much like an MLP following last year’s consolidation of its limited partner subsidiaries, to pay out virtually all of its distributable cash flow to unitholders instead of reinvesting it in the business.

In essence, Kinder took what would otherwise have been a slow-growing, utility-like business and super-charged its growth by ramping up leverage and issuing equity to yield-hungry investors.

One of the lessons from 2008 is that a falling share price can create a self-fulfilling cycle. By October, Kinder Morgan’s stock had fallen to a level where issuing equity would have been too costly. That forced it to raise capital via a convertible preferred that would cover its funding needs through the middle of next year.

And the firm’s investment-grade credit rating suggested that it could continue to tap the capital markets to a limited extent until operating conditions improved.

Unfortunately, that limited extent turned out to be very limited indeed. Kinder’s brash management misjudged just how accommodating the bond-rating agencies were willing to be in this situation.

In late November, the company announced that it was upping its ownership stake in a highly levered joint venture that controls a major natural gas pipeline that it operates–the Natural Gas Pipeline Company of America (NGPL). Up front, the deal involved $136 million in cash and the assumption of $880 million in debt.

But while the two other major credit raters, Standard & Poor’s and Fitch, both saw the deal as credit neutral and reiterated their ratings, Moody’s balked at the move and warned that it was changing its ratings outlook to “negative” from “stable,” signaling a possible downgrade from investment grade to junk.

In addition to the aforementioned deal amounts, the rating agency was worried that Kinder would have to inject additional cash into this struggling investment, further boosting the firm’s already uncomfortably high debt-to-EBITDA ratio of 5.8 for a protracted period. Moody’s negative outlook was enough to send the stock spiraling lower.

Kinder looked like it had more levers to pull until it suddenly didn’t, and the market responded swiftly. Backed into a corner, management was forced to slash the dividend by 75% in order to fund its growth projects, maintain an investment-grade rating, and pare its leverage. In response, Moody’s changed its outlook back to “stable.”

But for at least the next three years, Kinder is stuck being a highly levered slow-growing, utility-like firm. And it will also take time for its investor base to evolve accordingly, especially since management’s credibility has taken a substantial hit.

As the golden boy of the midstream sector, Kinder’s downfall was a mix of hubris and miscalculation. After all, the firm was still promising shareholders that it would be able to boost its payout by 6% to 10% mere weeks ago.

Still, the situation with Moody’s is a bit puzzling, since companies are routinely in communication with credit raters to understand exactly where their limits are. Based on an exchange with an analyst during this week’s conference call, it sounds like Moody’s took Kinder off-guard by suddenly changing how it normally evaluates such a deal:

Barclays Analyst Christine Cho: How should we think about how the credit-rating agencies are going to view your other assets in which you have a 50% ownership stake, where you’re also an operator and you have nonrecourse debt, like NGPL? Typically, it hasn’t been included in the debt portion of the calculation, but is there a shift in what rating agencies are thinking?

Kinder Morgan VP of Finance and Investor Relations David Michels: It was a bit of a surprise to us that Moody’s decided to potentially include NGPL in its proportional consolidation. None of the rating agencies have included our other unconsolidated joint ventures in that same proportional consolidation method in recent history. They’ve all reaffirmed our ratings recently, and haven’t given us any indication that they would consider proportionally consolidating our other unconsolidated joint ventures.

This exchange reveals a development that could prove to be an ill portent for Kinder’s peers. While most of the other midstream players are not nearly as heavily levered as Kinder, whose debt ballooned as a consequence of acquiring its MLP subsidiaries last year, they still have fairly high levels of debt by most standards, with debt to EBITDA for most ranging between 4.0x and 5.0x.

Obviously, low unit prices will preclude many of these firms from raising money in the equity markets. So if they have to raise substantial funding for capital expenditures next year, they will need both the capital markets and credit raters to remain accommodative.

But as the situation in the energy sector continues to devolve, credit raters may adjust their standards accordingly, as Moody’s apparently did in Kinder’s case. And that could threaten critically important investment-grade ratings for other MLPs. That along with rising interest rates or reluctant lenders could force other MLPs to cut their distributions or restructure, by selling off assets or folding subsidiary MLPs into their general partners.

By all accounts, there is a substantial amount of private-equity capital sloshing about. But we’re not sure that income investors want to be in a situation where they’re counting on vulture investors to save the day or forestall an eventual reckoning.

So what makes an MLP the best house in a bad neighborhood?

The MLPs most prepared to endure in this atmosphere are those whose cash flows will continue to fully cover their distributions.

In the past, we’ve said we’re comfortable with an MLP temporarily under-earning its distribution. But the market is now saying we no longer have that luxury.

As long-term investors, we usually ignore short-term market sentiment. But circumstances are now forcing us to factor sentiment into our analysis along with the fundamentals.

MLPs with a payout structure that doesn’t include incentive distribution rights (IDRs), which require distributing a huge amount of cash to the general partner first before the limited partners get paid, enjoy a significant advantage on this front. In fact, some general partners are already conceding that they may have to subsidize their limited partners by temporarily cutting their IDRs.

Low external funding needs and low relative leverage will also go a long way toward MLPs preserving their empires.

The list of such names is small, but we’ve already got one among our longtime holdings.

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