Few investments are better than a master limited partnership (MLP) with a long history of consistently boosting its distributions to unitholders. Steady Eddies such as Enterprise Products Partners LP (NYSE: EPD) have generated enormous wealth for unitholders over the long term and are the mainstays of our Conservative Portfolio.

But older MLPs don’t necessarily offer the best distribution growth potential. In many cases, MLPs grow distributions at the fastest rate in their first two years as public companies. And there’s nothing like rapid growth in distributions to drive strong price appreciation and total returns.

For example, in Williams Partners LP’s (NYSE: WPZ) first two years as a public company, the firm boosted its quarterly payout from $0.35 to $0.575, thanks to a series of asset drop-downs from its general partner, Williams Companies (NYSE: WMB). These deals helped the stock soar 80 percent from the close on its first full day of trading. Conservative Portfolio recommendation Sunoco Logistics Partners LP (NYSE: SXL) enjoyed a similar pop. The refined products pipeline giant increased its payout 23 percent in its first eight quarters as a public company, and the stock soared 100 percent. It pays to keep a close eye on initial public offerings (IPO).

Because distribution growth attracts investors, most MLPs are set up to generate rapid growth in their early years. Of course, not all MLP IPO are winners: The investment landscape is littered with the wreckage of small MLPs that never managed to establish a sustainable business model or reach critical mass. Others expanded too quickly and took on too much leverage and commodity risk; many of the worst offenders got crushed during the 2007-09 bear market.

As with any MLP, the key is to look at the underlying business and the likely growth avenues. Here’s a look at the prospects for the three of the biggest new MLP IPOs so far this year.

Chesapeake Midstream Partners LP (NYSE: CHKM)

Key Takeaways:

• Chesapeake Energy Corp (NYSE: CHK), the MLP’s general partner, is one of the largest independent exploration and production companies in the US and boasts a wealth of assets suitable for drop-down transactions.
• Chesapeake Midstream’s gathering contracts are structured so that it has little to no exposure to natural gas and other commodity prices.
• The MLP’s Mid-Continent gathering system should benefit from increased drilling in fields rich in oil and natural gas liquids.
• Chesapeake Midstream has a slightly lower-than-average yield but offers superior growth prospects and below-average business risks.

Chesapeake Midstream Partners LP is the most anticipated MLP IPO in recent memory, primarily because the MLP’s general partner (GP), Chesapeake Energy Corp, is one of the largest independent exploration and production (E&P) firms operating in US unconventional natural gas and oil fields. CEO Aubrey McClendon has talked about taking a midstream gas MLP public for years, so investors have awaited this IPO for some time.

The 2008-09 financial crisis temporarily shelved plans for an IPO of Chesapeake Energy’s midstream division, but improved credit conditions and solid demand for MLPs prompted the company to file its first registration statement for Chesapeake Midstream in February.

McClendon and his team appear to have picked an opportune time for the IPO; the units commanded prices at the top end of the projected range, suggesting strong demand from institutional investors. And since the IPO at $21, the units have climbed to $25, indicating that the secondary market is also interested in the new MLP.

Fundamentals support the market’s enthusiastic reception of Chesapeake Midstream; the new IPO offers lower-than-average business risk and superior growth potential.

 A Strong, Growth-Oriented GP

The GP manages the day-to-day operations of an MLP’s assets and makes key decisions on acquisitions and organic expansion projects. Investing in an MLP whose GP doesn’t have unitholders’ best interests in mind often entails its fair share of pain. Fees paid to the GP called incentive distribution rights (IDR) underscore point: High IDRs can make it tougher for the MLP to raise capital for future growth prospects.

Here are a few questions to ask when evaluating an MLP’s GP.

• Is the GP wholly owned by a private-equity firm? Private-equity firms often hold GP assets for a relatively short time and may look to sell at an opportune time.
• Is the GP an operating company with assets suitable for drop-down transactions? In drop-down deals the GP sells assets such as pipelines or gas-processing facilities directly to the MLP. Drop-downs are usually highly accretive to cash flow and allow the MLP to immediately boost its distribution payouts.
• What is the IDR structure and in which tier is the MLP? As noted earlier, IDRs are a fee paid by the limited partners (LP) in an MLP (for the most part, that’s us) to the GP. IDRs are usually related to the size of the distributions paid to LP unitholders; the GP’s take typically rises as distributions increase. Such a structure incentivizes the GP to grow the business, but high IDR payments early in an MLP’s life can stunt its growth.
• What is the GP’s ownership stake in the MLP? GPs often own a significant proportion of the MLP’s limited partnership interests when the MLP is first listed. Over time, the GP usually sells off its LP stake to raise capital. That being said, GPs that retain a significant stake in the LP are usually more sensitive to unitholders’ interests.
• Is the GP in a position to help the MLP when credit markets weaken? This was a key question to ask in 2008-09. Some GPs shored up the finances of the MLPs they sponsored by temporarily suspending IDR payments, providing direct loans or offering some sort of guarantee that the distribution wouldn’t be cut.
• How experienced is GP’s management team? This is the most basic question investors can ask of any company. An experienced management team like the ones in place at Enterprise Products Partners LP (NYSE: EPD), Kinder Morgan Energy Partners LP (NYSE: KMP) and Linn Energy LLC (NSDQ: LINE) is preferable.

On all of these points, Chesapeake Midstream and its GP score well.

Chesapeake Midstream owns nearly 3,000 miles of gathering pipelines in two key regions: the Barnett Shale around Fort Worth, Texas and an area collectively known as the Mid-Continent that includes the Permian Basin, Anadarko and Granite Wash plays.

These assets are small diameter pipelines that connect individual gas (or oil) wells to processing facilities and, ultimately, the interstate pipeline network. In addition to gas gathering, Chesapeake Midstream also provides ancillary services such as compression and treating. The latter process involves removing carbon dioxide from raw natural gas.

Chesapeake Energy drills actively in all of these regions. The company has spent north of $1.5 billion on midstream energy assets over the past few years because it needs gathering, treating and compression capacity to transport the gas, natural gas liquids (NGL) and oil it produces. Because these assets are integral to Chesapeake Energy’s operations, the GP is incentivized to ensure that Chesapeake Midstream remains healthy.

Chesapeake Energy’s motivation for spinning off these midstream assets is clear. First, holding these assets in an MLP structure is far more tax efficient. Second, the IPO brought Chesapeake Energy a substantial influx of capital, funds the firm can use to grow production. Meanwhile, capital raised by Chesapeake Midstream can be used to build out additional infrastructure to support Chesapeake Energy’s drilling operations.

Drop-down transactions should drive distribution growth at Chesapeake Midstream over the next few years. The MLP’s portfolio doesn’t include Chesapeake Energy’s extensive midstream assets in the Marcellus Shale of Appalachia, the Haynesville Shale of Louisiana and East Texas, and the Fayetteville Shale in Arkansas, among other regions. The gathering system owned by Chesapeake Midstream serves about 3,500 natural gas wells that produce about 1.532 billion cubic feet of gas equivalent per day, but Chesapeake has stakes in over 40,000 wells whose daily output amounts to 2.6 billion cubic feet of gas.

And this growth forecast isn’t idle speculation. Management anticipates as many as two drop-down transactions of $250 to $500 million worth of assets in each year going forward. 

With around $750 million available on its credit facility and the potential to raise low-cost cash in the debt markets, Chesapeake Midstream should have no trouble financing deals of that size. And as part of the partnership agreements, Chesapeake Midstream has the right of first refusal on any midstream assets that Chesapeake Energy chooses to sell.

Some analysts have expressed concern about Chesapeake Energy’s debt load and subpar credit rating, questioning whether depressed natural gas prices will constrain the GP’s ability to secure financing.

These fears are largely unfounded.

Chesapeake Energy has set a goal of working its way back to an investment-grade credit rating. Actions speak louder than words, but the bond markets appear to be putting faith in the company.

Source: Bloomberg

This graph tracks the price of Chesapeake Energy 6 7/8% due Nov. 15, 2020 (CUSIP: 165167BUO). As you can see, these bonds have appreciated steadily to the point that the current yield stands at roughly 6 percent, about 330 basis points (3.3 percent) above the current yield on a 10-year US Treasury note. A year ago this spread was more than 480 basis points. Falling spreads to Treasuries is a sign of improving sentiment. Although the Chesapeake Energy’s bonds still don’t command a yield spread that’s typical of investment-grade credits, the trend is heading in the right direction–even if natural gas prices aren’t cooperating.

In addition, Chesapeake Energy has partnered with major international oil companies on many of its key fields, a move that significantly reduces the out-of-pocket investment required to develop the plays.

Chesapeake Energy’s acreage in the Barnett Shale is far and away the single most important source of volumes for Chesapeake Midstream. These properties are developed as part of a joint venture (JV) with Total (NYSE: TOT). Under the terms of the deal, Chesapeake Energy sold Total a 25 percent stake in its Barnett Shale interests in exchange for $800 million cash and an agreement that Total will fund $1.45 billion worth of future drilling and completion expenses in the field. In other words, Chesapeake got cash and what amounts to a free ride on most of expenses through 2012.

Given the backing of a giant like France-based Total, worries about Chesapeake’s ability to fund drilling in the Barnett Shale are vastly overblown.

Finally, Chesapeake Energy has maintained a 41.5 percent ownership stake in Chesapeake Midstream, further aligning the GP’s interests with unitholders.

Asset Risk and Commodity Exposure

The natural gas gathering and processing business tends to entail significant exposure to commodity prices. Typically, gathering is sensitive to drilling activity; the more wells being drilled in an area, the greater the demand for new well hook-ups. Gatherers often earn a fee for hooking up new wells to their systems and are remunerated based on the amount of gas transported. Robust drilling activity translates into strong results

Frenzied drilling in key US shale plays despite low gas prices reflects superior economics in certain plays and the urgent need to secure leaseholds through production. But activity in these fields should pull back a bit in coming months. Aubrey McClendon noted in Chesapeake Energy’s second-quarter conference call that the firm would focus on drilling in liquids-rich plays until the price of gas recovers to more than $6 per million British thermal units.

All of these developments at the GP level won’t affect on Chesapeake Midstream’s ability to pay distributions. Roughly three-quarters of the MLP’s cash flows will come from its gathering operations in the Barnett Shale. These volumes are covered under long-term gathering agreements signed with the Chesapeake Energy-Total JV. Here are some of the key terms.

1. A fixed fee for every 1,000 cubic feet of gas gathered and treated from the Barnett Shale acreage. At the beginning of every year, this fee automatically increases 2 to 2.5 percent.
2. The JV has agreed to dedicate all gas produced from existing and future wells in the Barnett Shale to Chesapeake Midstream.
3. The JV has agreed to minimum volume commitments through mid-2019, and these commitments increase by 3 percent every year. In other words, the MLP will receive a certain contractually guaranteed minimum whether or not the gathering system is used. Not only will this minimum increase, but the volume-based fee will rise each year.

The remaining 25 percent of cash flow come from Chesapeake Energy’s Mid-Continent operations. This gathering agreement resembles the one covering the Barnett Shale, with one notable exception: No minimum volume is set.

This omission is less of an issue in the Mid-Continent, an NGL- and oil-rich region where Chesapeake Energy likely will increase its output to take advantage of superior economics.

Distribution Growth Potential

Chesapeake Midstream has yet to announce its first quarterly distribution. But the MLP indicated that it would pay distributions equal to about $0.3375 per unit per quarter ($1.35 per year). This is the minimum quarterly payout set forth in the registration statement.

The first payment would be prorated because the MLP will be publicly traded for only two months in the third quarter. Expect the partial third-quarter distribution to be around $0.225 per unit. Based on the current price and an annualized payout of $1.35, units of Chesapeake Midstream yield roughly 5.5 percent. Note that most brokers’ websites and sites like Yahoo! Finance won’t display the correct yield until the MLP declares a full quarterly distribution.

To forecast potential distribution growth, let’s examine the MLP’s IDR Tier structure, listed below:

• Tier 1: 98 percent to MLP holders and 2 percent to the GP, up to $1.55 per unit;
• Tier 2: 85 percent to MLP holders and 15 percent to the GP, between $1.55 and $1.69;
• Tier 3: 75 percent to MLP holders and 25 percent to the GP, between $1.69 and $2.03; and
• Tier 4: 50 percent to MLP and 50 percent to the GP, above $2.03.

To start, Chesapeake Midstream will be in the Tier 1 threshold, meaning that 98 percent of any distribution goes to the holders of the LP units. This scaled structure, which requires less growth in total cash flows to boost the payout to unitholders, often enables new MLPs to grow their payouts at a faster rate than mature rivals it takes less growth in total cash flows to produce a rise in the payout to LP unitholders.

And the GP is incentivized to grow distributions as quickly and sustainably possible; the higher the distributions paid to unitholders, the higher the percentage received by the GP.

An example will flesh this idea out more clearly. Williams Partners LP (NYSE: WPZ) offered a similar value proposition when it went public in 2005. The GP, Williams Companies (NYSE: WMB), owned a large number of assets appropriate for drop-down transactions. The MLP hit the top end of its Tier 1 payout in two quarters, exceeded its Tier 2 payout in a year and hit its Tier 3 payout just two years after the IPO.

Although it’s by no means a sure thing, Chesapeake Midstream could enjoy a similar growth rate, assuming that the GP drops down about $500 million in assets each year. If Chesapeake Energy sticks to its word, the MLP could pay out $0.3875 per quarter by mid-2011 and $0.4225 per quarter in early 201–an annualized growth rate of roughly 15 percent.

Chesapeake Midstream likely will end 2010 with an annualized yield of about 5.5 percent, less than the 6.2 percent average of the benchmark Alerian MLP Index. However, a lower-than-average yield is justified by fee-based gathering contracts that limit exposure to commodity prices. The potential for the distribution to grow at a double-digit rate also mitigates a lower yield.

Chesapeake Midstream Partners LP is a buy in How They Rate. 

Niska Gas Storage Partners LLC (NYSE: NKA)

• Niska is one of the largest owners and operators of natural gas-storage assets in North America.
• The MLP derives a large portion of its revenues from fees that are insensitive to gas prices. But the MLP’s proprietary operations do have considerable market risk.
• Gas storage fundamentals appear to be deteriorating, potentially putting Niska’s growth at risk.

Chesapeake Midstream’s market cap is more than double the size of Niska Gas Storage Partners LLC, an MLP that went public on May 11, 2010, at $20.50 per unit. The fledgling MLP has struggled, and its units trade for less than its IPO price despite a 12.5 percent rally in the benchmark Alerian MLP Index.

Niska controls 185.5 billion cubic feet (bcf) of natural gas-storage in the US and Canada, making the MLP one of the largest independent owners of these assets in North America. The majority of these facilities are located near major pipeline hubs, and gas in these facilities can be marketed to a large number of potential buyers.

Demand for natural gas storage has grown in recent years, driven by several long-term trends. One of the most important is the winter-summer spread in gas prices. Strong winter heating demand tends to drive high gas consumption in the winter months; prices are typically higher during the winter than during the summer or the fall and spring shoulder seasons.

As a result of seasonal demand patterns, US natural gas in storage tends to fall during the winter months because demand exceeds production; gas in storage rises from April to October as production exceeds demand. Gas storage is a sort of buffer between seasonal demand and supply.

These seasonal patterns offer profits for companies that buy gas at cheap prices in midsummer, store these volumes for a few months and sell it at sky-high rates in January. The bigger the difference between average summer and winter prices, the better the profits. Large winter-summer differentials and extreme volatility in gas prices tend to increase the value of gas storage.

Storage Contracts

Niska operates its storage facilities under three basic types of arrangements: long-term contracts, short-term contracts and proprietary management.

Long-term firm (LTF) storage contracts are multiyear deals between Niska and a third party that seeks the right to inject gas into storage and withdraw portions of this volume multiple times per year. Typically, these storage contracts specify the amount of gas and a maximum number of “cycles,” or the injection and subsequent withdrawal of gas from storage.

Capacity reservation fees guarantee a certain amount of storage for a customer and account for 90 percent of the revenue Niska earns in LTF deals. Note that clients pay these fees regardless of whether they use the storafe and how many times the gas is cycled.

In addition, Niska levies an additional charge based on the volume of gas that is stored, injected and withdrawn, but these variable fees offset fluctuating costs. The real cash flow comes from the dependable, low-risk reservation fee. On average, Niska uses about 70 percent of its capacity and generates about 50 percent of revenues from LTF deals. LTF contracts currently in force have an average of just over three years remaining.

Short-term firm (STF) contracts generally have an effective period of less than one year. The main difference between STF and LTF deals is customer flexibility; under an STF deal, the customer is required to inject gas on a certain date or specified dates and withdraw that gas on predetermined dates. The customer cannot inject and withdraw gas on an as-needed basis. The customer pays a preset fee for this service, usually based on gas price differentials at the time the contract is signed.

For example, say a customer enters an STF deal today and plans to withdraw the stored gas in February 2011. Natural gas currently trades at $3.95 per million British thermal units (MBTU), while futures expiring in February suggest prices of roughly $4.40 per MBTU. The fee charged under an STF deal would be based on this spread. Because STF contracts are renegotiated frequently and depend on prevailing spreads, there’s more risk in STF than LTF deals.  Typically, STF deals account for less than 20 percent of Niska’s revenue.

The remainder of Niska’s revenue comes from “proprietary optimization” deals. That is, Niska uses excess storage capacity for its own operations. Niska doesn’t trade gas directly but uses its storage capacity to capture various low-risk arbitrage opportunities.

Greater pricing volatility volatility, regional variations in gas prices and higher summer-winter spreads increase the number of these proprietary opportunities. This business can provide Niska with plenty of upside in strong markets but also introduces some volatility to cash flows.

All told, Niska’s business has a fee-based component but significant exposure to volatility in natural gas prices. Investors should demand a higher-than-average yield to compensate for this added business risk.

Growth Opportunities

Niska’s general partner is Niska Sponsor Holdings, a firm that’s 95-percent owned by Carlyle/Riverstone, an energy-focused private-equity fund. Generally speaking, an operating company with plentiful assets to drop down to an MLP is preferable to a private-equity concern as a GP. But the involvement of a private-equity GP isn’t necessarily a deal-breaker. In this case, the GP has significant operating experience with gas storage and other midstream energy assets.

Even better, the GP is pursuing a new gas storage development in western Canada and has permission to build a new facility in Louisiana; either of these assets would be suitable drop-downs for the MLP.

There’s also significant potential for organic expansion. At Niska’s storage hub in Alberta, Canada the company will add about 9 bcf of capacity by early next year and a total of 18 bcf by early 2014. The company is also awaiting approval to expand its storage facilities in California over the next three years.

Distribution Growth Opportunities

Niska paid a distribution of 0.173 in August, a partial quarterly payout because the MLP went public midway through the second quarter. The firm should disburse a full quarterly distribution of $0.35 in November, equivalent to an annualized yield of around 7.4 percent.

This quarterly distribution is still in Niska’s first tier of IDRs; the GP currently receives about 2 percent of the MLP’s cash distributable cash flow. Tier 2 of the IDR structure begins at $0.4025, a logical target for the quarterly payout in early 2012. Based on this level, Niska would yield around 8.4 percent.

At this stage in its life and in this environment, it’s unclear whether the MLP is a good risk. Although robust output from shale-gas plays suggests elevated demand for storage, the surfeit of production has pushed down prices along the future curve. In fact, the difference between summer and winter prices–a key driver of Niska’s margins–is relatively tight. An extraordinarily hot summer bolstered gas prices, further compressing this spread. Meanwhile, because prices have dropped, the dollar size of these spreads is smaller than it was a few years ago.

Although Niska yields about 1 percent more than the average MLP in the Alerian Index, it doesn’t compensate for these risks. We’re assuming coverage of Niska Gas Storage Partners LLC in How They Rate as a hold.

PAA Natural Gas Storage LP (NYSE: PNG)

• PAA owns two natural gas storage facilities, one in Louisiana and one in Michigan.
• Unlike Niska, PAA has almost no exposure to natural gas prices and storage fundamentals.
• PAA’s yield is lower than average, and its growth prospects may be hampered by weakening natural gas fundamentals.

PAA Natural Gas Storage LP owns two natural gas storage facilities, one in Louisiana and one near Detroit. Despite its apparent similarity to Niska Gas Storage Partners, the two MLPs aren’t carbon copies of one another; the main difference is that PAA derives a much larger percentage of its total revenue from simple fees that are unrelated to gas storage economics.

In fact, roughly 99 percent of PAA’s total revenue stems from fee-based businesses. The single most important source of revenue is what PAA calls “firm storage services,” a combination of LTF and STF contract. In both cases, however, most of the fees PAA collects are capacity reservation fees that are paid whether or not the capacity is used.

The MLP has decided to start a marketing division that would take advantage of some of the same arbitrage opportunities that Niska exploits, but this business would be much smaller and designed to utilize capacity not immediately committed under long-term deals. PAA has repeatedly reaffirmed that it will commit most of its capacity under long-term deals, including any new storage it adds.

PAA plans to expand its capacity at both of its storage facilities. The company’s Pine Prairie facility in Louisiana has 24 bcf of total storage capacity, up from 14 bcf at the beginning of 2010. PAA has plans to add another 21 bcf of capacity to Pine Prairie by mid-2012, and if it can get the necessary permits, management may expand the facility to as much as 150 bcf over the long term. The company’s Bluewater facility in Michigan has a capacity of around 26 bcf and PAA. 

PAA Natural Gas Storage also wins points because its GP is Plains All American Pipeline LP (NYSE: PAA), an oil-focused MLP with an excellent operational record. In fact, the GP is already supporting the MLP; Plains All-American owns units in PAA Natural Gas Storage and is foregoing some of its distributions on these units to support cash flows.

With decent organic growth prospects, a fee-based business model and a strong GP, PAA Natural Gas Storage is less risky than Niska despite exposure to the same business lines.

But PAA likely will pay a distribution of $0.3375 per unit in the third quarter, equivalent to an annualized yield of about 5.5 percent; the price of the MLP already reflects its low business risk and strong GP.

Given the potential near-term negatives for storage economics outlined earlier, investor sentiment towards PAA Natural gas is likely to remain tepid at best. We’re adding PAA Natural Gas Storage LP to How They Rate as a hold.