The Great Disconnect
Over the past two months, I’ve been pondering the sudden divergence between oil prices and MLPs.
While there’s no obvious answer to this conundrum, pressure from institutional investors may be the overriding factor here, as I noted last week.
Based on third-quarter earnings calls, MLP executives seem intent on showing Wall Street that they’re ready to tighten their belts and, in some cases, even pursue a self-funding model.
As the largest publicly traded MLP, Enterprise Products Partners LP (NYSE: EPD) is setting the new standard for the midstream space. EPD is slowing distribution growth with an eye toward covering the equity portion of its growth spending via internally generated cash flows by 2019.
And other operators are looking into eliminating their general partners’ onerous incentive distribution rights (IDRs), which can siphon off significant cash flow. Of course, most mature MLPs, including EPD, already did so years ago.
Meanwhile, other possible factors—ranging from uncertainty about how tax reform will shake out to OPEC’s annual meeting—didn’t seem to fully account for the MLP selloff, especially since they didn’t seem to be weighing on other industries with similar exposure.
That was the case, at least, until this week, as OPEC’s fateful meeting drew near. The market’s expectation appeared to be setting itself up for disappointment.
That’s because there were concerns that Russia, a key non-OPEC producer, had been balking at making a show of unity, while questions remained about what caps might be imposed on troubled producers Libya and Nigeria.
Accordingly, MLPs weakened noticeably from already-low levels in the last few days leading up to the meeting.
But unlike past OPEC disappointments, this time around the cartel gave the market just about everything it wanted. Production cuts will continue through the end of 2018, with Russia on board. And Libya and Nigeria agreed to the arrangement as well.
As a result, oil prices climbed higher, while the Alerian MLP Index jumped 5.5%. Suddenly, the correlation between energy prices and MLPs came back, at least for a day or two.
If OPEC’s agreement succeeds in setting a new floor underneath oil prices, then that should bode well for the U.S. energy sector.
Back in Black
The vast majority of our portfolio’s exposure to energy is via the companies that create the infrastructure that moves hydrocarbons from the wellhead to the market.
But we do have one interesting play that’s not a midstream company, but also not quite an energy producer either.
Black Stone Minerals LP (NYSE: BSM) owns mineral and royalty interests in 18 million acres across 40 states and 60 producing basins. At the end of 2016, estimated proved reserves were 29% oil and 71% natural gas.
Despite the name, it has no relation to the alternative asset giant—Blackstone Group LP (NYSE: BX)—that’s also in our portfolio.
Although BSM is a relatively young MLP, it’s been in the energy business for nearly 50 years. Prior to that, it was established as a lumber company back in 1876.
Clearly, the firm must have seen the greater potential in the oil and gas sitting under its land. After selling off its lumber business, it retained mineral and royalty interests in its former real estate and then began exploration and development.
But that high-capital business isn’t for everyone. So in 1998, it got out of exploration and shifted to acquiring mineral interests. Over the ensuing decade, the firm managed a number of institutional investment funds before deciding it wanted to pursue such acquisitions on its own.
In 2015, it went public, becoming the largest publicly traded mineral and royalty company in the U.S. But its timing, just as the energy boom turned to bust, was not fortuitous.
Still, BSM held up better during that period than many of its peers. While upstream oil and gas MLPs got absolutely slaughtered, BSM’s peak-to-trough decline was 43%.
That may sound bad, but some midstream MLPs with less direct exposure to commodities performed even worse, while many upstream MLPs were nearly annihilated.
One of the reasons why BSM survived the carnage is that it carries such low leverage. Net debt to EBITDA was just 1.4 times at the end of the third quarter, while total debt to equity was around 44.2%. By contrast, a lot of other energy players are still shouldering massive obligations.
Low debt comes courtesy of a business model that involves owning the perpetual rights to drill for oil and gas on land without necessarily having to pay to develop it.
Instead, Black Stone leases the land to other drillers and, in some cases, also enjoys a royalty stream of 20% to 25% on any hydrocarbons they manage to pull out of the ground. This arrangement gives it exposure to about 50,000 producing wells.
In some instances, however, Black Stone will contribute toward development costs. More recently, however, it’s begun to monetize these working interests by farming them out to third parties. And management expects more such arrangements will reduce capital spending in this area to minimal levels by the middle of next year.
To further mitigate risk, Black Stone typically hedges a majority of production 12 to 18 months out. For instance, the company has already hedged between 80% and 90% of next year’s oil and gas production.
The one potential overhang on the stock is that there are a substantial number of subordinated units that will convert to common units once a certain distribution threshold is met, probably sometime in 2019.
However, management is mindful of creating a situation where the conversion of these units won’t undermine distribution coverage or the prospect for further distribution growth. Accordingly, depending on the circumstances, this conversion may happen at a lower ratio than the 1:1 ratio that was originally intended. This should help mitigate the potential dilution resulting from this event.
With a forward yield of 6.9%, Black Stone Minerals remains a Buy.