Tear Down This Wall

Are MLPs and mid­stream com­pa­nies still “util­i­ties with­out walls?”

Alberta Oil - - SMART MONEY -

IN THE U.S., FRACK­ING AND HOR­I­ZON­TAL

drilling tech­nol­ogy have vastly ex­panded the pool of ac­ces­si­ble oil and gas, but the cap­i­tal mar­kets have pushed prices of en­ergy ser­vices mas­ter lim­ited part­ner­ships (MLPs) to lows not seen in years. With oil prices so far down, are MLP prices ap­pro­pri­ate? Or have the cap­i­tal mar­kets over­re­acted?

MLPs and mid­stream com­pa­nies’ ser­vices are vi­tal to the in­dus­try and the econ­omy as a whole, which is why we of­ten re­fer to MLPs as “util­i­ties with­out walls.” We think there is much va­lid­ity in com­par­ing MLPs to util­i­ties when de­ter­min­ing fair val­u­a­tions. MLPs pro­vide es­sen­tial ser­vices to so­ci­ety, de­rive durable rev­enues from long-term con­tracts charg­ing toll-like fees, and have rights of way for in­fra­struc­ture, giv­ing them de facto mo­nop­oly. On the other hand, MLPs are not ge­o­graph­i­cally lim­ited the way util­i­ties have ‘walls.’ MLPs also pay a higher yield, their rates of re­turn on in­vest­ment are higher, and they need to raise cap­i­tal to build in­fra­struc­ture, so their cost of cap­i­tal is higher than for bet­ter pro­tected util­i­ties. But on the whole, util­i­ties and MLPs, es­pe­cially mid­stream MLPs, are quite sim­i­lar.

The is­sue we’ve been study­ing is whether the de­val­u­a­tion of MLPs is jus­ti­fied or not. There seems to be in­vestor sen­ti­ment that low oil prices will ac­tu­ally re­verse the re­cent ex­pan­sion of the MLP busi­ness, even though most ob­servers sug­gest in­fra­struc­ture needs could be $30 bil­lion—$50 bil­lion for each of the next 10 years. To the ex­tent oil is in­volved in mid­stream in­fra­struc­ture, the re­duc­tion in oil prices raises ques­tions about growth as well as cred­it­wor­thi­ness of a com­pany’s trans­port and pro­cess­ing cus­tomers. And as stock prices de­cline, the con­se­quent ris­ing yields make it harder for com­pa­nies to raise cap­i­tal—through sell­ing equity—and ren­der unattrac­tive some (though not all) con­tem­plated projects.

The real mea­sure of trans­port, ter­mi­nal, and stor­age ser­vices has to be de­mand, not drilling or prices. Af­ter all, if us­age is ris­ing—it tends to rise with low prices—how does the prod­uct get to the user? Ac­cord­ing to the In­ter­na­tional En­ergy Agency, from third-quar­ter 2014 through third-quar­ter 2015, nat­u­ral gas us­age was up 3.2 per­cent. U.S. pe­tro­leum and other liq­uids us­age was up 1.4 per­cent. In­vestors should be fo­cus­ing on higher de­mand rather than lower prices since mid­stream com­pa­nies ben­e­fit from higher vol­umes. That is why cash flows and EBITDA (earn­ings be­fore in­ter­est, taxes, de­pre­ci­a­tion and amor­ti­za­tion) for mid­stream com­pa­nies have been ris­ing, even as prod­uct prices have de­clined.

In the ac­com­pa­ny­ing chart, note that the rel­a­tive en­ter­prise value/EBITDA spread of MLPs com­pared to util­i­ties is fore­cast to be neg­a­tive for the first time since 2002, far lower than that seen in the fi­nan­cial cri­sis. Con­sider that both MLP dis­tri­bu­tions and MLP EBITDA have grown much faster than util­i­ties even be­fore the shale rev­o­lu­tion.

Oil and nat­u­ral gas prices were higher or lower at cer­tain points, be­fore and af­ter the frack­ing rev­o­lu­tion. Why is this time dif­fer­ent in in­vestors’ eyes, when there will still be EBITDA and dis­tri­bu­tion growth on av­er­age, and there is still some $50-plus bil­lion a year of growth capex to be un­der­taken for the next decade or so, boost­ing cash flows and dis­tri­bu­tion re­turns? That’s more than dou­ble the cur­rent mar­ket cap of the sec­tor. Why is this time dif­fer­ent?

It isn’t. For MLPs, like util­i­ties, there can be un­ex­pected mo­ments of equity volatil­ity. But de­spite the sta­bil­ity of the un­der­ly­ing busi­nesses, those with a short­term view don’t hes­i­tate to as­sert that the end is near.

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