Tear Down This Wall
Are MLPs and midstream companies still “utilities without walls?”
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.