Leaky Pipes: The Coming Midstream Meltdown

The current thinking on midstream MLPs is that they offer insulation against oil and gas prices and a rich yield in a low-rate environment. We think this thesis gets the actual fundamentals of the current hydrocarbon space wrong, and that the midstream MLP business represents a prime short opportunity in a macro setting that only looks to get uglier in the medium term.

Flickr. MLPs are not the stable investment their advocates claim.

Flickr. MLPs do not offer the magic fix for sickly oil and gas prices their advocates claim.

The massive collapse in oil prices that occurred in the middle of 2014 changed the fundamentals across markets. Like all such changes, it has produced coping strategies. One such has been focused on investment in master limited partnerships (MLPs) operating midstream assets. But we think it is time to take another and much harsher look at midstream MLPs -- any serious investor wants, in our opinion, to consider shorting them.

MLPs were once a fairly esoteric way to operate in the commodities space, particularly in the oil and gas sector. Brought into existence by the U.S. tax code reforms of the late 1980s, they differ from C-corporations in significant ways. They have, instead of traditional management, a general partner, often another company. Though MLPs trade on the public markets, they do not issue shares -- they issue instead “units,” the purchase of which makes you a limited partner in the enterprise. These limited partners get slices of the MLP’s cash flow via distributions. Some of the big names in the space are Energy Transfer Partners (ETP), Plains All American (PAA), and until 2014 Kinder Morgan Energy Partners (KMP). Kinder Morgan, founded and co-helmed by controversial ex-Enron big Richard Kinder, was the first company to use the MLP structure as a “growth vehicle” (in its own words). They exited the structure last November, with their MLP rolled up into its eponymous parent company.

These companies would likely have remained off the retail investment radar were it not for the hydrocarbon boom in the U.S. This, fueled by high prices and new technologies that allowed access to previously unrecoverable oil, pumped hundreds of billions of dollars into the economy, resurrected general interest in fuel exploration, extraction, transport, and refinement, and whet the appetite of people for new and unusual tools to profit from exploding productivity. A significant amount of that interest settled on MLPs: between 2008 and 2014, the overall market capitalization of MLPs rose from $75 billion to $511 billion as the number of MLPs on the scene rose from 77 to 123, with pipeline assets constituting the largest sector in the space and natural gas pipeline assets constituting the largest single chunk of that. Some of this fervor appears to have rubbed off on the U.S. federal government as well, which loosened the qualification for assets that can be structured into MLPs in the fall of 2013 — several years late to the party, but still worth noting as an indicator of the broad-based fascination MLPs seem to exert.

The thesis underlying retail interest in midstream MLPs is credible on its surface: they fund their cash distributions (in theory) based on their contractual commitments from producers to pipe their oil and gas through the infrastructure they own. As a toll-taking businesses, advocates argue, they are insulated from price fluctuations in oil and gas: the upstream companies still have to honor their contracts and the midstreamers still get to take their cut no matter how low prices plunge. Even now, when midstream MLPs have seen big hits to their share prices and are staring down the barrel of a credit market still somewhat hospitable to them but looking more and more likely to turn ugly as the cost of equity issuance continues to rise and the cost of capital climbs, this theory has its adherents. True, they say, you have to be choosier in picking the right midstream MLP to invest in: look for those whose cash flows from contracts are set to grow, and you’re still going to find big value there despite the beaten-down prices.

We see them as overvalued. Why? First, no matter what their advocates say, MLPs are indeed exposed to commodity prices. It’s not as direct as the exposure faced by extractors and refiners, but it is there: midstream MLPs need a productive upstream to experience the growth required to fund distributions. When prices collapse, marginal producers suffer as industry retrenches by shifting towards oil and gas fields with lower break-even costs. The shale boom that powered so much U.S. interest in MLPs is a boom among marginal producers, like the Eagle Ford Shale, for example, which has an estimated breakeven cost of two times traditionally extracted Saudi oil. Other U.S. shales rise closer to three or 3.5 times that. Shale plays often have steeper decline curves than conventional fields. And the assets usually owned by midstream MLPs are single-purpose — the pipelines and other physical equipment that form the core of their businesses cannot be repurposed to transport other commodities should the commodity they were built for suddenly see a plunge in price. Which means midstreamers are locked in as the upstream end of their business falls apart.

Another issue in their overvaluation derives from the way MLPs are structured. The general partner or partners form the management of the company, and their compensation is directly related to the cash distributions to unit holders — i.e., as those distributions increase, so does the size of the cut taken by the GP. The measurement used by MLPs to calculate the distributions, distributable cash flow or DCF, is calculated in highly creative ways. In general it bears very little relation to the earnings power of the assets the MLPs owns, a fact masked by prosperity (as uncomfortable facts often are) — it’s not uncommon to see a DCF at two to three times free cash flow.

In some cases the multiple is much higher. But slashing the distribution as a balance-sheet-improving measure is not an option for MLPs. In the first place it would be sounding the business’s death knell, as higher yield is the MLP structures big draw; in the second it would do exponentially greater harm to the GPs, whose payouts are linked to the distributions to limited partners and who would be taking a geometrically larger hit. So during contractions, when the fundamentals for the growth in volumes transported that should be driving growth in MLP fee-taking, are not there, two ugly truths reveal themselves. The first is that because of the stair-step structure of the GP compensation, there exists a perverse incentive to buff up their DCF no matter what the market looks like, so that the management can reach the so-called “high splits” — where the GP is taking 50 percent of every distributed marginal dollar. This growth should be driven by healthy upstream players and in good times it is. When the upstream end is suffering (as it has been since last summer) from a perfect storm of slashed E&P budgets, high-profile bankruptcies among extractors (the biggest price tag being Samson Resource’s $4.1 billion), and big debt issuance by the survivors, midstream MLP management typically resorts to other measures. Witness Energy Transfer Partners, which bumped up its quarterly distribution by 8.2 percent in 3Q 2015 despite a nearly 15 percent decrease in its DCF. The company displays a number of alarming warning signs on its financial statements. It claimed DCF of $733 million for the quarter on FCF of negative $1.5 billion. There is a significant gap between its maintenance capex for the year, which it projects to be between $415 and $490 million dollars, and its depreciation and depletion expenses, which look set to hit $2 billion for the year. And its unit count increased almost 60 percent between 2014 and 2015.