Leaky Pipes: The Coming Midstream Meltdown

That last is a big part of the strategy midstreamers use to keep their distributions high: covering their funding shortfall via the issuance of new units. Kinder Morgan Energy Partners, for example, increased its unit count 17 times from 1997 to 2014, while its parents company has increased its share count by a factor of three since 2011. This allows them to generate big numbers for the GPs and to keep their limited partners happy — in the low-yield universe we currently occupy, returns around seven percent based on reassuringly physical assets look very attractive.

The trouble is that these returns exceed the earnings power of those assets, and that they are built on a very shaky model, at least in the cases of MLPs that expanded hugely in unit count during the boom and are now trying to keep up appearances during the bust by continuing to issue units. Those MLPs use the cash poured in via unit sales as a significant source of funding for the distributions they pay; thus, they have to keep issuing new units and signing up new investors in order to keep their returns high and their current investors happy. It’s not precisely sticking their hands into the pockets of newcomers to pay those who bought in before them. But it sure seems close.

As noted above, Kinder Morgan rolled up its MLP business in November 2014. The fact that the first big name in the MLP business — it acquired the pipeline assets of Enron in 1997 — got out of the MLP structure more than a year ago sends a huge signal both that the environment has changed for the worse and that the MLP model is unsustainable. KMP hung in for as long as it could via a bloated unit count and some highly creative accounting. The KMI complex listed, for example, its maintenance capex in 2014 at $500 million. In addition to being only around one percent of its asset book value, $500 million was about what one of Kinder Morgan’s big acquisitions, the El Paso Corporation, spent on maintenance capex prior to being snapped up in 2011. So $500 million is low for Kinder Morgan as a whole; its actual capex costs were closer to $4 billion 2014, according to the annual report.

With Kinder Morgan’s exit, we’ve already seen the retreat of a major player in the space, a retreat provoked by what looks like an increasing inability to fund its distributions. The company got out at a decent time; had it waited any longer to do so, the carnage would have been major given their high unit count and their massive debt. We see it as the first big casualty in a space soon to be riddled with them. Take Plains All American, which offers a juicy yield of 9.7 percent: earlier this year the company saw its CEO Greg Armstrong making noise in the spring about the possible deferment of distribution growth entirely for 2016 — an admission, albeit an oblique one, that Plains is foundering, and one that comes painfully close to actually cutting the distribution. It’s hard to see how, unless oil and gas prices improve dramatically over the next 18 to 24 months, Plains manages to survive without cutting its distribution and taking the massive hit to unit price that would invariably follow.

That time pressure is faced by every midstreamer with a bulked-up unit count and stagnating cash flow. And should the hydrocarbon lull last long enough for their upstream customers to go from suffering to insolvent, the take-or-pay contracts that the MLP model is based on — the contracts MLP management and evangelizing analysts describe as, essentially, riskless — become worthless. And upstream insolvency is not likely, if it occurs, to be isolated, which means that midstreamers will not be able to recontract their capacity on the fly: they’ll have to cut their dividends. And given that the investors who crowded into MLPs are as noted yield-driven, that send a signal so toxic as to be deadly. So despite the rosy views of the die-hards, we see the whole model falling apart. And it’s not just us, remember: GPs themselves are starting to pull out of the space. When expansionist pioneers get the jitters, it’s time for investors to rethink their positions as well.