Growing the distribution—or at the very least maintaining it—has long been held as sacrosanct in the MLP world due to the relatively large percentage of retail ownership. Rightly or wrongly, the consistency of these distribution payments was viewed as a barometer for the underlying health of the company.

Cash from in-service assets would be returned to unitholders and new assets would be financed with a combination of debt and equity. But given the 50% peak-to-trough move in unit prices, management teams are reluctant to fund growth with depressed and expensive equity. Funding growth through credit alone can only last so long until an MLP’s leverage ratios begin to push the limits of its debt covenants.

Accordingly, management teams are considering other potential (read: better) uses of MLP cash flow. After Kinder Morgan Inc., which is not an MLP but is owned by many of the same investors, cut its dividend with very little backlash, analysts have started calling for certain MLPs to cut their distributions. These calls are not necessarily based on the availability of an MLP’s current cash flows to support the distribution, but rather to avoid seeking public financing in the near and medium term.

Some MLPs have been quietly forgoing the equity markets for years. Magellan Midstream Partners LP has not raised equity since July 2010 and yet has more than doubled its distribution during that time frame. It had a leverage ratio just north of 3x, a distribution coverage ratio of 1.3x and still intends to raise distributions by at least 10% in 2016.

MLPs that intend to maintain their distributions but still need to raise capital to fund growth projects will have to get creative if access to traditional funding remains limited. Sales of non-core assets are an option, but we are also likely to see second-lien debt, joint ventures, payment-in-kind units, preferreds (convertible or not) and private investment in public equity with longer lock-ups.

At a different point in the cycle, investors avoided MLPs with general partners (GP), but now those MLPs lucky enough to have a supportive GP may be rewarded. For instance, MPLX LP-sponsor Marathon Petroleum Corp. has promised to maintain MPLX’s distribution growth profile, which may mean incubating projects at the GP level, dropdowns at attractive multiples or even intracompany loans.

Regardless, it’s a difficult world out there for MLPs without an investment-grade rating, without a supportive GP, with double-digit yields, with high leverage, without customer diversity, without basin diversity and so on. A distribution cut could very well be on the table for names like that.

Now that the MLP space is going through a cycle of restricted capital markets access combined with low energy prices for the second time in eight years, we may see a new normal for coverage ratios in the neighborhood of 1.3x or higher. That is, at least until capital markets reopen and commodity prices recover. The flexibility to grow with retained cash flow is something investors would be wise to reward, regardless of the capital markets environment.

Comments