Last month, we discussed MLP distribution growth expectations. This month, we’ll focus on coverage ratios, another investment metric, but one that—like a Broadway show—is best understood when you can see further than the program in your lap.
Coverage ratio is a simple measure of cash available to be paid (called distributable cash flow or DCF), to cash actually paid in distributions. The higher the coverage ratios, the higher the cash flow cushion, and the more assured investors are that they will be paid.
MLPs with higher-risk business models ought to have higher coverage ratios, just like the principal actors need understudies— just in case something unexpected happens. MLPs with long-term, fee-based contracts can safely maintain a coverage ratio of 1.05X, returning nearly all cash to investors. A variable distribution MLP, with no expectation of paying a particular distribution, needs no coverage ratio. To my knowledge, street performers never schedule replacements.
When midstream MLPs announced their distributions this past quarter (generally up or flat), coverage ratios came down. This may have spooked some investors, but coverage ratios are not designed to be constant. They are the cash buffers designed to protect the distribution and the business during a two standard-deviation event (for example, a drop in the price of crude by over 50%). Given the current environment, coverage ratios ought to have come down; a near- or medium- term temporary drop is not a harbinger of bankruptcy.
These days, if a company still has excess cash reserves, it is probably trying to be even more conservative with cash, in case something even worse happens. If the buffer is truly excessive, it may be hoping to buy a distressed company or at least to buy assets cheaply. If there are no such plans, the company should be paying out more to investors. Some companies that previously cut their distribution are extra cautious. When Boardwalk Pipelines Partners LP and Natural Resource Partners LP faced this situation, both companies reduced their distribution lower than strictly necessary—low enough to ensure 4X coverage. Other companies that want to avoid that situation, such as NuStar Energy LP and Crestwood Midstream Partners LP, will be keeping distributions flat in 2015 while raising coverage ratios.
Coverage ratios should be viewed with a wide-angle lens so you can take in not only the orchestra and actors, but also the set design and the theater itself. Cash cushions are meant to be used when necessary. When examining an MLP with a falling coverage ratio, consider whether there are mitigating factors such as hedges, temporary slowing of distribution growth, long-term fee-based contracts, minimum volume commitments or a short-term interruption like a plant fire that insurance will cover. All of these will help keep the ratio above 1.0 over the long term, for the show must go on.

Maria Halmo is the director of research at Alerian, an independent provider of MLP and energy infrastructure market intelligence. Over $19 billion is directly tied to the Alerian Index Series. For additional commentary and research, visit www.alerian.com/alerian-insights.

Comments