The ascendancy of master limited partnerships (MLPs) in the midstream space shows few signs of faltering. And even after pressure from heavy equity issuance in the final quarter of last year, there appears to be plenty of momentum to move the MLP sector further forward in 2014.

MLPs did not quite match the broader stock market’s remarkable performance in 2013—how many pundits would have predicted a gain of as much as 32.4% for the S&P 500 at the beginning of last year? The MLP sector came close, though, with a total return of 29.4% for the year as measured by the Wells Fargo Securities MLP Index.

And what is striking is the continued expansion of the sector, with a market cap that grew to some $459 billion last year, up 38.6% from $331 billion at the end of 2012. Just two years earlier, the MLP sector’s market cap stood at $280 billion.

What were the components that drove the MLP sector to its newly expanded market cap and a 29.4% total return?

Valuation multiple

By far the largest factor was the expansion of the MLP sector’s valuation multiple. According to Wells Fargo, the 29.4% total return consisted of the following: an initial yield of 6.5% augmented by 0.4% from distribution growth; 5.4% capital appreciation due to distribution growth; and 17.1% of appreciation due to expansion
in the sector’s median valuation multiple.

The improvement in the valuation multiple was such that, by the end of 2013, the sector traded at a median 2013 price-to-discounted cash flow multiple of 15 times, up from a multiple of 11.3 times a year earlier. Also contributing to appreciation in the sector was a median distribution growth estimated at 5.4%, adding on to growth of 5.5% in 2012. For 2014, growth is estimated at 5.8%.

“It was a year of records for MLPs,” says the Wells Fargo MLP research team, headed up by senior analyst Michael Blum. Last year saw a record 20 initial public offerings (IPOs), for example, and in the current year the backlog of identified and potential MLPs is similarly shaping up at around 20.

“If the capital markets remain open, the pace of MLP IPOs should remain brisk,” says Wells Fargo.
Records were also set in expenditures on organic growth capital and on acquisitions, which in 2013 totaled $31.3 billion and $56.6 billion, respectively. In terms of growth capital spending, Wells Fargo currently forecasts a 2014 total of $29.7 billion for organic expansions, but says this “is likely to grow and top 2013 spending levels.” On acquisitions—where visibility is limited—expenditures are assumed to drop to $19 billion, but “this forecast is
likely to prove conservative.”

The trend of “dropdown” transactions—in which assets are sold from a parent to an MLP subsidiary—accounted for almost half, or 47%, of the total value of MLP acquisitions last year. Thirty-nine dropdowns, with a combined value of $26.8 billion, were transacted in 2013, up from 24 dropdowns (total value of $15 billion) in 2012 and 17 dropdowns (total value of $6.1 billion) in 2011.

While Spectra Energy’s sale of certain assets to its underlying MLP accounted for $11 billion of the dropdown tally for 2013, Wells Fargo says continued strength in dropdown acquisitions can be ascribed to several factors. These include broader acceptance of the MLP asset class; dropdowns providing a means for incorporated, C-Corp sponsors to unlock the value of MLP-appropriate logistics assets via an MLP structure; and more activist shareholders at the general partner level prompting management teams to employ more aggressive MLP strategies.

Not surprisingly, 2013 was the largest year ever in term of equity raises, totaling $41.8 billion versus $33.8 billion in 2012 and $16.9 billion in 2011. Follow-on offerings, combined with units offered to sellers of MLP assets that are being acquired (e.g., to help finance an M&A transaction), accounted for 70%, or $29.1 billion, of the total.

The 2014 outlook

Numerous factors are cited by Wells Fargo to maintain its positive outlook, with a caveat that MLP valuation multiples are expected to contract somewhat in 2014. Positives include “solid” fundamentals, with visibility of continued infrastructure buildout for the next two to three years, driven by robust growth in shale plays; valuations that still screen attractive; and positive fund flows supported by “the growth, maturation and mainstreaming
of the MLP sector.”

Other positive trends include potentially greater export of refined products and liquefied petroleum gas, mainly propane; development of new pipelines/pipeline reversals; and midstream opportunities related to the ongoing Marcellus/Utica build-out.

The No. 1 headwind to performance cited by Wells Fargo is the potential for a correction in the equity market related to the Federal Reserve’s plans to taper its quantitative easing program.

The forecast is for a median sector total return in 2014 that just gets into double digits. Wells Fargo projects an anticipated yield of 7% augmented by net capital appreciation of 3.5%, made up of 5.8% distribution growth and a contraction in valuation multiple of 2.3%, arriving at 10.5%. ?

Chris Sheehan can be reached at csheehan@hartenergy.com or 303-800-4702.

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