MLP Outlook: Fundamentally Sound

The downturn in the oil market that began in 2014 has had a long-lasting impact on the MLP sector. Many MLPs have shifted to a self-funding model rather than regularly tapping into equity markets, there have been several high-profile transactions which have seen MLPs consolidated by C-corp parents, and there have also been moves to moderate distribution growth.

While there has been a lot of change in the space, the fundamentals of the MLP sector remain strong with record-high U.S. natural gas and oil production and growing exports that are creating a lot of opportunities for midstream operators.

“Fundamentally things look very good, but there’s been some frustration with performance. Despite this fundamental strength, we need more money to come back into the space and more interest coming into energy, including the midstream,” Stacey Morris, director of research at Alerian, told Hart Energy.

She noted that there is an underinvestment in energy with the sector being out of favor and having a low weighting in the S&P 500. According to Morris, several of the changes in the space have served to distract people from focusing on the underlying fundamentals, which look very good.

“There’s been a lot of focus around structure questions and whether an MLP makes more sense or a C-corp makes more sense. There’s an impression that being a C-corp attracts a different investor base. MLPs aren’t eligible for broader market indices so being a C-corp can help with eligibility and inclusion,” Morris said.

The high-profile C-corps consolidations such as with Kinder Morgan have in some ways created distractions for investors. “People are more focused on structure than on fundamentals. To some extent, you probably have investors waiting on the sidelines for some of these structure questions to be solved before getting back into the space. The more that fundamentals are in focus for investors, the better off this space would be,” she said.

It’s still likely that there are more C-corp consolidation transactions on the horizon for some MLPs, but Morris doesn’t anticipate a wholesale abandonment of the MLP model because of its many advantages.

“The MLP structure still provides attractive benefits and it’s the most tax-efficient structure for midstream assets. Despite the tax reform that lowered the corporate tax rate, MLPs still enjoy an advantage relative to C-corps. An MLP converting to a C-corp isn’t a silver bullet or a cure-all. It doesn’t change your asset base. There are a lot of considerations that go into it, but ultimately each company will have to choose what is best for it. The C-corp structure may make more sense in some cases and the MLP structure may make more sense in others," she said.

The MLP sector also retains its ability to generate income for investors. Investors most interested in tax-deferred yield can reap these benefits by investing in MLPs, while investors interested in total return and broad exposure will want a mix of MLPs and C-corps investments in a RIC-compliant structure.

“Any midstream MLP benefits from the current positive fundamentals. Growing exports of crude, LNG, NGLs and LPGs represent a growth opportunity for the space as well since they require infrastructure like pipelines, storage tanks and export terminals,” Morris said.

The move to self-funding will change the way that investors think about the space. “For a long time, the focus has been on yield and income. The shift to self-funding has resulted in moderated distribution growth with companies taking on more of a total return focus. Instead of MLPs issuing equity, they're retaining some of their cash flow to fund their projects so they don't need to tap into the capital markets as often or at all. It also lessens dilution for unitholders. This is a transition that's still taking place, but one that I think is a positive change for the space and its investors,” she said.

In an Alerian research note from May, “Is Self-Funding an MLP Pipe Dream?,” Morris said that this transition also appeals to MLPs that weren’t being properly rewarded for consistently growing their distributions. “Multiple MLP management teams have expressed frustration with weak unit price performance despite distribution growth.… If growing the distribution isn’t being rewarded and is increasing an MLP’s cost of equity because the unit price isn't improving, it’s understandable that management would prefer to retain that cash for growth projects.”

As a result of this change, distribution growth has slowed. In the past, MLPs typically grew their distributions by 6% to 8% annually, but with the oil price downturn distribution growth has shifted from growing at a certain amount to growing at a sustainable amount, according to Morris. “The focus has really shifted to how do companies grow the distribution sustainably and create long-term sustainable value for unitholders,” she said.

While there has been a lack of recent MLP IPOs due to the downturn in the oil and gas markets, the exit strategy for many private equity midstream companies remains going public as an MLP or selling their assets.

“I think private equity’s involvement in the space is a validation for the overall midstream business model to some. Private equity-backed midstream companies can be rivals to midstream MLPs, but they can also be a source of funding for public companies by partnering with them on projects,” she said.

Diamondback Energy’s Rattler Midstream LLC subsidiary is among the recent MLP IPO announcements. Rattler operates oil, gas, and water gathering pipelines in the Permian Basin and is seeking to raise $100 million when it goes public. This IPO could help to serve as a weather vane for future IPOs in the space.

Regardless of the IPO, the underlying fundamentals of MLPs remain strong. This was evident in October when the overall stock market fell by more than 5% from Oct. 10 to Oct. 11 and MLPs outperformed during that time.