Energy

Liam Denning is a Bloomberg Gadfly columnist covering energy, mining and commodities. He previously was the editor of the Wall Street Journal's "Heard on the Street" column. Before that, he wrote for the Financial Times' Lex column. He has also worked as an investment banker and consultant.

Calling all MLPs: If the market says it hates what you're doing, then maybe you should stop doing it.

Back in the good old days of the energy industry -- about a year ago -- investors paid a premium for master limited partnerships. MLPs pay out most of their profits, which are based on supposedly stable fees from pipelines and the like, providing clarity on returns. Squint hard enough and they sort of looked like bonds.

Even better, the flipside of that premium was a lower cost of capital. That meant MLPs could pay out their cash flow and then just issue more units to fund growth projects -- there was a shale boom on, after all -- which made investors even more enamored. Rinse and repeat.

Investors aren’t feeling so lovey-dovey now. Hot sectors usually end up attracting too much capital, leading to too much competition and too much leverage. America’s pipeline renaissance has run into an oil-price crash that promises to cut the volume of fuel running through those shiny new pipes. It turns out the operators aren’t as immune to commodity prices as advertised.

The Alerian MLP Index has dropped about 40 percent in the past year, wiping out roughly five years of price gains. Its dividend yield has jumped from less than 6 percent to north of 8 percent. With equity costing that much, the sector has been at pains to emphasize its ability to soldier on without tapping the public market for more cash. The results have been mixed, to say the least.

Priced Out
Kinder Morgan's dividend yield
Source: Bloomberg
Note: Indicated gross yield

Take Kinder Morgan, for example. It isn’t actually an MLP any longer, having merged its various partnerships into a regular corporation last year. But it has kept the same payout strategy. And with its own dividend yield having spiked above 7 percent, it recently resorted to selling convertible preferred stock at the much more reasonable yield of…almost 10 percent. Since then, the dividend yield on Kinder Morgan’s common stock has risen further, to 8.7 percent -- which at least means that, if the stock declines another 13 percent, then that convertible preferred yield will start to look OK.

Other companies in the sector have also been pulling levers that end up opening trapdoors rather than raising platforms.

Targa Resources said earlier this month it would buy out its MLP, Targa Resources Partners. The rationale is that doing so removes the so-called "incentive distribution rights," whereby the general partner controlling the MLP gets a disproportionate share of the cash flow. Investors are fine with these during periods of rapid growth, but balk at them otherwise -- thereby raising the cost of issuing new equity. Kinder Morgan consolidated for this very reason last year, to its benefit. But times have changed: Targa and its MLP are both down substantially since the move was announced.

Enough already.

The problem here is that the MLP cash cycle works great on the way up. But when you hit a cyclical downturn and confidence in the future slides, paying out most of your cash flow and letting your balance sheet take the strain quickly becomes a pretty bad idea.

A key number to watch is the coverage ratio, which measures how much distributable cash flow a company generates versus what it pays out. In general, you want this ratio to be greater than one; and in this environment, the higher the better. Michael Kay, an analyst at Bloomberg Intelligence, has compiled the coverage ratios for several MLPs and Kinder Morgan in the chart below.

Cover Me
Cash flow coverage ratios for selected MLPs and Kinder Morgan
Source: Bloomberg Intelligence

In that mass of lines, a couple of things stand out. First, everyone’s coverage has dropped. Second, some have more of a cushion than others -- which leads, appropriately enough, to the next chart.

Haves and Have Nots
Price performance of selected MLPs and Kinder Morgan, indexed to 100
Source: Bloomberg

Notice the gap that has opened up between relatively well-cushioned Magellan Midstream Partners and Enterprise Products Partners at the top versus the others -- not too dissimilar to what has happened with coverage ratios. As an aside, notice that Plains All American Pipeline's ratio has been below 1 since the second quarter. It announced early last month it would tack half a penny onto its dividend anyway -- and has been rewarded since with a 22 percent drop in price, taking the yield to almost 11 percent.

Investors are spooked by the severity of the oil downturn. Any who listened to recent quarterly earnings calls by exploration and production companies will have heard a pretty consistent message: Forget growth for now, cut costs, live within cash flow and repair balance sheets.

And since the E&P companies provide the revenue for the pipeline operators, it is high time the latter also got with the program.

Looking at Kinder Morgan again, its cash flow math for next year looks too finely balanced for this environment. Analysts forecast Ebitda of $7.93 billion, according to numbers compiled by Bloomberg. Andrew DeVries at CreditSights estimates interest and preferred stock obligations swallow $2.4 billion and maintenance capital expenditure takes another $600 million.

That leaves $4.93 billion, most of which is earmarked already for dividends. Despite Kinder Morgan having reduced guidance recently, the mid-point would still mean dividends taking $4.81 billion of it, leaving less than $120 million to spare -- fine, but not exactly huge in today's climate. Holding the dividend flat would boost that cushion to about $470 million.

It might seem like abandoning the promise of dividend growth would cause a mass exodus from pipeline stocks. But with the yields where they are, that has happened already. "Since no one’s valuing growth, it pays to put that incremental dollar to work in a new project or cutting debt," is how Darren Horowitz, an analyst at Raymond James, sums it up.

Since at least the summer, the message from markets across the energy and resources sectors -- from solar power to oil majors to copper miners -- has been: Hunker down. If a company doesn’t follow that advice and is carrying a high debt load, its executives risk seeing their initiatives ignored and the share price becoming the plaything of capricious commodities markets. Just as highly indebted, London-listed miner Glencore has seen the correlation between its stock and copper prices jump this year, so Kinder Morgan’s shares are now more closely tied to oil prices than previously. The same is true of the Alerian MLP Index as a whole.

Scaling back, or even cutting, dividends is anathema in a sector sold on the promise of payouts. Times have changed, though. And if investors are pricing it in anyway, taking them at their word would go a long way to starting the healing process.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Liam Denning in San Francisco at ldenning1@bloomberg.net

To contact the editor responsible for this story:
Mark Gongloff at mgongloff1@bloomberg.net