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.

Why am I here?

It's a question we all ask ourselves from time to time -- when feeling philosophical, say, or just hungover. But it's a real live issue for a company suffering a sort of hangover itself: Plains GP Holdings.

This is the general partner for Plains All American Pipeline, one of the largest master limited partnerships. Plains GP, which was listed in October 2013, has recently seen its longstanding outperformance of the underlying MLP disappear.

Pipe Down
Plains GP's stock has tumbled even more than the underlying MLP.
Source: Bloomberg

First: what's a general partner? Some MLPs, such as Plains, consist of two main entities: a limited partnership that owns the operating assets of the pipeline business and a general partner that manages the operation. The general partner usually gets so-called "incentive distribution rights," or a cut of the MLP's cash flow that rises as dividends increase.

For example, once Plains' quarterly payout went above 33.75 cents per unit, then for every further cent, another cent goes to Plains GP -- that is, the latter gets 50 percent of incremental cash distributions. Think of it as a bonus payment to encourage growth: The faster distributions rise and the MLP issues more units to fund growth, the more cash flow the general partner gets.

Plains' quarterly distributions had been growing in mid-single-digit percentages, year over year, until 2013, when they accelerated into double digits at the height of the shale boom and ahead of the general partner's IPO. Public shareholders effectively own about 38 percent of Plains GP, with the rest controlled by a mix of private investors, including Plains' management.

The Boom
Plains jacked up its dividends ahead of the energy bust.
Source: Bloomberg

Acceleration feels great, of course, until you suddenly have to slow down. Low oil prices and excessive investment in pipeline capacity have hit the MLP sector hard. Capital markets are pretty much closed, which is a problem for a business model that pays out most of its cash flow to investors and has relied on selling new units and issuing debt to fund growth. It is especially problematic for MLPs that sport high leverage already and aren't generating enough cash to cover the existing dividend.

Which is precisely where Plains, sporting a yield of more than 13 percent, finds itself.

I recently laid out the issues facing Plains. The short story is that, using the consensus Ebitda forecast, it looks like Plains will generate just over $1.6 billion of cash flow available for distributions in 2016. But at the current level, payouts to limited partners and Plains GP would run to a bit more than $1.7 billion. An extra $1.5 billion is needed for anticipated growth spending. And net debt to trailing adjusted Ebitda was already 4.8 times as of the end of September.

So Plains sure could use the $600 million dollars or so it looks set to pay the general partner this year -- especially as encouraging more growth in a market preoccupied with preserving cash looks decidedly surplus to requirements.

To understand why Plains GP is like an old friend who has overstayed their welcome, imagine the following scenario. In order to cover its funding gap in 2016, say Plains the MLP somehow manages to sell $1 billion worth of new units at a 10 percent discount to the current price. To do this, it issues about 54 million new units. Barring a dividend cut, these will add up to an extra $152 million of payouts, meaning an effective cost for that new equity of about 15 percent. Not exactly cheap.

But now factor in the general partner's incentive rights, which add up to an extra $87 million. The effective cost of that new equity jumps to almost 24 percent. Cue much wailing and gnashing of teeth.

Sticking with this theoretical scenario, Plains GP could alleviate the burden by waiving its rights on the new equity, something it has done to a limited degree in certain cases already. This still wouldn't address two things, though: why the general partner structure is needed to encourage further growth at this point and the still very high cost of equity confronting the underlying MLP.

Besides scaling back capital expenditure or selling assets, the obvious way to solve Plains' cash flow conundrum is to reset the payouts at a lower level, effectively taking back some of that acceleration since 2013. This is unappealing, of course -- although rival Kinder Morgan's stock has thus far survived that company's savage 75 percent dividend cut announced in December.

In Plains' case, though, cutting payouts would have a dramatic effect on Plains GP because that entity's sole source of income is the dividend stream. Say, for example, Plains cut its payout rate in half. All else equal, about 90 percent of Plains GP's cash flow would evaporate.

As an alternative, it is possible that Plains GP's controlling shareholders could perhaps inject more money into the general partner or raise more debt at that level, with the proceeds then pushed down to the MLP. Indeed, Plains' chief executive talked about such support potentially being available at an investor presentation a month ago.

Injecting more equity would presumably mean all controlling investors in Plains GP essentially agreeing with management's thesis that a turnaround should start later this year and pick up speed in 2017. This may well be the case. But with the oil market continuing its frighteningly convincing impression of a lead balloon, it isn't a given.

With regards to raising debt at the general partner level, Andrew DeVries of CreditSights pointed out in a recent report that Plains GP is certainly less leveraged than its peers. However, he also deems it unlikely that Plains GP would try to issue bonds backed solely by its incentive distribution rights. One look at spreads for investment grade debt in the energy sector suggests he is onto something.

Lost Confidence
Option-adjusted spreads on U.S. investment-grade debt have blown out.
Source: Bloomberg

An alternative would be to dispense with the general partner structure altogether, something other companies have done, including Kinder. Plains has said it is looking into it. Apart from acknowledging the changed environment, such a move could also entail another useful outcome from a cash flow perspective: a stealth dividend cut.

Assume that Plains GP bought the underlying MLP in an all-stock transaction at a nominal 5 percent premium. The general partner's so called "Up-C" structure means it might be able to do this deal without unit holders in Plains taking a tax hit.

At current prices, Plains investors would get about 2.7 units in Plains GP for every 1 they hold in the underlying MLP. Critically, the annualized distribution on those Plains GP units is currently 92 cents, so selling unit holders would effectively be getting units paying out $2.53 a year -- roughly a 10 percent cut from the existing payout.

From the company's perspective, the savings from the effective dividend cut and abolition of the incentive payment to the general partner would be largely offset by the 1 billion or so new units issued as part of the merger. Even so, it would conserve about $160 million a year and probably a bit more once the overhead of maintaining two separate entities goes away. Dividend cover would rise back above 1 times.

Plains GP unit holders might not like it -- although the alternative of a potential dividend cut eviscerating their earnings would offer some compulsion. And this wouldn't solve everything: The implied dividend yield would be about 12 percent, and Plains would still need to fund its growth spending.

Yet if the transaction were combined with, say, a decision to defer a large chunk of that spending, it could go a long way to assuaging the market's concerns. 

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