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.

If you invest in MLPs, then you're probably muttering to yourself: "Is it really only Thursday?"

It's been a wild week for the traditionally sleepy sector. On Wednesday, the Alerian MLP Index plunged 6 percent to close at its lowest level since 2009. Brent crude dipping a toe below $30 a barrel didn't help, but there has also been plenty of action on the deal-making and financing front. 

The Other Energy Crash
The Alerian MLP Index has fallen 56 percent from its peak
Source: Bloomberg

I've written about the difficulties facing MLPs here and here. In short, their financing model combining high dividend payouts and high growth, together with a long-thought relative immunity to energy price swings, has run into an oil price crash. More than half the members of the Alerian Index now sport dividend yields higher than 12 percent.

Take Williams Cos and Energy Transfer, whose units have fallen by 33 percent and 25 percent so far this week.

When a hot sector hits the skids, it often involves a deal or two that run into trouble -- like the one between Williams and Energy Transfer, announced in September and valued originally at $38 billion. With oil having fallen by a third or so since then, Energy Transfer looks like it overpaid, especially as $6 billion of the purchase price is due to be paid in cash. And because of an earlier pipeline deal, Williams suffers from relatively high exposure to Chesapeake Energy -- not the most desirable of counterparties given the state of its balance sheet

With Williams' stock now trading at a roughly 30 percent discount to the offer, many investors clearly think Energy Transfer will walk or push to renegotiate terms. At the very least, it should try to reduce the cash component or remove it altogether.

If that deal exemplifies the sector's overreach, a financing deal announced by Plains All American Pipeline involved reaching of a different sort.

Before the deal was announced on Tuesday, Plains was facing a funding gap this year of an estimated $1.7 billion after paying its dividend, distribution to its general partner and investment in growth spending. Yielding almost 14 percent, issuing more units wasn't an option. Instead, Plains said it would sell $1.5 billion of convertible preferreds to private buyers with a coupon of 8 percent. 

This alleviated the immediate concern. Plains raised capital more cheaply than new equity -- though it should be cheaper, given it is higher in the capital structure. And, based on current forecasts, it doesn't have to cut either dividends or capital expenditure this year and possibly next. The chart below shows how Plains' units responded:

Boom
Plains' units surged on news of new financing but then lost momentum. They still ended the day up almost 8 percent
Source: Bloomberg
Note: Intraday pricing for 12/1/2016

The initial euphoria -- or short-squeezing -- wore off somewhat, largely because of plunging oil prices. And therein lies the potential problem.

The private placement has bought Plains valuable time. Using its guidance for Ebitda and capex, its ability to cover its cash distribution promises should rise comfortably above 1 times what's paid out next year. And with this extra cash, net debt should drop to less than 4.7 times Ebitda, treating the converts as 50 percent equity. Look at Plains' assumptions on oil prices, though:

Recovery Position
Crude oil assumptions, estimates and futures prices
Sources: Plains All American Pipeline, Bloomberg
Note: Plains' full-year 2017 figure is an average of its assumptions for the first and second halves of that year

These start relatively modest but then pull ahead of analysts, which are themselves higher than lower-for-longer oil futures. In its defense, Plains, which handles 4.4 million barrels of oil and liquids a day, has better insight than most into supply and demand. Andrew DeVries of CreditSights points out that Plains' management proved more prescient than the market in the calls it made in 2014 and 2015. The company's view of a faster recovery cannot be discounted.

That said, this is the most tumultuous energy market since at least the financial crisis and is likely worse, given the pressure on E&P companies and lack of price support from OPEC. Barclays' latest survey of North American E&P budgets, released on Wednesday, concludes that spending may fall at least 27 percent this year and possibly by as much as half, assuming current futures prices.

So any forecast could prove wrong in this environment. And this isn't a question of oil crashing to $20 or even $10 a barrel but rather the possibility that it takes longer than a year or two to recover meaningfully.

If Plains' Ebitda stayed flat next year -- and that assumes this year's forecast holds -- its coverage ratio could drop below 1 again. Plains has some protection in the form of minimum volume commitments from buyers. Still, these risks are presumably why the company has retained the option of paying out coupons on the converts with more paper instead of cash for the first two years. Plains' units closed on Wednesday lower than before the financing deal was announced, yielding more than 14 percent.

Looking at the wider sector, DeVries stress-tested the investment grade MLPs he covers by cutting 15 percent from their consensus 2016 Ebitda forecasts. All ended the year with projected debt of more than 4.5 times Ebitda, and some came in at 5 times or more.

An increasingly common question is whether the MLP model is broken. It isn't. But its current iteration is straining to keep the high-cost funding and growth model built up during the shale boom. Implicitly, many MLPs are banking on energy prices to rally soon -- extraordinary for a sector long viewed as being above the vagaries of the commodity market. If that rally proves elusive, pressure on balance sheets will build further, and the need to reset payments and growth expectations at much lower levels will come into sharper focus.

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