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.

Master limited partnerships have long been thought of as low-risk toll roads. And that remains true in a way, judging by the toll they are taking on investors' wealth.

Plains All American Pipeline on Tuesday notched up another double-digit percentage price decline. Reporting quarterly results, the company slightly missed the guidance it provided in only in November. That was enough to prompt an 11 percent selloff, following Monday's 13 percent drop. At less than $16, the units are down roughly three quarters from their September 2014 peak and back to levels last seen in the fraught final quarter of 2008.

Rain on Plains
Source: Bloomberg

It's easy to blame panic selling, given the market environment, and that has no doubt played a role. The bigger issue is that MLP investors, used to thinking of their holdings as reliable, utility-like dividend payers insulated from the commodity cycle, have realized their mistake. Plains' own results, with lower volumes that the company blamed largely on weather effects, demonstrated this.

What amplifies the anxiety is the borrowing built up over the past several years and the uncertain outlook for the oil industry, as exemplified by the International Energy Agency's monthly oil report, published the same day.

Plains, with its units now yielding more than 17.5 percent, has a credibility problem. At face value, its guidance suggests the company faces a tough 2016, but can muddle through without cutting the dividend and then take advantage of a rebound in energy prices, as today's cutbacks in exploration and production investment translates into tight supply tomorrow.

Plains ended the year with debt equivalent to 5.2 times adjusted Ebitda. Assuming the mid-point of its guidance for this year, and adding in the funds just raised from selling convertible preferreds as well as roughly $450 million of projected proceeds from asset disposals, that implies Plains would end 2016 with a ratio of about 5.1 times. Factor in a projected 15 percent increase in Ebitda in 2017, along with much lower investment in expansion projects, and by the end of that year leverage would fall to about 4.4 times -- a big move in the right direction.

Such numbers only reassure, though, if they are viewed as solid -- and the entire energy sector right now looks about as solid as jello. Investors in MLPs have this week been shaken by the management turmoil at Energy Transfer Equity and heightened fears of bankruptcy around Chesapeake Energy. On Tuesday's call, Plains emphasized that it regards its counterparty risk as pretty minimal. And, indeed, it is hard to imagine an E&P firm struggling to raise cash defaulting to the firm it relies on to ship its oil and gas -- hard, but not impossible, as shown by the very fact that MLPs are having to address this issue on their quarterly calls. 

Plains also revealed on Tuesday that Moody's Investors Service wouldn't be giving the company's recently-issued convertibles 50 percent equity treatment, as had been assumed, but 25 percent instead. Plains disagrees and says even a one-notch downgrade to its credit rating wouldn't have a material effect on its business anyway. Still, the Moody's move again demonstrates how fluid the current environment is.

It is worth noting that Plains' own guidance for diluted net income per unit in 2016 is in a wide range of $1.00 to $1.61. That 61 percent difference compares with the 19 percent and 39 percent ranges given in original guidance for 2014 and 2015, respectively.

The point is that the numbers are finely balanced, and Plains' own assumptions for where oil prices are going look aggressive relative to both the futures market and some rivals, such as Magellan Midstream Partners, which reported results last week.

That's a problem because the outlook for oil remains decidedly cloudy -- and we're talking bulging black storm-clouds.

The IEA's updated projections show why. Commercial oil inventories in the OECD ended the year at more than 3 billion barrels, equivalent to 65 days of forward demand, which is high enough compared to history as it is. Using current projections, and assuming OPEC maintains its current output, almost 300 million more barrels would flow into inventory by the middle of the year (this analysis assumes it all goes into tanks in OECD countries). By then, stocks would cover more than 71 days of demand. Factor in higher Iranian output after the lifting of sanctions, and that number would continue to rise into at least the third quarter.

It is possible that demand ends up being higher than anticipated or there is some sort of supply shock. Still, as I explained here, the level of inventories is now so high that it would take a sizable and immediate cut to clear the glut. Last month saw oil prices jump briefly on hopes of a coordinated 5 percent cut by Saudi Arabia and Russia. It would likely require a cut of 10 percent or more by those two countries to get demand cover back down to 60 days by the third quarter, based on current projections and assuming any increase in oil prices would likely slow the current decline in U.S. output. And that is, to perhaps err on the side of understatement, unlikely.

Glut Check
OECD oil inventories look set to climb through at least the first half of 2016, keeping pressure on prices.
Sources: International Energy Agency, Bloomberg Gadfly analysis
Note: Iranian revival and 10 percent cut scenarios assume Iranian output reaches 3.6 million barrels a day by the fourth quarter.

The risk this poses to the cash flow math of MLPs is illustrated by what has happened with Plains GP Holdings. This is the listed general partner that relies entirely on income from its incentive distribution rights in Plains All American and so is highly sensitive to any concerns that the dividend may be at risk. It has taken even more of a beating in the past couple of days:

General Anxiety
Normalized price performance of Plains GP and Plains All American

The oil market may yet belie such panic. The bigger issue is that the energy world's supposed toll roads should be relying on such support at all. 

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