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.

Necessity, mother of invention, has also spawned acrobatics when it comes to pipeline companies. 

With equity markets largely closed off -- and in an effort, successful or not, to stave off cutting dividends -- companies including Kinder Morgan, Targa Resources, and Plains All American have resorted to selling convertible preferred stock, sometimes with extra tweaks such as payment-in-kind options.

On Wednesday afternoon, Energy Transfer Equity, which runs a family of master limited partnerships and is in the throes of closing a multi-billion-dollar acquisition of The Williams Companies, joined in -- and added its own twist.

In a filing with the SEC, Energy Transfer said it had issued 329.3 million convertible preferred units to a select group of investors, including Chairman Kelcy Warren, who took just over half of them. Each one is linked to existing common units held by the buyers; hence Warren's high participation, as he owns about 18 percent of Energy Transfer.

Rather than paying cash for the convertibles, investors taking them agree to forgo part of their dividend payment on their existing common units for up to nine quarters. At the current payout, they'll get 11 cents per unit each quarter instead of the 28.5 cents everyone else gets, though that could go down if dividends end up getting cut anyway. At the end of the period, the converts do what they usually do and convert, with the number of common units they become depending on how much has been paid out in dividends on them over the period. Got it?

In effect, rather than slash dividends across the board to conserve cash, Energy Transfer has arranged for a select few to take a temporary cut, on the understanding they'll be paid-in-kind at the end: The strike price on the converts is $6.56 a unit, roughly 10 percent below where Energy Transfer closed on Wednesday. Assuming dividends were to stay flat across the next nine quarters, the company would end up issuing about 79 million new units, diluting the existing shareholder base by roughly 8 percent.

Retail investors tend to make up a disproportionately large cohort in MLP and pipeline stocks, and they're enduring an unexpected crash course in just how closely these are tied to the commodity cycle. For them, dilution deferred may seem preferable to a smaller dividend check now. Saving the same amount via a dividend cut for everyone would require taking away 6 cents per unit per quarter, or about 19 percent. That's hardly huge compared to, say, Kinder's 75 percent cut, but still big at the individual level.

Yet, for the company as a whole, the savings are small. At the current dividend level, it enables Energy Transfer to retain about $518 million across two-and-a-bit years. As Andy DeVries of CreditSights points out, assuming the Williams deal closes, Energy Transfer's dividend payments will rise to $2.5 billion a year and its parent-level debt will be a pro forma $17.1 billion. So deferring $231 million of annual payments for a couple of years or so isn't a game changer.

For Energy Transfer, the symbolism may be an important end in itself, showing some deference to credit rating agencies and shielding the sacrosanct dividend for now. The company stressed on its recent fourth-quarter earnings call that an investment grade credit rating for its subsidiary Energy Transfer Partners is a "top priority."

By their nature, though, symbols can be read in any number of ways. Energy Transfer's resorting to this convoluted means to save a relatively small amount of cash is also another sign of how tightly pipeline companies caught out by the collapse in oil and gas prices -- and investor sentiment -- have boxed themselves in.

The Williams deal itself, struck well into the bear market in MLP stocks, looks like an act of hubris. At current prices, Energy Transfer is still paying almost 14 times the income Williams makes off its incentive distribution rights, a stiff premium to peers. It is notable that Williams blocked Energy Transfer from extending this latest convertible offering to all of its unitholders rather than a select few, something revealed in Wednesday's filing.

Fighting Fate
Source: Bloomberg

Above all, the structure of the latest funding plan, with its short-term horizon and deferred dilution, epitomizes the sector's struggles to recalibrate cash flow. Implicitly, some companies are relying on an upturn in the commodity cycle, against which they were previously thought to be insulated. Resetting expectations on growth and payouts, while painful initially, would provide a more sustainable foundation -- Kinder is now ahead of the Alerian MLP Index since its own cut was announced in December (albeit with a little help from this guy).

Recovering
Source: Bloomberg

Investors grateful for companies that are bending over backwards to maintain dividends should also ask themselves how long they can really hold that position.

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