For the year through August, the AMZ is up 1.5% on a price basis, resulting in a 7.6% total return. This compares to the S&P 500 Index’s 8.5% and 9.9% price and total returns, respectively. The Compression group has produced the best average total return year-to-date, while the Propane subsector has lagged.
MLP yield spreads, as measured by the AMZ yield relative to the 10-Year U.S. Treasury Bond, widened by 23 basis points (bps) over the month, exiting the period at 504 bps. This compares to the trailing five-year average spread of 480 bps and the average spread since 2000 of approximately 367 bps. The AMZ indicated distribution yield at month-end was 7.9%.
Midstream MLPs and affiliates raised no new marketed equity (common or preferred, excluding at-the-market programs) and $1 billion of marketed debt during the month. MLPs and affiliates announced approximately $1.2 billion of asset acquisitions during August.
Spot West Texas Intermediate (WTI) crude oil exited the month at $69.80 per barrel, up 1.5% over the period and 37.1% higher year-over-year. Spot natural gas prices ended August at $2.96 per million British thermal units (MMbtu), up 5.1% over the month and 2.3% higher than August 2017. Natural gas liquids (NGL) pricing at Mont Belvieu exited the month at $38.07 per barrel, 7.2% higher than the end of July and 38.6% higher than the year-ago period.
Growth Projects Continue to Materialize. Several new growth projects were announced in August. Tallgrass Energy, LP (NYSE: TGE) announced plans for the Seahorse Pipeline, a new crude oil pipeline from Cushing, OK, to the St. James, LA, refining complex, as well as a separate new export-capable liquids terminal strategically located near the mouth of the Mississippi River. Further, Targa Resources (NYSE: TRGP) announced plans for the Whistler Pipeline, a 2 billion cubic feet per day natural gas pipeline from the Permian basin to the Gulf Coast. TRGP’s partners in the project include MPLX (NYSE: MPLX), NextEra Energy Resources (NYSE: NEE), WhiteWater Midstream (private), and Ridgemont Energy Partners (private). Finally, Magellan Midstream Partners (NYSE: MMP) announced expansions of its Seabrook Logistics’ crude oil and condensate storage and dock capabilities and an additional expansion of the western leg of its refined petroleum products pipeline system in Texas.
New Midstream Entities Coming. Apache (NYSE: APA) announced plans to form Altus Midstream via a transaction with an existing “SPAC,” a special purpose acquisition company. Altus will be a C-corp structured midstream company anchored by Apache’s gathering, processing and transportation assets at Alpine High, an unconventional resource play in the Delaware Basin. The company will also own options for equity participation in five gas, NGL and crude oil pipeline projects from the Permian Basin to various points along the Texas Gulf Coast. Additionally, Rattler Midstream, a midstream subsidiary of Diamondback Energy (NYSE: FANG), filed preliminary documents with the SEC for an initial public offering.
Second Quarter Earnings Season Concludes. Through the end of August 2018, 68 midstream entities had announced distributions for the quarter, including 31 distribution increases, two reductions, and 35 distributions that were unchanged from the previous quarter. Through the end of August, 69 sector participants had reported second quarter financial results. Operating performance was healthy for the period, with 77% of sector participants reporting results that were in line or better than consensus. Sector EBITDA was 2.4% higher than the preceding quarter and up over 20% from the same period last year.
Thought of the Month: Midstream Growth is Underappreciated
Second quarter earnings continued to reflect the midstream sector’s healthy fundamental backdrop. In fact, the sector has exhibited sequential growth in each quarter for more than two years running. Many sector participants have also captured new growth opportunities, particularly related to the Permian and Appalachia basins. However, midstream equity prices remain range bound at mid-2016 levels when crude oil prices were still below $50 per barrel and the succeeding period of operating performance strength just described was anticipated by few.
At least one important driver to this fundamental and price performance disconnect are the mixed signals and investor anxieties caused by some key structural changes that have been unfolding within the sector. First, companies that are overly dependent on the equity capital markets to fund growth spending have traded less well than those that appear to have little or very limited need to issue equity. As a result, many companies have worked to become self-funded, or nearly so. Second, MLPs with incentive distribution rights (“IDRs”), which is in essence a “promote” payment that accrues to some MLP general partners (“GPs”), have traded less well as investors have become wary of the outsized burden an IDR payment can place on the MLP over time. As a result, many MLPs have removed the IDR mechanism from their structure. Typically, this is accomplished by having the general partner buy the MLP to create one entity.
It would seem apparent that a midstream sector that is less dependent on issuing equity and is less burdened by IDRs is healthier, but the sector has only recently begun to improve and has yet to break-out of its mid-2016 ranges. It may be that the actions taken to progress towards self-funding and IDR-freedom have clouded investor visibility of the underlying health of the industry.
In mid-2015, weighted average midstream distribution coverage was approximately 1.1x, or 10% excess cash flow. Today, weighted average coverage stands at approximately 1.4x, or implying roughly 40% excess coverage. While this dramatic improvement in coverage leaves the operator in a much better financing position and provides for better distribution security going forward, achieving this coverage improvement has, at times, caused equity price volatility.
For instance, in 2017, Enterprise Products Partners (NYSE: EPD) announced plans to reduce the growth rate of its distribution from an approximately 5% annualized rate to a 2% to 3% annualized rate for a period in order to lift its coverage ratio to a point where it could largely self-fund its growth plans. EPD’s ability to self-fund one of the largest capital investment programs in the industry by simply slowing distribution growth demonstrates the health of their business and the midstream sector; however, the initial market reaction did not reflect this sentiment. Instead, when EPD announced this plan, its equity price experienced a period of volatility as some investors feared the distribution growth slowdown signaled weakness in the underlying business.
Alternatively, some sector participants have elected to fund capital spending by reducing their distribution payout. For instance, Genesis Energy (NYSE: GEL) reduced its distribution by approximately 30%, providing flexibility to pay down debt and eliminate equity capital needs for growth spending. Here, too, despite no immediate change in the underlying business, market price volatility ensued.
Some sector participants have combined the goal of eliminating the IDR burden and improving coverage through GP/LP mergers, as discussed above. Generally, GP equities trade at a lower yield, or better multiple, than the operating MLP’s equity since GPs typically offer greater growth prospects. Therefore, these transactions have commonly been structured so that the GP buys in the MLP. As a result, the per unit cash payout of the combined company is typically lower, leaving a healthier coverage ratio for the merged entity and no IDR burden. For example, Energy Transfer Equity (NYSE: ETE) and Energy Transfer Partners (NYSE: ETP) recently announced a consolidation plan, which is expected to be completed in the fourth quarter of 2018. Post transaction, ETE anticipates distribution coverage of 1.6x to 1.8x, which is expected to allow ETE to largely self-fund its robust growth plans. Today, only 29% of the sector, by market cap, continues to employ an IDR mechanism.
Looking through the volatility, the changes underway further strengthen a sector that has been growing meaningfully over the last two years coming out of the commodity price down-cycle. This growth, coupled with attractive current valuations, and the reduced need for external equity capital discussed herein, continues to position the sector well for long-term investors seeking an attractive blend of current income and moderate growth.
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