For the year through February, the AMZ is down 6.3% on a price basis, resulting in a 4.5% loss once distributions are considered. This compares with the S&P 500 Index’s 1.5% price gain and 1.8% total return year to date through February. The Upstream group has produced the best average total return year to date, while the Natural Gas Pipelines subsector has lagged.
MLP yield spreads, as measured by the AMZ yield relative to the 10-Year U.S. Treasury Bond, widened by 67 basis points (bps) over the month, exiting the period at 555 bps. This compares with the trailing five-year average spread of 464 bps and the average spread since 2000 of approximately 363 bps. The AMZ-indicated distribution yield at month-end was 8.4%.
Midstream MLPs and affiliates raised $1.3 billion of marketed new equity (common and preferred, excluding at-the-market programs) and $9.6 billion of marketed debt during the month. MLPs and affiliates announced approximately $1.3 billion of asset acquisitions during February.
Spot West Texas Intermediate (WTI) crude oil exited the month at $61.64 per barrel, down 5% over the period and 31% higher year over year. Spot natural gas prices ended February at $2.66 per million British thermal units (MMbtu), down 20% over the month and 9% higher than February 2017. Natural gas liquids (NGL) pricing at Mont Belvieu, Texas, exited the month at $29.16 per barrel, 6% lower than the end of January and 6% higher than the year-ago period.
ONEOK Adds More Growth Projects to the Queue. After announcing plans for a large Rockies/Mid-Continent NGL pipeline in January, ONEOK, Inc. (NYSE: OKE) revealed additional plans for a new Mid-Continent/Gulf Coast NGL pipeline, a new NGL fractionator at Mont Belvieu, and a new natural gas processing plant in North Dakota. Importantly, despite the added $2.3 billion of capital spending, OKE noted that it does not expect to issue additional equity in 2018 and well into 2019.
EQT and NuStar Announce Simplifications. EQT Corp (NYSE: EQT) announced a plan to separate its upstream and midstream businesses, creating a standalone publicly traded corporation that will focus on midstream operations. The simplification process will include a drop-down of EQT’s retained midstream assets to EQT Midstream Partners, LP (NYSE: EQM), a merger of EQM and Rice Midstream Partners LP (NYSE: RMP), and a sale of the RMP Incentive Distribution Rights (IDRs) to EQT GP Holdings, LP (NYSE: EQGP). Separately, NuStar Energy, LP (NYSE: NS) and NuStar GP Holdings, LLC (NYSE: NSH) announced an agreement for NS to acquire NSH and eliminate the IDRs. NS also announced plans to recommend to their board of directors a distribution reduction starting with the first-quarter distribution payable in May 2018. For further discussion of MLP simplifications, please see the Thought of the Month below.
Fourth Quarter Earnings Summary. Fourth-quarter reporting season effectively concluded in February. Through month-end, 70 midstream entities had announced distributions for the quarter, including 30 distribution increases and 40 distributions that were unchanged from the third quarter. Through the end of February, 66 sector participants had reported fourth quarter financial results. Operating performance was, on average, better than consensus expectations, with Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA) coming in 1.2% higher than consensus estimates and 10.3% higher than the third quarter of 2017.
Thought of the Month: Simplifying Simplifications
In recent months, a growing number of MLPs have either eliminated or announced their intent to eliminate their IDRs. These announcements appear to have varying effects on an MLP’s equity price performance, from positive to indifferent to negative. Obviously fearful of the negative potential, investors have been asking questions recently about this trend.
While most MLP investors may know IDRs exist and that an MLP’s general partner (GP) holds them, few know much more. This opaque understanding is a natural consequence of the complicated and unusual nature of the IDR mechanism. A brief explanation may help. At the time of the Initial Public Offering (IPO), the GP sponsor typically only receives 2% of the cash distributions paid by the MLP, a share equal to its nominal ownership interest. However, the IDR structure allows the GP to receive an increasing share of the cash flows disbursed by the MLP as the distribution rate is increased (similar to a progressive tax mechanism).
To put the IDR mechanism into perspective, consider this example. Kinder Morgan Energy Partners (NYSE: KMP), distributed $0.63 per unit (on an adjusted basis) to its LPs in 1995 and $2.1 million to its GP through IDRs. In 2013, prior to the roll-up of KMP by its GP, Kinder Morgan Inc. (NYSE: KMI), KMP was paying $5.33 per unit to its LPs and $1.6 billion annually to KMI through IDRs. For little incremental investment, KMI experienced a 75,000% increase in IDR cash flow, which accounted for 52% of the total cash flow being distributed by KMP.
This example suggests the term “incentive” may understate things a bit. But, the argument went, the IDR cash flows only go up this dramatically when the LP does really well for a very long time. Further, if things take a turn for the worse, the LP should experience a less dramatic decrease in cash flows than the GP because the IDR mechanism is designed so that a decrease in distributions per LP unit results in a much more dramatic decrease in IDR cash flow.
Therefore, the implicit bargain offered to LP investors has been that the LPs get to enjoy a lower-risk stream of cash flow in exchange for giving up some upside (or a lot of upside), while the GP, through the IDRs, takes greater risk in exchange for potentially eye-popping returns. This bargain seems nearly fair, in our opinion.
However, over time, the cash flows owed to the GP can become so outsized, such as in the KMP example above, that the MLP’s cost of capital is quite negatively impacted. Further, while GPs seem to dutifully comply with the accepting-of-tremendous-upside part of the bargain, some have failed to live with the accepting-of-greater-risk part and, during difficult periods, have chosen to sell their IDRs to their LPs at attractive multiples instead of accepting the lower cash flows.
As a result, pressure to eliminate IDRs has increased in recent years and many MLPs who have not already done so say they plan to in the future. The term “simplification” is broadly used in reference to the process of eliminating the IDRs and comes in two primary forms:
- One entity acquires another, eliminating the IDRs and removing at least one publicly traded security. Recent examples include ONEOK (NYSE: OKE) acquiring ONEOK Partners (NYSE: OKS), Targa Resources (NYSE: TRGP) acquiring Targa Resources Partners (NYSE: NGLS), and the NuStar transactions noted above.
- The MLP acquires the IDRs from the GP, and both entities remain. Recent examples include MPLX, LP (NYSE: MPLX) acquiring its IDRs from Marathon Petroleum (NYSE: MPC) and Williams Partners (NYSE: WPZ) acquiring its IDRs from Williams Companies (NYSE: WMB).
As mentioned above, short-term stock performance in reaction to these transactions has varied materially based on the price paid for the IDRs in the case of an IDR buyout (option 2 above) or the impact on the growth outlook of the remaining entity (option 1 above). We believe the majority of recent transactions have been fair to both parties and that most management teams will seek a fair balance on future transactions given the intent in each case to improve the cost of capital available to the partnership.
It is also important to note that while the simplification narrative is ongoing, most of the sector’s largest companies,1accounting for approximately 62% of the sector’s market capitalization, have already eliminated, or announced the elimination of IDRs.
- ^These companies include: Enterprise Products Partners (NYSE: EPD), Kinder Morgan (NYSE: KMI),Magellan Midstream Partners (NYSE: MMP, Williams Partners (NYSE: WPZ and NYSE: WMB), Plains All American Pipeline (NYSE: PAA and NYSE: PAGP), ONEOK, Inc. (NYSE: OKE), MPLX, LP (NYSE: MPLX), Targa Resources (NYSE: TRGP), Spectra Energy Partners (NYSE: SEP), Buckeye Partners (NYSE: BPL), Andeavor Logistics (NYSE: ANDX), Genesis Energy (NYSE: GEL), SemGroup Corp (NYSE: SEMG), NuStar Energy (NYSE: NS and NYSE: NSH), Holly Energy Partners (NYSE: HEP), Crestwood Equity Partners (NYSE: CEQP), Archrock Partners (NYSE: APLP and NYSE: AROC), and USA Compression Partner (NYSE: USAC).
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