After a false start rally in early October, the MLP sector has, once again, retracted below the September lows. Since the end of October, the Alerian MLP Index (AMZ) reflects an 18.7% decline, significantly underperforming the S&P 500 Energy Sector Index. Therefore, once again, we have been asked by retail and institutional investors near and far: Is this a technical selloff or is the MLP sector fundamentally at risk?
Last week, Moody’s revision of Kinder Morgan’s (NYSE: KMI) credit outlook from stable to negative appears to be a significant selling catalyst for the entire MLP sector. In this environment of “shoot first and ask questions later,” market participants appear to have extrapolated Moody’s opinion to the entire MLP sector. Notably, Moody’s maintained its investment-grade rating for Kinder, and S&P and Fitch affirmed their ratings and stable watch status for Kinder.
Moody’s action appeared to be the result of a leverage elevating transaction at Kinder, not an indictment of the midstream business model. On November 30, Kinder announced a $136 million transaction to acquire an additional 30% interest in Natural Gas Pipeline Company of America (NGPL). Moody’s expressed leverage concerns with this transaction due to NGPL’s elevated leverage at nearly 11x debt-to-EBITDA, or earnings before interest, taxes, depreciation and amortization. Therefore, in Moody’s view, this transaction had a more significant impact to Kinder’s already elevated leverage metrics well beyond simply the $136 million actually paid.
Though all equities carry the risk that management may choose to make an acquisition that is viewed negatively by the markets, this appears to be an extreme example. Since November 30, the date the NGPL acquisition was announced, through Friday December 4, Kinder’s shares lost 28.6% or approximately $15.1 billion in market value, making Kinder’s “small” NGPL acquisition incredibly expensive, and, perhaps, suggesting the market has overreacted.
Regardless of the market perception of Kinder or this transaction, SteelPath does not own Kinder in our funds. We have long held the view that Kinder was overvalued relative to its underlying cash flow profile, and calculated the company’s leverage and distribution coverage metrics as too aggressive relative to the volatility inherent in certain of its underlying business segments. Though, notably, Kinder reaffirmed its previous 2016 cash flow guidance on Friday.
So, could Kinder cut its distribution? They may. As described, we have long maintained that Kinder’s dividend payout was too aggressive. Further, Kinder’s leverage metrics are very high and the company is in the midst of funding a very large capital spending plan. So, Kinder must choose how to fund its capital spending plans, whether from greater retained cash flows through a dividend cut or by accessing other areas of the capital markets (the company issued preferred equity recently).
But, the company’s midstream assets have been performing resiliently, and in maintaining the company’s 2016 cash flow guidance it appears management expects this resiliency to continue. So, this Kinder “noise” is not about midstream but about Kinder’s overly aggressive financing choices historically and it would be a mistake to extrapolate Kinder’s issue to the rest of the midstream sector.
Despite the extreme level of negative sector sentiment today, we believe the fundamentals underlying the majority of midstream businesses remains intact. Though the extreme pressures existing in the energy industry today have, and likely will continue to, impact certain operators and certain businesses, we have not seen and do not expect to see sector-wide, systemic operating issues that would justify recent market sentiment.
As a result, we believe many valuations in the sector have entered an extreme oversold condition creating potential buying opportunities. Of course, we can’t predict when energy or MLP sector sentiment will change. However, periods of poor sentiment and trading are quite common. What we are seeing now is only unique by the degree and longevity of the price volatility that appears to be tracking with crude oil sentiment. But, we are confident today’s negative sentiment will eventually turn, just as it has so many times before and investors are likely to find the resiliency of midstream operating cash flows compelling once again.
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Mutual funds are subject to market risk and volatility. Shares may gain or lose value.
Investing in MLPs involves additional risks as compared to the risks of investing in common stock, including risks related to cash flow, dilution and voting rights. The Fund may invest no more than 25% of total assets in MLPs. Energy infrastructure companies are subject to risks specific to the industry such as fluctuations in commodity prices, reduced volumes of natural gas or other energy commodities, environmental hazards, changes in the macroeconomic or the regulatory environment or extreme weather. MLPs may trade less frequently than larger companies due to their smaller capitalizations which may result in erratic price movement or difficulty in buying or selling.