When oil was selling for $100 per barrel, energy master limited partnerships (MLPs) seemed like an excellent investment.
But when oil prices dropped to the $20s, many MLP investments proved to be disastrous, for holders of both debt and equity.
Today, as oil prices have stabilized, MLPs look like a decent bet again. But don’t just choose any random MLP. It’s time to pick through the rubble for those that boast long-term viability.
When oil prices were high, MLPs provided income investors with high dividend yields. Their dividend payouts kept rising, and their balance sheet leverage appeared to be only a minor threat, given low interest rates.
Producing MLPs also claimed to be hedged against oil price declines in the futures and options markets.
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Theoretically, MLPs were bulletproof investments, as long as you didn’t pay too much for them.
After oil prices began to drop in late 2014, it seemed like the price hedges would protect the producing MLPs and that midstream MLPs wouldn’t be affected by any price changes. Refinery MLPs, on the other hand, would benefit. Indeed they’ve done very well over the last 18 months.
But by early 2015, the hedges were beginning to run out, and it became apparent that companies such as Linn Energy LLC (LINE) had been overpaying dividends and overleveraging themselves for years, and were now in deep trouble.
By law, MLPs must pay out 90% of their income in dividends to benefit from the “pass through” structure by which they don’t pay corporate income tax. That leaves them with very little money for expansion or maintenance investment, except through borrowing.
Furthermore, since MLPs primarily sell based on their yield, and the sponsor wants the ability to expand them through issuing new shares, he pushes up the dividend beyond earnings.
In theory, this is sustainable provided the depreciation charge is more than the need for reinvestment. But in practice, it leads to excessive borrowing and leverage, which is further encouraged in a time of ultra-low interest rates, such as the present.
Given these drawbacks, even the recent recovery in oil prices to the mid-$40s hasn’t been enough for production MLPs to fully recover.
And even though some of them, such as those producing from the low-cost Marcellus Shale, are now profitable on a production cost basis, they still have too much debt and an inadequate cash flow to pay a stable dividend.
Almost all of them have been forced to at least trim their dividends during the downturn – and some have omitted their dividends completely. So they’re currently struggling for survival and simply aren’t viable as income investments.
However, that’s not true of midstream MLPs, those focusing on pipelines, etc. They’ve also had a difficult ride during the price decline, because in many cases, it’s reduced the revenue they can charge for their services.
The stabilization in the oil market also stabilizes their finances, and there are some attractive yields available.
In general, I would expect the trend in oil prices to be upward from here, as the majority of U.S. shale plays are only profitable with prices above $60 per barrel. With generally expanding global demand, this provides both a floor and ceiling for prices in the long term.
There are two midstream MLPs that are worth considering right now.
Valero Energy Partners LP (VLP) owns and operates oil and refined petroleum pipelines, terminals, and other transportation and logistics assets in the United States.
Its dividend yield is somewhat thin at 2.9%, but it’s very well-covered, with the latest quarter’s net income of $0.61 per share being almost twice the $0.34 quarterly dividend. Valero is somewhat overleveraged, with about a two-to-one debt-to-equity ratio, but it has a stable asset base and solid earnings, as well as a plan to increase distribution by 25% in the next year.
All of these things make it an attractive play for conservative income investors, especially since it’s valued at a modest 13.9 times 4-traders’ estimate of 2017 earnings.
Columbia Pipeline Partners LP (CPPL) is a natural gas transmission and storage company with 15,000 miles of pipelines stretching from New York to the Gulf of Mexico.
Its $0.1875 quarterly dividend was covered in the last four quarters and was well-covered in the first quarter by net income of $0.25 per common share. The company has a negative tangible net worth, but it has a $500 million line of credit, of which only $15 million was drawn. So in a stable business of this kind, its liquidity is ample, even if its asset cover isn’t.
The dividend gives it a yield of 5.3%, so it provides a satisfactory income with possibilities for growth, and is a good value at only 13.8 times 4-traders’ estimate of 2017 earnings per share.
I don’t recommend devoting large amounts of capital to this sector – the risks are still substantial. In addition, the MLP structure with 90% dividend payouts makes the sector prone to overleveraging, with a strategic rigidity that can lead to trouble when market conditions change, as we’ve seen already.
Still, modestly valued companies with good dividend coverage offer something of a haven for income investors, now that oil prices have stabilized.
Good investing,
Martin Hutchinson
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