MLP Sector Searching for a Floor

MLP values are still being driven by the ups and downs of energy prices, primarily crude oil. The benchmark WTI crude price has bounced off the $38 dollar low set a month ago and is now fluctuating in the mid $40’s. Here is the one-month chart of the spot WTI price:

MLP prices have been quite volatile, but again, the one month chart shows that values have swung up and down but currently are little changed over the last 30 days. On this chart, the blue area is dollar trading volume in the MLP sector and the black is the Alerian MLP index.

The market is very much in a wait and see position concerning MLPs. Each time energy prices fall, there is selling. But when crude prices climb, we are not seeing a corresponding amount of unit price recovery. The next few months are a shoulder season for energy in the U.S. The summer driving season is over, so there is an expectation that refinery output will slow, reducing crude oil demand. The flip side is that gasoline prices should drop quite a bit as refiners shift to producing lower cost winter blend fuels. The WTI price through fall depends on the balance between whatever amount production slows in relation to consumption. The weekly crude oil storage numbers will tell the tale. This week the EIA reported crude inventory of 454 million barrels, down 1.9 million barrels. The American Petroleum Institute reported a crude stockpile decline of 3.7 million barrels. I believe that traders are under-estimating the coming slowdown in production, both in the U.S. and globally. As I like to repeat, the markets move rapidly when focused on short term information. The energy business operates on the long term with changes in production and consumption happening at a much slower pace.

Another item to watch over the next several months will be the price of natural gas. Volatility in the price of gas has been very low compared to historic swings. Here is the one year price chart for natural gas, showing little price change since early in 2015, and the 5-year price chart.

It is possible that the market has become complacent about the price of natural gas and a bout of cold weather could send the price significantly higher. Unlike crude oil, natural gas storage amounts are in line with the five-year average.

As MLP investors, we need to stay aware that the factors that will generate a recovery in unit values will take time. History shows us that after a bear market in the sector, values are much higher a year later. In the meantime, the goal is to stick with high-quality MLPs that will maintain their practices of quarterly distribution increases.

Incentive Distribution Rights

Let’s talk about incentive distribution rights, commonly referred to as IDRs. This partnership expense has a significant effect on how an MLP is managed and the total return potential of the limited partner units.

IDRs are payments made by the MLP to the company or organization that holds the general partner interest in the partnership. Typically the GP interest equals 2% of the total units in the company, but that 2% gives the general partner control over how the partnership is managed and operated. Incentive distribution rights are a section of the partnership agreement that provide for extra payments above the GP’s 2% share of the regular distributions paid to unit holders. The incentive part of an IDR functions to significantly increase the cash flow paid to the GP if the distribution rate paid on the LP units grows. Most partnership agreements have a minimum distribution rate. If a partnership is able to grow distributions above that rate, the GP gets a large cut of the total cash distribution based on tier levels set in the partnership agreement. To illustrate, here are the IDR tiers for Phillips 66 Partners LP (NYSE:PSXP):

Tier levels are cumulative. In the case of PSXP, the general partner gets 2% of the amount of cash needed to pay $0.244375 of the current $0.40 quarterly distribution. The GP gets 15% and 25% of the cash needed to pay the amount to cover the next two tiers, and above a distribution rate of $0.318750, distributable cash is split 50/50 between payments on LP units and the general partner. The IDR structure results in several factors that are important to MLP investors.

 

• A new MLP IPO is typically expected to initially pay the minimum distribution rate. The GP is highly motivated to increase distributions as quickly as possible to get the payouts into the 50% split tier.
• When distributions are above the 50% tier threshold, the GP receives an IDR increase that is equal to the increase paid on LP units. As an example, if there are 10 million LP units outstanding a 5 cent increase in the distribution rate will require $500,000 in excess cash flow to pay for the increase in LP distributions and another $500,000 to pay the higher IDR rate. The general partner is very well compensated if it can manage the MLP to grow distributable cash flow and the LP distribution rate.
• An MLP pays for growth projects or acquisitions with a combination of new debt and new equity (LP units) issuance. Increasing the number of units outstanding will also increase the IDR payments. The GP is also motivated by the IDR structure to add revenue paying assets to the partnership.
• IDRs increase the cost of equity capital. For example, PSXP LP units currently yield 3.4%. With the added IDRs, the cost of new LP units to fund an acquisition will be about 4%. As the distribution rate moves further above the 50% tier level, the equity cost of capital can approach double the LP yield. New acquisitions or projects developed by an MLP must be able to generate returns above the blended equity cost of capital yield and debt interest rates. The asset EBITDA returns must be enough to cover future expected distribution increases.
• If a project has a low initial return rate, but that rate is forecast to grow in the future, the GP can elect to waive the IDR increase on newly issued units until a point in the future where the project generates enough cash flow to cover planned distribution increases and the higher IDR amount.

In general IDRs are somewhat of a double-edged sword. They are a very strong financial motivation for general partner to manage the MLP to produce growing distributions. On the other side, IDRs increase the cost of equity capital which reduces cash flow available for distribution from new assets. As the distribution rate gets higher, the effect of IDR payments on the equity cost becomes more pronounced.

There are a handful of midstream MLPs that do not have IDR payments in their partnership agreements. For these MLPs, the equity cost of capital is equal to the current LP unit yield. I have compared the distribution yield and growth results of these MLPs with the rest of the MLPs in the sector that do have IDR payments. The lack of IDRs is not a strong indicator for above average performance. In most cases, the LP unit yield is the biggest factor that affects an MLPs distribution growth. Higher yields result in lower growth rates. This becomes a self-fulfilling event since, with lower growth rates, the market will price an MLP to carry a higher yield.

The current bear market in MLPs has pushed yields up to very high levels. If yields stay this high, capital to fund new assets will be expensive, preventing partnerships from taking on marginal projects or acquisitions. This will produce a natural slowing in the growth of the energy infrastructure system.

You may have noticed that IDR payments are a sweet deal for whoever holds the general partner interest. There are a handful of publicly traded pure play or near pure play MLP general partners. The Tax-Smart Income Hunter database includes a listing of these companies. Next month I will highlight some of the more attractive general partner stocks.

Portfolio Review

The most basic fact is that the MLPs I have selected since launching Tax-Smart Income Hunter in July have posted poor results. The entire sector is down significantly since the start of May thanks to depressed crude oil prices. It is the reality of the situation in this sector right now, and is something that I take into consideration heavily when I write these issues.

The Income Portfolio is down an average of 6.5% since the four MLPs were added to the portfolio. On the flip side, the average yield is over 11%. For variable distribution paying Northern Tier Energy LP (NYSE:NTI) I am using the trailing four payouts to calculate yield. Oneok Partners LP (NYSE:OKS) is in positive territory by 5% since its inclusion in the portfolio on July 31. OKS was able to place a sizeable equity issuance with its general partner, Oneok Inc. (NYSE:OKE), which gave the market confidence that the MLP could fund its near-term growth plans.

The MLPs in the Total Return Portfolio have been hammered over the last few days. Average return is now a minus 19%. Yield is 4%. This group should be able to average 20% distribution growth over the next year, giving these stocks great potential over the long-term. The next increases will start to come in a month, so that may help unit values.

Next week is the end of Q3 2015. It has been a tough quarter for MLPs, with the Alerian AMZ index off 23% in just the last three months. Earnings season for the sector starts around October 14, with MLP-like Kinder Morgan Inc. (NYSE:KMI) releasing earnings and announcing its next dividend. Total Return Portfolio component EQT Midstream Partners LP (NYSE:EQM) is scheduled to report on October 22.

Some positive results and distribution news would be a welcome help to start to turn around the MLP sector.