U.S. Energy MLPs May be Running Out of Road

Investment vehicles that funneled more than $100 billion into U.S. pipelines, storage and other facilities during the shale boom now face an existential crisis after oil tumbled so low that it upended assumptions about risks and returns they offer.

Those tax-protected structures were the Holy Grail of energy investing during the upswing, combining hefty payouts made possible by fast growing energy bloodstream with some protection against oil's ups and downs offered by the "midstream" segment.

The collapse in stock prices of such master limited partnerships as Plains All American and Energy Transfer Partners shows such protection proved illusory once global oil prices reached depths that began threatening survival of their customers - oil and gas producers.

A sharp selloff at the start of the year left crude prices hovering around $30 per barrel, below break-even levels for most drillers, fuelling expectations that many may seek protection from creditors this year.

"That means they will have an opportunity to renegotiate or cancel many of the long term contracts they've signed with midstream players," said John Castellano, of Chicago-based AlixPartners. "I think that is the next shoe to drop."

The Alerian MLP Index, which includes 50 MLPs, more than doubled in value between the start of 2013 and September 2014 when shale oil production growth was peaking. It fell by more than a third in 2015, compared with a drop of just under 3 percent for the S&P index. (Graphic: http://tmsnrt.rs/1TGzIPG)

Mutual and exchange traded funds' investment in MLPs fell to $3.4 billion last year from 16.1 billion in 2014, the lowest since 2010, according to Morningstar (MORN). (Graphic: http://tmsnrt.rs/1Pg380K)

Described as the energy highway's toll takers, pipeline and storage companies get paid by shippers who move crude oil and refined products through their networks that include more than 12,000 miles (19,312 km)of new oil pipelines built since 2010.

Many of them revived the three-decade old tax-beneficial MLP structure during the shale boom to exploit the surge in U.S. oil production. The current MLP legislation was signed into law in 1986 by Ronald Reagan as way to spur investment in energy infrastructure.

TAX BENEFITS AND DISTRIBUTIONS

MLPs do not pay corporate taxes and must pay out most of their profits to investors in dividend-style distributions, which until recently were growing as much as 8 percent a year. Yield-seeking investors often treat MLPs like fixed-income instruments, such as bonds, and many flee if a company is considering cutting or suspending its distribution.

That was not a problem when U.S. oil output was rising: companies kept raising billions of dollars selling new shares to build fee-generating pipelines or terminals that kept distributions rising.

When the oil rout began in mid-2014 and a slowdown in production followed, it called into question that model of brisk investment growth and rising payouts.

"There's been a rapid build out of capacity and it kind of overshot the production growth," Plains All American CEO Greg Armstrong told investors in December.

The latest leg down in the 19-month crude slide is also casting doubt over the perceived safety offered by so-called minimum volume commitments, where customers pay pipeline operators whether they move any oil or not.

Such contracts may not amount to much if producers end up in a bankruptcy court fighting for their survival, says Ed Hirs, an energy economist at the University of Houston and advises investors to pay attention to what MLPs are funding.

"If you were the last one to build a pipeline in the Bakken or the last guy to build a processing area in the Eagle Ford, it could be painful," Hirs says. "If your producer goes bankrupt, then the court can reject the contract."

SURVIVAL SKILLS

Since the sell-off made it harder for the pipeline operators to raise money by issuing new shares and the downturn made viable new projects scarce, many MLPs will have to sell assets, and cut investor payouts, analysts say. Some may even abandon the tax-friendly MLP structure to reduce the investor pressure to grow payouts, while others will not survive, they say.

"History tells us that not everyone will make it through this cycle, at least not in their current form," Jim Teauge, CEO of Enterprise Partners, said on a Jan. 28 earnings call.

Plains All American recently turned to private equity firms rather than the stock market to raise $1.5 billion in financing for capital projects already underway and to maintain its 70 cents per share distribution.

Energy Transfer Partners $40 billion deal to buy William Cos is at risk after their stocks have taken a nosedive, falling by roughly 60 percent before recovering a bit.

One strategy that most MLPs have adopted to maintain investor payouts is to slash capital spending. Williams Cos cut its 2016 spending plan by $1 billion, or nearly a third, while Kinder Morgan (KMI), which abandoned the MLP model in 2014 but remains a top pipeline operator, slashed its long term spending plans by $3.1 billion, including a $900 million cut this year.

Brian Kessens, who helps manage a $13.2 billion MLP fund at Tortoise Capital Advisors, said reduced spending will slow the growth of investor payouts to 4-6 percent from 6 to 8 percent during the upswing.

The sell-off, however, may have already pushed valuations low enough to attract private equity firms, according to Jay Hatfield, portfolio manager of New York-based InfraCap.

"It's already happening," he says, noting a recent $350 million acquisition of TransMontaigne GP by private equity firm Arclight Capital. "They look at these trophy pipeline assets like they would look at real estate in New York City - a long term asset that delivers discounted cash flow."

By Jarrett Renshaw