Energy Transfer Partners (ETP): Will Oil Price Collapse Sink the Payout?

In the past few months, oil prices have experienced their fastest collapse since 2011 and are now trading at less than $70 per barrel, a four-year low. 

WTI Crude Oil Spot Price data by YCharts

Many investors in MLPs, such as Energy Transfer Partners (ETP), may be concerned that these declining energy prices might put their generous distributions in jeopardy. Let's examine how likely such a scenario is -- in both the short and long terms.

Midstream business model is protective of the distribution

Source: Energy Transfer Partners investor presentation.

Energy Transfer Partners is well protected from exposure to volatile commodity price swings by long-term contracts (10-15 years) that generate fixed fees. What's more, these contracts usually stipulate annual price increases that are some percentage above the rate of inflation.

In addition, Energy Transfer's cash flows are protected by diversification into natural gas, which includes LNG exports, and natural gas liquids transportation and processing. The MLP actively hedges its exposure to these commodities such that its downside risk to gas and NGL price volatility in 2015 is decreased by 45%. 

However, while the midstream business model is protective of generous distribution payments, that is not to say, Energy Transfer's distribution of 6% is foolproof. There are three reasons its payout is at higher risk than competitors such as Enterprise Products Partners (EPD 0.48%) and Magellan Midstream Partners (MMP).  

Risk factors to Energy Transfer's distribution

Sources: Investor presentations, Morningstar.com, MLPdata.com, partnership 10-Ks, 10Qs, author calculations, Yahoo! Finance.

Energy Transfer Partners is at a disadvantage relative to Enterprise and Magellan in three key areas: fixed fee contract exposure, higher debt, and lower distribution coverage. 

Although Energy Transfer has a majority of its gross margins protected by long-term contracts, that proportion is only 75% as large as some of its peers. In addition, Energy Transfer Partners, while aggressively hedging its natural gas and NGL exposure, doesn't hedge its exposure to oil transportation, whereas Enterprise Products Partners and Magellan Midstream do. 

Of larger concern, however, is the high amount of debt Energy Transfer has used in the past to drive down its cost of capital. It's likely that in the future, to preserve its investment-grade credit rating, Energy Transfer Partners will have to turn to equity issuances to fund its $12 billion project backlog, an action that will dilute existing investors. 

That dilution, in addition to management's focus on restoring faster distribution growth -- a 7.2% annualized rate over the last five quarters -- is likely why management is only guiding for a long-term 1.05 coverage ratio going forward. While that still covers its distribution, it's substantially weaker than both its current payout and those of some of its peers. 

However, of greatest threat to Energy Transfer's distribution would be a long-term decline in oil prices. While no one can predict the short-term direction of oil with any accuracy, there are several reasons to believe that the recent plunge in crude prices may not last much longer. 

Why low oil prices might be temporary

Sources: Reuters, Bloomberg, Marketwatch.

A large proportion of today's oil production is currently occurring in nations who depend on far higher prices to balance their budgets. Similarly, while the average production cost in North Dakota's Bakken shale is just $38 per barrel, nationwide U.S. shale production costs are higher, with an average cost of $70 to $77 per barrel, according to Reuters.  

This means that at current oil prices, production growth in the US may soon grind to a halt. For example, according to analyst firm Sanford C. Bernstein & Co. at $70 per barrel, U.S. oil production growth will halt, and below it, production will begin to shrink. 

Simply put, budgetary necessities faced by many petro-states as well as the economic reality that one third of U.S. shale production is uneconomical below $80 per barrel, mean things will likely have to change sooner rather than later. Over the coming months, it's probable that someone, OPEC, Russia, or U.S. producers, will be forced to cut production, which could cause oil prices to stabilize and rise to more favorable levels. 

Bottom line: Distribution is likely safe
While the recent collapse of oil prices and subsequent decline in energy stocks may be frightening, the fact is, most midstream distributions are likely safe. In the short term, long-term fixed fee contracts will probably insulate cash flow sufficiently for MLPs like Energy Transfer Partners, with its strong coverage ratio, to continue paying and growing its payout long enough for oil prices to recover. However, current and potential investors in Energy Transfer Partners should be aware of its heavy debt burden and potentially higher cost of capital that could affect the MLP's future distribution growth.