As oil and gas production has boomed across the U.S., integrated energy companies have realized that there is a fair bit of money to be made by exploiting the master limited partnership structure that governs many American midstream companies. These outfits – comprised of pipelines, terminals, and processing centers – are tax-advantaged entities that generate substantial income for unitholders, which has also made them popular with investors in the current low-interest environment.
Increasingly, big-name companies like Phillips 66 (NYSE:PSX) and Devon Energy (NYSE:DVN) have announced plans to spin off their midstream assets into MLPs. In order to prepare ourselves for the potential deluge of new midstream spin-offs, let's take a look at one company that has already executed on this strategy. Today we size up the Marathon Petroleum (NYSE:MPC) MLP spin-off MPLX (NYSE:MPLX).
All of MPLX's assets are located in the Midwest, with the exception of one 70-mile pipeline in Louisiana. (Click here to check out the entire interactive asset map.) Stretched between Illinois and western Pennsylvania, MPLX owns, leases, or has an interest in about 2,800 miles of crude oil and refined products pipeline and 3.1 million barrels of storage capacity. It also runs a barge dock on the Mississippi River and a butane storage cavern in Kentucky.
MPLX exists to serve MPC, which is why its asset footprint mirrors the refiner's footprint. These assets connect to hubs that are growing increasingly important as more energy pours into the Midwest from the Bakken Shale in North Dakota and the Marcellus and Utica shales in Pennsylvania and Ohio.
Here is a look at the post-IPO performance of both MPC and MPLX:
Here we see very little lag in the MPLX share price after its IPO, while MPC is clearly benefiting immensely from cheap domestic crude.
Mother and child reunion
Investors benefit from these spin-offs, as the chart above shows, but parent companies have much to gain as well. Historically, Marathon Petroleum has accounted for more than 85% of the volumes shipped over MPLX assets. In return, MPC owns the general partner of MPLX, which entitles it to a 2% general partner stake in the MLP, and 100% of the incentive distribution rights. It also holds a 71.6% stake in the limited partner units, with the public holding the remaining 26.4% interest.
Essentially, Marathon pays MPLX to cart its oil around, and then meets MPLX at the bank, laughing, to recollect part of that profit. And despite less than one full quarter as a publicly traded entity, there is profit. MPLX only launched its IPO on Oct. 31, 2012, but its earnings for the last two months of the year looked good:
- Adjusted EBITDA attributable to MPLX of $18.2 million
- Adjusted EBITDA attributable to MPC interest of $16.4 million
- Net income of $13.1 million
- $16.7 million in distributable cash flow
- Prorated cash distribution of $0.1769
- Distribution coverage ratio of 1.25 times
Though its 2.2% yield is low by MLP standards, distributions will grow as MPC continues to drop down assets to MPLX.
The most important part
The biggest upside to MLP spin-offs like MPLX is the guaranteed income. There has been a movement over the past five years or so for midstream companies to make the transition away from taking possession of the commodities that pass through their systems in exchange for fixed-fee transportation and processing contracts.
Fee-based income allows midstream companies to avoid commodity risk, which in turn results in stable cash flows. Gone are the days when performance would swing wildly with the volatile price of oil and gas. The bigger midstream companies that have been around for a while are making this transition as quickly as they can, but some are still hurt by commodity prices quarter after quarter. For example:
- ONEOK Partners watched operating income at its NGL segment plummet $141 million because of lower NGL price differentials.
- Enterprise Products Partners saw natural gas processing and NGL marketing lose $66 million in gross margin in 2012.
- Despite record volumes and a strong hedging strategy, Kinder Morgan Energy Partners' (UNKNOWN:KMP.DL) CO2 segment failed to meet management's expectations for growth because of pain inflicted by low NGL prices.
Of course, when prices go up, these midstream companies will benefit just the same as they are losing now. However, the draw to these companies as investments comes from the high-yielding distributions, the continuation of which is completely dependent on stable cash flows.
Which brings us right back to our spin-offs. Right now, MPLX generates 100% of its revenue from fixed-fee pipeline contracts and storage agreements, primarily with MPC, but also with some third parties.
A similar MLP, Holly Energy Partners generates 100% of its revenue from fixed-fee contracts with the refiner HollyFrontier. Holly Energy sports a 4.9% yield with zero exposure to commodity risk, which makes it a compelling investment.
As the months go by, investors will have more and more MLP spin-offs to choose from. Remember that fundamentals remain important, and having more options is all the more reason to be as picky as possible.