Master limited partnerships (MLPs) focused on midstream energy transportation and storage may not offer yields as high as upstream producers, but coverage ratios are generally better, and the partnerships are not as exposed to commodity prices. The acquisition of Access Midstream Partners (NYSE: ACMP) by Williams Partners (NYSE: WPZ) would create the second-largest midstream partnership in the United States and could be a sign of further consolidation in the space. Beyond analysis of asset synergies, valuation and the coverage ratio are two of the best metrics to help you position ahead of a takeover.
A boom in growth for years to come
The boom in U.S. energy production is driving changes in the economy that we are only starting to realize. From energy independence, more jobs, and a stronger macro-environment the country could have some great years ahead of it.
There is just one problem, the infrastructure to transport the massive growth in production is nowhere near sufficient. Pipeline companies are spending tens of billions every year to build out infrastructure, but the amount of oil transported through more expensive and riskier rail continues to increase on volume constraints.
Williams attributed its offer for Access Midstream Partners to what it called an "ongoing energy infrastructure super-cycle." The acquisition is expected to deliver immediate and future distribution growth as well as increase capabilities in key regions. This infrastructure super-cycle should continue at least through 2020 when domestic oil production is forecast to start leveling off.
The table below presents twenty-two midstream energy MLPs and the general data I look at when analyzing value. All data are from the most recent filing and believed to be current.
Highlighted are the best three partnerships in each category of distribution coverage, unit price-to-DCF, and yield. While higher yields may be tempting, I prefer the coverage ratio as my favorite metric for two reasons. First, a partnership that can cover its distribution is more likely to increase the payout and less likely to issue more units. Second, a partnership with a high coverage ratio is a more attractive target because its cash flow can help support a lower coverage ratio at another partnership.
A strong outlook for transportation demand and the increasing capital expenditures needed to build out infrastructure could lead to more acquisitions in the midstream space. A high coverage ratio and low price do not guarantee the partnership may become a takeover target but they do make the company relatively attractive as an investment.
Boardwalk Pipeline Partners (BWP) is the least expensive on a price-to-DCF basis but pays a relatively low distribution. The partnership provides transportation, storage, and processing of natural gas and liquids with 14,450 miles of pipelines and a storage capacity of approximately 207 billion cubic feet. The company cut its distribution by 80% in February to help free up cash for growth and reduce leverage. The action and subsequent 46% drop in the price of units highlights the need to monitor a partnership's coverage ratio and expected DCF.
Despite the recent weakness, the partnership has solid assets and should benefit from a stronger balance sheet going forward. The units now have a coverage ratio of nearly double the group's average, and I am expecting the distribution to be increased by mid-2015.
Kinder Morgan Energy Partners (NYSE: KMP) is currently the second-largest midstream player and, combined with other assets owned by general partner Kinder Morgan Inc, is the fourth largest energy company in North America. I like the partnership for its 1,300 miles of CO2 pipeline and 1.3 billion cubic feet of daily volume. Traditional techniques only allow for about 40% of a well's total reserves to be extracted on average, but pumping pressurized carbon dioxide into the field can allow for up to 60% extraction. As U.S. fields continue to deplete, the company's vast CO2 resources could become a huge asset. There has been strong insider interest in the general partner lately with Richard Kinder and Fayez Sarofim purchasing $26.4 million in shares, much of it since the last earnings report.
While they do not currently rank within the top three in the metrics above, I also own units of Enterprise Products Partners (EPD -0.72%) and DCP Midstream Partners from positions started in 2012. Both are relatively more expensive than other choices, but I am a long-term investor in the space and will hold on to both positions.
Right now, the downstream partners have two important points in their favor. First, interest rates continue to hover around historic lows and the debt market is hungry for higher yield. This should continue for at least another year and allow companies to raise money through debt to fund acquisitions. Approximately half of the Access Midstream Partners acquisition is being funded with a combination of long-term debt and revolving credit.
Unit prices are fairly strong, which will also allow the companies to issue more units to raise cash for acquisitions. While issuing more units is not optimal since it dilutes current holders, using the cash for acquisitions should increase distributable cash flow, so it is not usually met with the negativity seen when other companies issue more shares. Williams is using equity to fund half of its Access Midstream Partners acquisition.
You will want to look at how partnership assets fit with possible acquirers to cement your acquisition thesis. I would not necessarily take a position in a partnership on the hope for a buyout alone, but valuation and coverage metrics can also be used to make the case for adding units to a portfolio. With the developing theme of U.S. energy production and independence, even the partnerships that do not get bought should provide strong income and returns over the next several years.
