Recently I came across an interesting article that makes the case that cheap oil may be a prolonged event. This got me thinking about some of the high-yield MLPs and which of them would be most adversely affected should this prove to be the case.
Specifically it got me concerned over how Energy Transfer Partners' (ETP +0.00%) distribution growth prospects might be badly hurt in a world of cheaper oil while those of Enterprise Products Partners (EPD +2.23%) and Magellan Midstream Partners (MMP +0.00%) are less likely to face similar challenges.
The case for cheap oil as the new normal
While no one can predict the short-medium term trend in oil prices with any certainty, and The Motley Fool advises against speculating on commodity prices, it might be a good idea to look at the three factors that might result in a prolonged period of cheaper oil.
The first factor is slowing economic growth in key regions of the world that could decrease demand for oil.
For example, Japan, in an effort to tackle its rising debt problem, recently raised its sales tax from 5% to 8% with further plans to hike it to 10% by October 2015. The effect on its economy was shockingly immediate and pronounced, with quarterly GDP declining at an annualized rate of 7.1%, its worst contraction since the financial crisis.
Over in Europe, Germany, long the strongest economy on the continent, saw its manufacturing base decline by 5.8% in August, its sharpest decline since the great recession. This piled bad news on top of worse earlier statistics that its economy had contracted .2% in the most recent quarter. News from France, Italy and much of the Euro zone was similarly grim.
France's economic growth last quarter was 0%, thanks to consumption decreasing .3% and unemployment hitting an all time high of 11%. In Italy the economy contracted .2% while in Portugal, Greece, Cyprus, and Slovakia central bankers are now facing the scourge of deflation.
Meanwhile, China, which in recent years has propped up many commodity markets with its insatiable demand for everything from oil to steel, is now experiencing its slowest growth since the financial crisis, a fact that is weighing down economic partners such as South Korea.
All told the IMF now expects global economic growth in 2014 and 2015 to be 2.5% and 5% weaker than previously estimated. That weaker growth would likely be correlated with declining oil demand and further weakness in the oil market.
Factors affecting long-term supply and demand
According to a BP study on the outlook of oil markets through 2030, increased competition from cheap natural gas and higher fuel efficiency standards could slow oil demand growth in the transportation sector, which accounts for 60% of oil demand in developed economies.
On the supply side of the equation improved fracking techniques such as horizontal drilling, increased fracking stages, more use of frac sand, and additional wells per drill pad have lowered the break even cost for US shale producers by 19% since just last summer. Whereas the average shale oil well required $70/barrel to be economically viable in 2013 it now takes just $57/barrel, according to analyst firm IHS.
This might allow U.S. shale producers to hold out longer in its battle with OPEC, who recently voted to keep production constant despite a nearly 40% decline in oil prices this year. Many analysts believe OPEC is hoping its actions can lower oil prices to the point where US shale producers are forced to slow or decrease production, however as just described that may require far lower prices than OPEC initially thought.
Meanwhile Monday's comments by the CEO of Kuwait's national oil company that he foresees oil prices remaining at around $65/barrel until OPEC's next meeting on June 5 sent crude prices crashing another 4%. I believe this only increases the likelihood that oil prices may remain weaker longer than previously expected as US shale producers and OPEC continue to play their dangerous (for them) game of chicken.
Why Energy Transfer may be in trouble in a world of cheaper oil
Recently I wrote about why Energy Transfer Partners' distribution is likely safe in the short to medium term, but with the prospect of long term cheaper oil becoming more likely let's examine three reasons why I'm concerned about this MLP's distribution growth prospects.
| MLP | % Gross Margin from Fixed Contracts | Barrels of oil hedged |
| Energy Transfer Partners | 64.10% | 81,000 |
| Magellan Midstream Partners | 85% | 4.7 million |
| Enterprise Products Partners | 85% | 7.5 million |
Sources: investor presentations, MLP 10Ks, 10Qs
My greatest concern is with Energy Transfer's increasing exposure to oil. For example, between 2009 and today, the proportion of its gross margin coming from crude oil increased 50% from 14% to 21%.
In addition, as the above table shows, Energy Transfer's cash flows are much less protected by long-term, fixed-fee contracts. This could cause distributable cash flow, or DCF, to be far more volatile than competitors such as Enterprise Products Partners and Magellan Midstream. In contrast to Energy Transfer, these MLPs have a far greater proportion of cash flows derived from toll-road like fees with annual price increases baked in.
Finally Energy Transfer has a much weaker oil transportation hedging position than does Enterprise and Magellan, which exposes its future cash flow to greater commodity risk at a time when, thanks to its high debt levels, it can least afford it.
Higher debt and a weaker balance sheet
| MLP | Debt Rating | Total Debt ($Billion) | Debt/EBITDA | EBITDA/Interest |
| Energy Transfer Partners | BBB- | 10.9 | 5.95 | 3.67 |
| Magellan Midstream Partners | BBB+ | 2.1 | 2.81 | 8.78 |
| Enterprise Products Partners | BBB+ | 19.65 | 4.07 | 5.49 |
| Industry Average | 5.21 |
Sources: Fastgraphs, Yahoo Finance, Morningstar.com, MLP 10Ks,10Qs
Another major concern I have for Energy Transfer's long-term distribution growth rate is its high debt levels. In an era of cheap credit and high oil prices, the MLP loaded up on debt since it was less expensive than selling additional equity.
Now however, with oil prices potentially remaining much lower for much of 2015, the potential negative effects on this MLP's DCF, when combined with its high interest costs, means that the distribution may soon be threatened.
In addition its Debt/EBITDA--earnings before interest, taxes, depreciation, and amortization--ratio is at a level that potentially threatens its investment grade credit rating. Rating agencies usually like to see this ratio at 4.5 or less and a credit downgrade would greatly increase the cost of rolling over its debt in the future, especially since the Federal Reserve is expected to start raising interest rates in mid-2015. This is especially true if lower energy prices help boost U.S. economic growth.
Thus Energy Transfer faces the possibility that its high debt levels, when combined with declining cash flows due to sustained low oil prices, might result in a credit downgrade that raises its future interest costs substantially. That in turn could weaken any chances the distribution has of growing in the future and may even result in distribution cuts in years to come.
Why Enterprise and Magellan are likely to keep growing distributions despite cheaper oil
There are three reasons I'm confident that Enterprise and Magellan will be able to not only sustain their distributions better than Energy Transfer, but also grow them even if oil prices stay low for a prolonged period of time.
The first reason is their much stronger distribution coverage ratios, which is made possible by the second reason, the fact that neither Magellan nor Enterprise has a general partner and the incentive distribution rights, or IDRs that go with them.
| MLP | TTM Distribution Coverage Ratio | Last quarter's coverage ratio |
| Energy Transfer Partners | 1.22 | 1.25 |
| Magellan Midstream Partners | 1.6 | 1.26 |
| Enterprise Products Partners | 1.56 | 1.48 |
Source: MLPdata.com
The lack of a general partner is a massive competitive advantage that only five midstream MLPs can claim. Whereas Energy Transfer Partners must send 50% of its marginal cash flows to its general partner, Energy Transfer Equity (ETE +1.60%), Enterprise, and Magellan are free to retain that cash flow and use it for funding growth projects (making them less dependent on debt and equity markets) and for growing distributions faster and during difficult market and economic conditions. This brings me to my final reason why I think Enterprise and Magellan can continue growing their distributions despite the apparent oilpocolypse.
Proven track records during a crisis
In 2008 and 2009 the financial crisis had many expecting another great depression. The price of oil plunged almost 80% from nearly $150 to just $30 as credit markets froze solid and many energy companies scrambled to find enough cash to keep their doors open.
ETP Dividend data by YCharts
During this time of financial terror Enterprise Products Partners and Magellan Midstream not only managed to keep their distributions safe, but managed to grow them at rates similar to before the crisis. In contrast Energy Transfer Partners was forced to cut its distribution and hasn't been able to raise it until the last five quarters. If oil prices remain depressed for a longtime I think it's very possible that Energy Transfer may be forced to halt its distribution growth once more or even reduce its payout.
Bottom line: Enterprise and Magellan best set to grow in a world of cheaper oil
Don't get me wrong. Energy Transfer Partner's strong current distribution coverage ratio means that in the short term its distribution is likely safe. However, if oil prices were to remain suppressed for several years its larger exposure to commodity prices, lack of hedging, larger debt burden, and presence of general partner's IDRs means that its distribution growth may be threatened. Meanwhile, Enterprise Products Partners and Magellan Midstream Partners' much more conservative balance sheets, ability to retain more cash flow, and stronger hedging practices means a safer long-term distribution. In addition, I believe these factors create a strong probability that they will be able to continue growing their payouts even in a world of cheaper oil as they did during the financial crisis.
