The oil crash and market correction have combined to generate some truly mouthwatering high-yield investing opportunities. However, it's imperative that income investors always perform their due diligence and check to make sure that a sky-high-yield, such as Plain All American Pipeline's (NYSE: PAA) 8.5% distribution isn't too good to be true.
In this case there are three reasons I think income investors should be wary about this midstream MLP and look elsewhere for a combination of both high and growing yield, because management's previous distribution growth plan may have to scrapped.
Distribution growth profile is throwing up red flags
The thing to remember about energy income investments is that a high yield is just one of three prongs of a distribution profile that will ultimately determine how well an investment will do over the long term. Equally important are distribution security and long-term distribution growth.
To determine how safe a distribution is, you need to look at the distribution coverage ratio, or DCR, which compares distributable cash flow, or DCF, to the quarterly payout. As long as the ratio is above 1.1, then a growing payout is usually sustainable, which is important, since in the second quarter Plains All American raised its distribution 8%, slightly better than its previous 2015 distribution growth guidance of 7%.
However, in part because of two oil spills on its pipelines -- as well as seasonally weaker demand for NGL transportation -- Plains All American reported a 17% decline in DCF during the second quarter. This means the three- and six-month DCR came in at a rather weak 0.73 and 0.93, respectively.
Backing out the costs of the two oil spills Plains All American's DCR for the past three and six months were .87 and .96, respectively. This kind of seasonal dip in DCR wouldn't necessarily concern me, except for some troubling recent events.
Low oil prices and short-term oversupply of oil midstream logistics means distribution growth may need to be halted
Normally, Plains All American's DCR catches up in the fourth and first quarter of the year and allows the full year's DCR to be sustainable. However, in the last quarter's conference call, Chairman and CEO Greg Armstrong warned that a combination of low oil prices and an oversupply of midstream oil transportation assets might lead to volume shortfalls and falling margins..
While Plains All American does have certain contracts in place that lock in some minimum volume commitments by customers, the fact is that 26% of Plains' cash flows are currently exposed to commodity prices, which is perhaps why Armstrong warned that Plains might have to defer distribution growth entirely in 2016.
Recent accidents combine to create even larger headwind against distribution growth
On May 19, Plains All American's 901 pipeline in California suffered a leak that spilled as much as 3,400 barrels of oil, or 148,000 gallons. On July 10, an Illinois pumping station failed and spilled 4,200 gallons of crude. The company estimates the two spills will cost $262 million to clean up and shut down the 901 line for the rest of the year as the pipeline undergoes metallurgical analysis to determine why it failed.
While the two oil spills themselves are far from financially disastrous for the MLP -- the $257 million cost of the California spill has been offset by a $192 million insurance payout -- they will none the less hurt the chances of payout growth in the short-term.
For one thing the EPA could still levy a punitive fine of $1,100 to $4,300 per barrel, which could amount to a maximum fine of $14.6 million.
More importantly management recently warned investors that its second half of 2015's EBITDA would come in $75 million below expectations. This was partially due to the shutting down of the ruptured 901 line, in addition to lower margins due to oil prices remaining lower than management's average 2015 forecast of $50.
Takeaway: There are plenty of other high-yielding MLPs with more solid payout growth prospects and less risk
Given Plains All American's current difficulties covering its payout, its regulatory risks, and its greater exposure to oil prices than other midstream operators, I really can't say that this MLP is jumping out as a screaming buy right now.
By no means am I saying current investors should sell at today's low prices. However, if you do own this MLP, I do think that Plains' DCR needs to be paid careful attention too, especially should oil prices fail to recover in 2016.
Adam Galas has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.