One of the best parts of my job is scouring the investing world for lesser-known, high-quality stocks and MLPs, as well as pointing out various trends that can help investors make money.
One such trend that I think more income investors should pay attention to is the creation of very fast-growing midstream MLPs by refiners. I believe two partnerships in particular, Phillips 66 Partners (NYSE:PSXP) and MPLX (NYSE:MPLX), have the potential to be two of 2016's best energy income investments, even should oil prices fail to recover. Here's why.
A relationship that makes sense
When oil prices crash, refiner margins improve, because their input costs fall. For example, Phillips 66's (NYSE:PSX) refining division during the first half of the year reported earnings soaring 64% compared with 2014.
This means that periods of low oil prices such as now represent a boom time when refiners can invest in expanding their capacities and diversify their operations. For example, Phillips 66 2016 capital budget calls for $3.6 billion in capital expenditures. 56% of that program is dedicated to midstream infrastructure.
Phillips 66 is aggressively diversifying into more stable businesses such as its MLP, Phillips 66 Partners. The refiner, which acts as sponsor, general partner, and manager of the MLP, gradually sells its midstream assets to this entity under long-term secure contracts. This ensures predictable, commodity-insensitive cash flows that allow for fast distribution growth. As the following image shows, Phillips 66 plans to drop down billions of dollars in midstream assets to its Phillips 66 Partners over the next few years. Management believes these dropdowns will help achieve its goal of 30% distribution growth through 2018.
The incentive distribution rights and large equity stake in Phillips 66 Partners means that the refiner will generate increasing fee-based income from the MLP over time. This arrangement also allows the refiner to monetize its midstream assets in a tax-efficient manner.
Large sponsors mean huge merger potential
Another great refiner based midstream MLP is MPLX which is sponsored and managed by Marathon Petroleum Corporation (NYSE:MPC). MPLX is a perfect example of a refiner MLP that's striving to extend beyond its original refining footprint and into America's enormous shale gas potential. Specifically, the immense Marcellus and Utica formations via the $16 billion acquisition of MarkWest Energy Partners (NYSE:MWE).
Technically, Marathon will acquire MarkWest and become an independent subsidiary of MPLX. Through this complex relationship between subsidiary, MLP, and general partner we can see the benefit of this business model. Specifically, Mark Semple, CEO and chairman of MarkWest, believes that his team will be able to locate up to $9 billion worth of growth projects in the Marcellus and Utica, assuming they can access sufficient cheap capital. Before the merger, MarkWest's lower credit rating meant that its cost of debt was 5%, versus Marathon Petroleum's 4%.
The lower borrowing costs mean that MPLX will now have an entire new world to conquer and the financial means to do so. This suggests that its 4.4% distribution yield is likely to have one of the fastest growth rates in its industry over the next few years.
Of course investors must realize that management distribution growth guidance is never a hard promise but rather a target. To hit these optimistic projections will require energy prices to eventually recover. If future demand from oil and gas companies fall to the point where distributable cash flow growth potentially falls below a level that can safely sustain previous growth targets. In addition, debt markets must remain open to lending substantial amounts of cheap cash to midstream MLPs to fund these billions in growth projects. So investors should be sure to check up on the company's finanical health and infrastructure demand.
Takeaway: There are likely to be very good distribution growth years ahead for these MLPs, regardless of oil prices
No one can predict what oil prices will do in the short term, so it's best not to even try. Rather focus on finding investments with sound business models that are largely immune from crude's volatility and buy for the long term. With such strong sponsors and many years of likely exceptional distribution growth ahead of them, I'm confident that patient investors will be more than pleased with the result.
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.