Source: Enlink Midstream Partners.
Kinder Morgan's recent announcement that it's slashing its dividend 75% was a bombshell that potentially calls into question the entire industry's business model. When faced with such mounting uncertainty and fear, investors in EnLink Midstream Partners (NYSE: ENLK) and its general partner, EnLink Midstream LLC (ENLC +0.00%), might be questioning the safety of their own 12.1% and 8.1% respective payouts. To shed some light on this issue, let's look at the four most important things that will determine whether EnLink Midstream's distributions survives potentially rock-bottom energy prices in 2016 and beyond.
Distribution coverage ratio: the first line of defense
The easiest way to see whether an MLP's payout is sustainable over the long term is with the distribution coverage ratio, or DCR. As long as it's above 1.0, the likelihood of a distribution cut is reduced.
Source: EnLink Midstream earnings releases; author's chart.
Even before the oil crash began in Q3 of 2014, EnLink Midstream Partners' DCR had a habit of hovering dangerously on the knife's edge of sustainability. EnLink Midstream LLC is in a better position, since its cash flow is derived from its 27.5% ownership of its MLP plus 100% of its incentive distribution rights.
However, over the past two quarters, EnLink Midstream Partners was able to seemingly stabilize its DCR at 1.05, mainly because of DCF growth from $4.35 billion in dropdowns over the past year from its sponsor, Devon Energy Corp. (DVN +1.88%). This seems to give hope to EnLink Midstream investors that perhaps its distributions may be safe despite low energy prices that could persist for several years.
However, that might not necessarily be true, and to understand why, we need to examine EnLink Midstream's contracts more closely.
Contract mix is key to understanding commodity risk
Secure and generous midstream MLP yields are predicated on a tollbooth business model, with distributable cash flow, or DCF, protected by long-term, mainly fixed-fee contracts. Indeed, 95% of EnLink Midstream Partners' gross margin is fee-based. However, that doesn't necessarily make its DCF immune from plunging commodity prices.
Low energy prices mean that oil and gas producers are slashing spending, and 2016's production is likely to decline. This creates secondary commodity volume risk to various midstream MLPs, including EnLink Midstream, Energy Transfer Partners (ETP +0.00%), and Enable Midstream Partners.
Now, EnLink Midstream does have 80% of its cash flow secured by minimum volume commitments. or MVCs. This mark compares favorably with Energy Transfer Partners and Enable Midstream Partners, which have only 51% and 53% of their respective volumes and margin protected in this manner. In fact, Energy Transfer Partners' "hidden" volume exposure to energy prices is a major reason its DCF per unit collapsed by 62% in the last quarter.
Given how EnLink Midstream Partners' DCR is so close to potentially requiring a distribution cut, even that 20% exposure to commodity prices might be enough to cause its DCR to dip below 1.0 in 2016 or 2017. That's especially true, given that about 50% of its gross margin is derived from Devon Energy.
Should trouble arise for Devon Energy or Linn Energy -- which is also a customer with which EnLink Midstream has MVC contracts -- they may end up having to default on their payments or renegotiate away those MVCs, which expire on their own in 2018.
Linn Energy especially represents a potentially substantial risk to EnLink, because the oil producer is drowning in an ocean of debt that could result in its eventual bankruptcy, should oil prices stay too low for too long.
Outgrowing 2016's oil and gas production decline is vital...
The best way for EnLink Midstream to protect its distribution is to continue growing quickly, so increasing DCF can hopefully offset any declines in next year's volumes. Toward that end, the MLP just announced the $1.55 billion acquisition of Tall Oak Midstream LLC.
EnLink expects this acquisition to result in around $200 million in annual Adjusted EBITDA growth -- 33% -- over the next two years. Better yet, management expects the deal to be accretive to EnLink Midstream's DCF, so it should help sure up its DCR as soon as the deal closes in Q1 of 2016.
...and access to growth liquidity is paramount
Sources: Morningstar, EnLink Midstream Partners 10-Q, 10-K, author calculations. Author's table.
Midstream MLPs have three sources of growth funding: debt, equity, and excess DCF. With EnLink Midstream's DCR so close to 1, and its units now so cheap as to essentially give it no access to equity markets, debt is pretty much the only remaining liquidity source left to it. The good news is that its strong balance sheet results in total liquidity of $1.35 billion and should allow it to keep growing next year. This situation will hopefully secure its distribution.
Bottom line
EnLink Midstream remains a potentially good long-term income investment, with 2016's DCF growth potentially minimizing the probability of a payout cut. However, investors need to realize that the MLP does have significant commodity exposure and thus remains one of the more speculative midstream MLPs, barring a strong and sustained recovery in energy prices.
