Pipeline Partnerships Face Identity Crisis That's Killing Shares

(Bloomberg) -- Even as U.S. drillers produce at near record levels, a key part of the shale boom’s support system is undergoing an identity crisis that’s leaving investors nonplussed.

The pipeline and storage companies known as master limited partnerships, or MLPs, have seen shares drop by 18 percent this year, and they’ve slumped 52 percent on the Alerian MLP index since hitting a high in August 2014. Of 39 companies in the index, only six have gained in 2017.

With most MLPs, limited partners work in concert with general partners that manage and administer the facilities. The structure allows MLPs to avoid paying corporate taxes, helping stabilize investor returns. But growth has a dark side, as well. Built-in mandates tied to expansion continually boost what general partners are paid, forcing MLPs to either add debt to maintain their growth or become more financially conservative. The result: Investors get less, dimming their enthusiasm.

"We’re in a state of flux right now in MLP land," said Phillips 66 Chief Executive Officer Greg Garland on an earnings last month. "A lot of people are going to be challenged."

A change in the investor mix, now less dominated by retail investors, is, in part, forcing the sector toward a new model. As the flow of money from funds has slowed, MLPs are seeking to appeal to a broader audience to thrive. The result: Some MLPs are, for the first time, cutting their costs to trim debt and looking to internally fund growth projects, according to Tyler Rosenlicht, vice president and portfolio manager at Cohen & Steers.

"It’s a space in transition," Rosenlicht said by telephone.

The MLP model dates to 1981, when the Apache Petroleum Company was launched. Since then, there’s been a focus on pipeline companies, seen as the toll roads of the energy space. Historically, they’ve offered energy investors both high yields and a steady source of revenue based on the fact that shipping rates are generally not affected by oil prices.

Additionally, MLPs don’t pay corporate taxes. Instead, tax responsibilities by law are passed on to individual investors as capital gains, a designation that carries a lower rate than income taxes.

Part of the shift involves doing away with so-called incentive distribution rights, or IDRs, which are paid to the company’s general partner. Those payouts motivated companies to "get as big as possible" because it sent more cash to the general partner, said Rosenlicht.

Several companies have already eliminated the payout. Plains All American Pipeline LP removed its IDR last year, noting it lowers the company’s cost of equity capital. Williams Cos. in January said it’ll get rid of payments it receives for managing Williams Partners LP and instead take a bigger stake in the MLP. Marathon Petroleum Corp.’s MPLX LP also plans on nixing it.

Self Funding

As MLPs lower payouts, many are also shifting to self-fund growth rather than tap equity markets. Enterprise Products Partners LP, for instance, expects to reach a self-funding model in 2019 with "very modest needs, if any," next year. By 2020, companies that rely on outside equity markets will become the exception, Rosenlicht said.

In the meantime, companies like Plains are struggling with the transition. The Houston-based MLP, which has seen its stock tumble 38 percent in 2017, said in August that it plans to trim its debt burden by about $1.4 billion with asset sales and lower payouts to investors. A few days later, though, Moody’s Investors Service downgraded its bonds to junk, noting strained earnings and concern that steps taken by the company wouldn’t be nearly enough to address its debt.

There’s also a question of how much U.S. output will grow in the near term.

Pipeline companies such as Plains and Enterprise stand to benefit from a continuing shale surge. U.S. crude production next year is forecast to be 9.95 million barrels a day, according to the Energy Information Administration. But there is some disagreement on the viability of different outlooks and how sustained that growth will be. 

Growth opportunities are slowing down, according to Hinds Howard, associate portfolio manager at CBRE Clarion Securities. While the changes being undertaken by many MLPS may be beneficial longer term, “there’s a lot of skepticism" about the future among investors, he said by telephone.

The sector will continue to be bumpy as more companies lower payouts and reassess their spending, according to Howard. Along the way, he said, it’s likely there will be more consolidation.

"We’re in a transition period and it’s going to take a little while before things shake out," Howard said.

©2017 Bloomberg L.P.

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