Have MLPs and Midstream Actually Reduced Leverage?

Summary

  • Reducing leverage to more comfortable levels is important for midstream in terms of increasing financial flexibility and supporting broader investor appeal.
  • The average leverage ratio for the current North American midstream universe was 4.6x in 2016 and decreased to 3.7x at the end of 2018. More than 60 percent of the North American midstream universe reduced leverage from 2016 to 2018.
  • Getting leverage to a sustainable level is typically a prerequisite for pursuing shareholder-friendly actions such as share buybacks or greater dividend growth.

After becoming overextended during the oil price downturn from 2014-2016, midstream companies have placed greater emphasis on reducing leverage to a more comfortable and sustainable level. Lower leverage provides increased flexibility to withstand challenging market environments and lays the foundation for companies being able to grow their dividend or buy back shares. Today, we examine leverage metrics from 2016 to 2018 for the current North American midstream universe. Whose positioning has improved, who has seen leverage increase, and what are the broad implications of leverage reduction? Keep reading to find out.

Midstream reducing leverage to increase flexibility and broaden investor appeal.
Ahead of the significant drop in oil prices from late 2014 to early 2016, midstream (and energy in general) had become overextended through heavy spending, leading to higher leverage. High leverage constrained financial flexibility for companies, limiting management teams’ options for reacting to the energy downturn when flexibility was most needed. As a result, many MLPs experienced painful distribution cuts. With lessons learned from the oil downturn, management teams have reprioritized financial flexibility and balance sheet strength. Institutional investors (including generalists) are also increasingly focused on leverage, with the topic coming up frequently in panel discussions and company presentations at the MLP and Energy Infrastructure Conference last month (Read More). Ultimately, what matters to investors should also matter to management teams. Furthermore, leverage ratios are an important determinant in credit ratings (Read More), which impacts cost of debt and project returns. It is important to note that ratings agencies and banks may have their own approach to calculating leverage.

Leverage across midstream has generally improved over the past few years.
Most names in the North American midstream universe decreased their leverage from 2016 to 2018. Annual leverage ratios from 2016 to 2018 were calculated using long-term debt divided by adjusted earnings before interest, taxes, depreciation, and amortization (EBITDA) for the constituents of the Alerian Midstream Energy Index (AMNA), a broad-based North American midstream index including both MLPs and C-Corporations. See the appendix to this piece for leverage ratios by company for 2016-2018.

As of the end of 2018, 61.8% of AMNA constituents (34 out of 55 names) had reduced leverage from their 2016 levels as shown in the pie chart below. Overall, leverage decreased for the index on both an average and median basis. Average leverage for the AMNA Index was 4.6x in 2016 and decreased to 3.7x at the end of 2018, while median leverage decreased from 4.3x in 2016 to 3.9x in 2018. The color-coded chart below shows the distribution of leverage ratios for individual constituents of the index. The majority of constituents (54.5%) had a leverage ratio below 4.0x as of the end of 2018, and nearly three-fourths of the companies in the AMNA Index had a leverage ratio below 4.5x.

Several midstream companies have prioritized deleveraging as part of strategic, long-term plans. For example, Plains All American (PAA) recently completed its deleveraging plan announced in August 2017, with its leverage falling from 4.7x in 2016 to 3.4x in 2018. Going forward, the company is targeting leverage of 3.0-3.5x and plans to grow its distribution contingent on meeting its leverage and distribution coverage targets. Gibson Energy (GEI CN) has also decreased leverage significantly from 5.2x in 2016 to 2.3x at the end of 2018, well below the company’s long-term target range of 3.0-3.5x, with asset sales helping to fund growth capital and reduce the need to issue debt. While its leverage remains elevated compared to the rest of midstream, Cheniere Energy (LNG) has reduced its leverage since 2016 as a function of higher adjusted EBITDA stemming from the start-up of its LNG export capacity. In early June, the company released a capital allocation plan, which included achieving an investment grade corporate rating by reducing debt as one of its primary goals. Notably, the ten largest companies in the AMNA Index by weighting all reduced their leverage from 2016 to 2018.

Earlier-stage midstream companies and companies deploying capital for major projects were more likely to see leverage increase from 2016 to 2018. EQM Midstream Partners (EQM) saw its leverage rise from 1.2x in 2016 to 4.1x in 2018 and is in the process of constructing the Mountain Valley Pipeline, a $4.9-billion Northeast gas pipeline expected to be completed in mid-2020 (EQM is funding $2.4 billion of the overall cost). Similarly, Crestwood Equity Partners (CEQP) has increased leverage from 3.3x to 4.2x but has said it expects leverage to fall below 4.0x in the first half of 2020 after major projects come online. Among the names that have increased leverage are early stage companies and dropdown MLPs such as Noble Midstream Partners (NBLX) and BP Midstream Partners (BPMP), which went public in 2016 and 2017, respectively. While NBLX expects leverage of 4.0-4.25x in 2019, the company is targeting long-term leverage of 3.0x.

Lower leverage clears the way for a capital return focus.
Manageable leverage is important for running a sustainable midstream business through periods of market volatility, but it can also be viewed as a requirement before pursuing greater returns to shareholders. In short, it’s impractical to pursue accelerated distribution growth or share repurchases if leverage and the balance sheet in general are suboptimal. Furthermore, if growth capital expenditures are in the process of peaking for midstream broadly (as we suspect), that should support greater free cash flow generation, which enhances financial flexibility and the potential for returning capital to shareholders. Clearly, the progress being made across midstream to reduce leverage is positive for investors as companies become financially healthier. Reduced leverage provides an added benefit as a steppingstone to potentially greater shareholder returns.

Appendix

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