Is Self-Funding an MLP Pipe Dream?

Self-funding has become a buzzword in the MLP space, but is it really translating to MLPs’ capital plans? Admittedly, the shift to self-funding is still in early innings, and the transition will take time. That said, it seems like a logical next step as the MLP space continues to mature. In today’s post, we discuss the impetus behind MLPs’ shift to self-funding and give some examples of MLPs that are pursuing self-funding. We’ll discuss why self-funding doesn’t equate to never issuing equity again, and we’ll also look at the potential benefits of self-funding. For purposes of this discussion, self-funding means funding the equity portion of an MLP’s capital spending with cash retained after paying distributions.

Why are MLPs shifting towards self-funding?

MLPs’ shift from serial equity issuance towards self-funding is arguably both a necessity and a logical next step for a maturing industry. As any MLP investor knows, equity prices for MLPs have remained depressed as this energy downturn has persisted. With equity prices depressed, the cost of equity has gone up, and issuing equity to finance growth projects is not very attractive. So, rather than issuing equity, some MLPs are retaining cash, instead of paying it out as distributions, and they are using that retained cash to fund growth projects.

Self-funding is also a growing pain for MLPs as this space matures. MLPs have had to shift from growing the distribution to focus on growing the distribution sustainably. Competition has increased, and we’re no longer in the boom years of the shale revolution when there seemed to be limitless growth opportunities. The oil downturn has led to more moderate distribution growth in general, and some MLPs have had to cut their distributions. The macro environment has also forced MLPs to practice more capital discipline, which is a tenet of self-funding. While moderating distribution growth was already happening, self-funding further accelerates the trend as MLPs choose to retain cash to fund growth capital.

To look at it from another angle, self-funding may also appeal to MLPs that were growing their distribution but felt the market wasn’t rewarding them. Multiple MLP management teams have expressed frustration with weak unit price performance despite distribution growth, including Enterprise Products Partners (EPD) when it announced that it was moderating distribution growth to move towards self-funding (discussed more below). If growing the distribution isn’t being rewarded and is increasing an MLP’s cost of equity because the unit price isn’t improving (higher yield), it’s understandable that management would prefer to retain that cash for growth projects. In other words, self-funding may be more appealing for management teams in an environment where distribution growth seems to go unrewarded.

Can MLPs really self-fund? Which MLPs are pursuing self-funding?

MLP investors that have grown accustomed to regular equity issuances in the past may be skeptical of the reality of self-funding and rightfully so. Magellan Midstream Partners (MMP) is the posterchild (or poster MLP) for self-funding and proves that it can be done. MMP has spent over $5 billion on growth capital over the past decade and only issued $260 million of equity over that period. That equity issuance was back in 2010. MMP has demonstrated that it can self-fund while growing its distribution and is not expecting to need equity capital to fund its current growth plans.

To be fair, the transition towards self-funding won’t happen overnight. EPD announced in October 2017 that it was moderating distribution growth in favor of moving towards self-funding. EPD’s target is to self-fund the equity portion of its annual capital budget in 2019. As it transitions towards its 2019 target, EPD does not expect to issue equity in 2018, aside from its distribution reinvestment program (DRIP) and employee unit purchase program. MPLX (MPLX) plans to follow a self-funding model for its organic growth, but it bears mentioning that MPLX issued 389 million units to its parent Marathon Petroleum (MPC) earlier this year to fund an $8 billion dropdown and to buy out MPC’s incentive distribution rights (IDRs). The dropdown and elimination of IDRs were arguably helpful groundwork for pursuing a self-funding model going forward.

Self-funding Not the Only Way to Address Equity Overhang

Several MLPs have not explicitly committed to self-funding but have given guidance around not needing equity for a certain timeframe. For example, DCP Midstream’s (DCP) 2018 guidance includes no planned equity issuances, and Western Gas Partners (WES) plans to fund its $1.3+ billion 2018 capital budget without issuing equity. Genesis Energy (GEL) announced no current plans to access equity capital markets for the immediate future, absent a specific opportunity for organic growth or an acquisition, when it cut its distribution in October 2017. Pro forma for the acquisition of gathering assets from its parent (partially funded with units) and the unit-for-unit acquisition of Rice Midstream (RMP), EQT Midstream (EQM) is guiding to no additional equity requirements through 2020 at least.

Guidance on not needing equity tends to be well-received by the market as it helps to alleviate the equity overhang investors fear. We provided just a few examples, as opposed to an exhaustive list. In some cases, a distribution cut has helped reduce the need for future equity (GEL) or a dropdown transaction that included issuing equity to a parent has helped set the stage for not needing additional equity for a time (EQM).

Never say never when it comes to issuing equity

“Never say never” may be the first rule of corporate messaging. Issuing equity is an important financing tool, and even MLPs pursuing self-funding aren’t promising to never issue equity. For example, even while not expecting to issue equity, MMP indicated it will issue equity if needed to manage leverage or to pursue a growth opportunity. Similarly, EPD has made clear that it will not limit growth capital spending or acquisitions by its ability to self-fund. MPLX takes a self-funding approach to organic growth but makes a distinction when it comes to a large project or acquisition that may require accessing capital markets.

The potential positives of self-funding

Self-funding should result in less equity dilution and more of a total-return focus, which should be desirable to investors. However, this transition will take time. Both analysts and investors will have to change the way they view the space. Investors that were solely focused on income growth may be disappointed. On the other hand, institutional investors that were wary of equity issuance in the past may find MLPs more attractive, particularly as IDR eliminations improve corporate governance. A broader investor base, particularly of institutional investors, would certainly be positive for MLPs, which likely lost some investors permanently in the oil downturn.

Bottom line

The transition to self-funding in the MLP space is still in early innings with just a few MLPs really pursuing it. Self-funding is a natural response to depressed MLP equity prices for a maturing industry with a more focused opportunity set. Self-funding has the potential to be a positive for the MLP space, but it’s a transition that won’t happen over night and may leave some traditional MLP investors disappointed with distribution growth.

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