The Brave New World of MLP Financing

Kinder Morgan (KMI) has been making headlines for the past few weeks. First, cryptically holding up their investment grade rating as a sacred cow, then putting their money where their mouth is by drastically slashing their dividend to protect the rating.

Growing the distribution, or at the very least maintaining it, has long been held as sacrosanct in the MLP world due to the relatively large percentage of retail ownership. Rightly or wrongly, the consistency of these distribution payments was viewed as a barometer for the underlying health of the company.

In the past two years, every single upstream MLP has cut its distribution. Investor response has been predictably dismal: one of these MLPs is now trading on the pink sheets and others may be joining it soon. Given that low commodity prices is most challenging for those closest to the wellhead, upstream distribution cuts make sense, since Production is at the wellhead. So far, no energy infrastructure names have cut distributions.

The wheels of change have started to turn. There is more institutional ownership for one, and after Kinder cut its dividend with very little backlash, analysts have started calling for certain MLPs to cut their distributions. These calls are not necessarily based on the availability of an MLP’s current cash flows to support the distribution, but rather due to other potential (read: better) uses of the cash flow.

While MLPs have traditionally paid out the vast majority of their available cash flow, they have never had a legal requirement do so. We count five potential uses of MLP cash flow:

  • Return to unitholders in the form of distributions
  • Return to unitholders in the form unit buybacks
  • Pay down debt
  • Make an acquisition
  • Build new assets

The last two are not traditionally associated with uses of MLP cash flow. Previously, cash from in-service assets would be returned to unitholders and new assets would be financed with a combination of debt and equity. But given the 50% peak-to-trough move in unit prices, management teams are reluctant to fund growth with depressed and expensive equity. Funding growth through credit can only last so long until an MLP’s leverage ratios begin to push the limits of its debt covenants.

As much as analysts and Kinder alike crow about how, post-dividend cut, KMI will not need to access the equity markets in 2016, and maybe not ever, it’s not a new concept. Some MLPs have been quietly self-financing for years.

Exhibit A: Magellan Midstream Partners (MMP) has not accessed the equity markets since July 2010, and yet has more than doubled its distribution during that timeframe. Without fanfare, MMP has a distribution coverage ratio of 1.3x, and still intends to raise distributions by at least 10% in 2016.

Exhibit B: Enterprise Products Partners (EPD) has raised its distribution steadily each quarter for over a decade and also has a coverage ratio of 1.3x. While EPD maintains a healthy ATM program, the last time EPD sold units in a follow-on offering was November 2013. They still plan to put $8 billion of growth capital to work over the next two years.

Other management teams have come out strongly in defense of their distributions. Greg Armstrong, CEO of Plains All American Pipeline (PAA), ever the outspoken executive, has publicly insisted PAA will not cut its distribution. And Jamie Welch, CFO of Energy Transfer Equity (ETE), has likewise said that cutting the distribution just isn’t an option. More recently, NGL Energy Partners (NGL) has also declared that it is “not contemplating a distribution cut.”

MLPs that intend to maintain their distributions but still need to raise capital to fund growth projects will have to get creative if access to traditional funding remains limited. Sales of non-core assets are an option, but we are also likely to see second lien debt, joint ventures, PIK units, preferreds (convertible or not), and PIPEs with longer lock-ups. At a different point in the cycle, investors avoided MLPs with GPs, but now those MLPs lucky enough to have a supportive general partner may be rewarded. For instance, MPLX (MPLX) sponsor Marathon Petroleum (MPC) has promised to maintain MPLX’s distribution growth profile, which may mean incubating projects at the GP level, dropdowns at attractive multiples, or even intracompany loans.

Regardless, it’s a difficult world out there for MLPs without an investment grade rating, without a supportive GP, with double-digit yields, with high leverage, without customer diversity, without basin diversity, and so on. A distribution cut could very well be on the table for names like that.

However, now that the MLP space is going through a cycle of restricted capital markets access combined with low energy prices for the second time in eight years, we may see a new normal for coverage ratios in the neighborhood of 1.3x or higher. That is, at least until capital markets reopen and commodity prices recover. The flexibility to grow with retained cash flow is something investors would be wise to reward, regardless of the capital markets environment.

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