Investors have long favored those energy infrastructure MLPs considered dropdown stories. A parent company (often the GP) owned a suite of assets that suited that MLP structure and that same parent company planned to sell the assets down to the MLP over time. Since MLPs have an easier time raising capital due to their structure, this arrangement frequently resulted in a steady predictable cash flow stream for the GP, and steady predictable distribution growth for the MLP (as the new assets hit their books).
Over the past six months to a year, however, dropdown names have underperformed the Alerian MLP Index (AMZ). The underperformance has lasted long enough that some parent companies are stepping in to help the market realize the value of their MLP.
- Equity Overhang
Last year, as most MLPs were finding ways to reduce their capital spending, drop down MLPs with visible growth stories from committed sponsors outperformed. However, this year, as capital spending projections for MLPs have stabilized, with many funding their growth internally with retained cash flow, the drop down MLP story has become relatively less appealing, as many investors have a hard time getting on board knowing that further equity issuances are coming and necessary for growth.
- Parents Are Struggling Themselves
As commodity prices rise, drilling and production increases, as does the need for midstream. The parent company is profiting from the commodity exposure and can sell midstream assets to the MLP for a modest multiple. However, the cycle can also reverse—just as the MLP needs new profitable assets at the most accretive prices, the parent may be less willing to sell the assets and sign fee-based long-term contracts if it’s uncertain it will be able to fulfill the terms of the agreement.
- New IRS Regulations
At the beginning of October, the IRS released regulations for disguised sales involving partnerships. Fair warning: I am neither a lawyer nor an accountant, and you should consult yours. However, from my reading, it appears these new rules apply only to transactions completed after January 3, 2017. What the regulations seem to imply is that the GP would no longer be able to sell an asset with a low-cost basis to the MLP, have the MLP issue debt (and have the sponsor guarantee the debt), and then, the GP receive cash (debt proceeds) without ever paying taxes on the gain. When the drop down is structured this way with guaranteed debt, it’s not considered a sale, so no gain or loss gets triggered. While there are other ways to drop down an asset, this adds another factor of uncertainty.
HOW GPS ARE HELPING
- A Detailed Plan
Sometimes knowing the plan is half the battle. In the case of MPLX (MPLX), the parent company Marathon Petroleum (MPC) has come out with their detailed plan to create value. MPC outlined 2017 dropdowns, which ended up being higher than analysts had anticipated. MPC is also considering more traditional strategic actions such as buying in the IDRs, a restructuring of the GP, or a partial public sale of the GP.
- Accepting Units for Dropdowns
In the third quarter earnings report for Shell Midstream Partners (SHLX), Royal Dutch Shell (RDS) reiterated its plan for $2.5-$2.7 billion of dropdowns and 20% distribution growth. SHLX would not necessarily have to raise cash or debt for these deals, as RDS management remains willing to accept both common and preferred SHLX units. Issuing units directly to the parent is much easier than selling them to the public, although this tactic cannot be continually pursued.
- Reducing the IDR Burden
A tried-and-true strategy to benefit an MLP: the GP will forgo its IDRs, either for a certain dollar amount, or for a certain period. The most recent of these occurred back in August when Energy Transfer Equity (ETE) gave back $720 million to Energy Transfer Partners (ETP) over seven quarters to relieve part of ETP’s cash burden in the midst of its organic capital growth plan.
What This Means for Investors
Generally, investors should take this MLP-by-MLP. For instance, regarding the IRS regulations, Valero (VLO), the GP of Valero Energy Partners (VLP) has publicly said it does not expect to see any impact from the new regulations. PBFX Logistics (PBFX) said it has used this structure in the past, but will not be able to going forward. More speculatively, it’s possible for companies that have dropdowns scheduled for 2017 to move them up to 2016.
Some companies you won’t have to worry about anymore: EQT Midstream (EQM) acquired the final assets from its parent, EQT Corporation (EQT), although this had been part of the plan for a while. Going forward, EQM is now an organic growth story.
Of course, there are other options. Helping the LP doesn’t always mean helping it continue to exist—it means maximizing value for shareholders, even if that involves ending the MLP’s existence. Rich Kinder famously got tired of championing Kinder Morgan Energy Partners (former ticker: KMP) and bought it into Kinder Morgan (KMI), a C corporation. TransCanada (TRP) bought the GP of Columbia Pipeline Partners (CPPL) in July and just recently bought the MLP as well. SunCoke Energy Inc (SXC) also offered to buy in its MLP, SunCoke Energy Partners (SXCP). While I’d say the next likeliest target would be ETP purchasing the rest of PennTex Midstream Partners (PTXP), it has agreed not to do so for the next six months.
The primary theme of 2016 keeps repeating: uncertainty remains the enemy of premium valuations. If investors are unsure how IRS rules will impact their investments, unit prices will continue to struggle. If equity overhang remains, unit prices may hit a potential and arbitrary ceiling. On the other hand, IDR solutions and explicit dropdown schedules are likely to be positively received by the market.