Midstream MLPs: Strong Performance Continues

Master limited partnerships (MLPs) recorded another strong year in 2010 as the Cushing 30 MLP Index (Bloomberg ticker: MLPX) delivered a 42 percent total return.  This was primarily driven by investors continued thirst for high-yielding securities in an environment of low interest rates, broadening ownership of the asset class by both retail and institutional investors, and improving company fundamentals and growth prospects.

Even though MLPs outperformed the broader market by approximately 27 percent (the S&P 500 rose 15 percent), we continue to see opportunities within the MLP space. With cash yields of about 6 percent and distribution growth potential of roughly 5 percent, we estimate baseline total returns in the low double-digit percent range over the next year. 

In 2011, several themes within the MLP space could provide continued positive performance. For example, we would focus on companies with exposure to crude oil and natural gas liquids (NGL) rich shale plays.  MLPs with exposure to these areas will be presented with high-return infrastructure opportunities and should provide above-average distribution growth.  

Review of 2010

2010 was an eventful year for the MLP industry.  With high yields, stable business profiles and strong growth outlooks, MLPs continued to gain more media and investor attention as highlighted by the over $4.0 billion in fund flows into the sector. In 2010, the MLP sector saw approximately $3.0 billion raised by MLP closed-end funds (CEFs), the launch of two MLP open-end mutual funds, the creation of several exchange-traded notes (ETNs) and the launch of an MLP ETF. 

Additionally, the industry saw seven IPOs and the creation of a new industry subsector, natural gas storage. The large inflow of capital into the sector was a reflection of investors’ desire for yield, the stable toll-road nature of the MLP business, and visible and accelerating distribution growth outlook.  
A recurring theme during 2010 was the announcement of six MLP general partner (GP) buyouts or restructurings. This was driven both by a desire to reduce the cost of capital to the underlying MLP by eliminating the incentive distribution rights, as well as GP owners wanting to get in front of any potential carried interest legislation. 

In addition to simplifying the organizational structure, these restructurings and resultant lower cost of capital improve the accretion of future organic growth projects and also allow the MLP to bid more competitively for acquisitions.

Another key theme was the shift in focus by producers from dry natural gas shales to crude oil and NGL-rich shales. The additional value producers receive from processing NGLs incentivized them to divert capital to oil and liquids-rich gas plays, resulting in increased need for midstream infrastructure in these areas.  These plays include the Bakken Shale, Eagle Ford Shale, Niobrara Shale and Barnett Shale Combo.  

Current Valuations

MLPs had another year of outperformance, and while not cheap, we believe they are not necessarily expensive either. The tremendous stock appreciation we have seen in MLPs since January 2009 has returned us to more “normal” levels.

We concede the low-hanging fruit and easy money has likely been taken off the table, but we do not believe the sector is overbought or expensive.  It is now essentially a “stock pickers” market with stock selection being the ultimate driver of outperformance.

With regards to market valuation multiples, MLPs are currently trading at about 12.2 times enterprise value to trailing EBITDA multiple.  Although slightly higher than the long-term average of 11.6 times, it is comfortably lower than the near 14.0 times multiples achieved in the summer of 2007.  We also note that excluding the “distressed valuation” period of late 2008/2009, the long term average EV/EBITDA multiple for MLPs is 12.0 times, essentially in line with where MLPs are trading today.

Compared to other yield-oriented asset classes, the sector actually remains attractively priced.  For example, the yield spread to REITS at year-end 2010 was 254 basis points (“bps”) versus the 147 bps average spread since 2002.  Additionally, the current MLP spread to BBB bonds is 126 bps versus an average spread since 2002 of 86 bps.

Employing a more conventional distribution discount model using conservative company specific rates of return, we project low to mid-teens returns for the MLP sector in 2011. This projection is in line with the aforementioned “yield plus growth” construct.  We believe this still presents a compelling investment opportunity on a risk-adjusted basis.  

Outlook for 2011  

MLP yields of about 6.0 percent remain attractive in this low-yield environment and could continue to attract fund flows into the sector. We expect MLP fundamentals to remain solid, with growing inventories of organic growth prospects and a robust acquisition market. Supportive of this growth, we expect capital markets to remain open and hospitable for both debt and equity issuances, as well as several more IPOs.

We believe the best return prospects in 2011 will likely come from MLPs benefitting from exposure to crude oil and NGL-rich shale plays. MLPs with exposure to these areas should continue to see strong fundamentals and additional gathering, natural gas processing and NGL infrastructure opportunities. These MLPs could experience above-average distribution growth and price performance relative to peers.

Crude Oil

The U.S. oil rig count increased 83 percent year-over-year in 2010 to 765 rigs. This led to the first increase in domestic onshore crude oil production in more than 20 years and the highest U.S. oil rig count level since January1988. This growth was driven by advancements in horizontal drilling techniques making crude oil shale plays (Bakken Shale, Eagle Ford Shale, Niobrara Shale and Barnett Shale Combo) more profitable.

Even traditional crude oil basins, such as the Permian Basin in West Texas are seeing renewed interest.  With oil prices above $90/barrel, we expect the trend towards crude oil shale development to continue. These new crude oil shale plays will require significant new infrastructure to transport production to end markets and provide additional growth opportunities for MLPs.   

NGLs & Liquids-Rich Shale Plays

Natural gas liquids are no longer an insignificant link in the energy value chain.  NGLs have become a key element and very profitable business for MLPs and producers with exposure to them.

The divergence between crude oil and natural gas prices has incentivized E&P producers to divert capital to liquids-rich gas plays, resulting in increased need for infrastructure in these areas. In the current high-priced liquids environment, producers recognize additional value uplift and higher returns by extracting and processing NGLs. The uptick in drilling in these areas has resulted in gathering, processing, fractionation and pipeline expansion opportunities for MLPs.