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Michael Blum: Headwinds or Clear Sailing for MLPs?

Source: Brian Sylvester of The Energy Report 02/03/2011
February 5th, 2011

Noting that 2009 and 2010 provided an "extraordinary run" for master limited partnerships (MLPs), Wells Fargo Senior Energy MLP Analyst Michael Blum still sees plenty of potential, including strong business fundamentals, distribution growth and attractive yields. Learn what might take the wind out of an MLP's sails, which sectors are positioned to run ahead of the wind and which MLPs have set their sights on achieving investment-grade status in this exclusive interview with The Energy Report.

The Energy Report: Michael, a recent Wells Fargo research report said that master limited partnership valuations looked "full, relative to historical valuations." Does that mean there's nowhere to go but down?

Michael Blum: Hopefully, there's somewhere else to go. I think what the report is trying to say is that MLPs look fairly valued, relative to historical levels. Our outlook is for mid-single-digit total return, maybe 6% to 8%. We think investors will continue to receive an attractive yield, but that price performance is probably going to be choppy for a while. I don't know if that's necessarily a negative outlook.

On the face of it, relative to other investment alternatives, if you can get a 6%–8% return, along with the tax advantages MLPs afford, that's a pretty decent investment. It's not that MLPs are necessarily going to go down or trade down, but we do think that the upside in price is limited in the near term.

TER: Is it fair to say that you expect MLPs to go sideways this year after a relatively impressive 2010?

MB: That's right. The last two years have been a pretty strong run. In 2010, MLPs generated a total return above 30%; in 2009, they were up over 50%. I think maybe we'll take a breather this year.

TER: In that same report, you wrote about the two prevailing camps, in terms of MLP performance in 2011. One camp believes a new paradigm is being brought to bear that will revalue MLPs and drive down yields. You are in the other camp, which believes MLPs are just going through another cycle, that they are fairly valued and yields will grow slightly. What explains the different positions and why do you believe you're right?

MB: There's always been an argument that MLPs, on a risk-adjusted basis, are mispriced. That's because, relative to their underlying fundamentals, one could argue that the yield is too high considering the growth rate. As an example, if you compare MLPs to real estate investment trusts (REITs)—another yield product—REITs typically have lower yields. But they also have lower growth rates in their dividends. Arguably, the fundamentals are less attractive than the MLP business model. Why shouldn't an MLP yield less than a REIT, given that it has higher growth trajectory with better business fundamentals?

The other side of that argument is that MLPs trade at some discount to their intrinsic value because there are tax, liquidity and administrative burdens to owning MLPs. The pool of capital that can own MLPs is more limited because some investors can't or don't want to deal with the tax issues associated with owning them. In addition, it's still a relatively small group. The market cap is right around $200 billion. That's relatively small in the grand scheme of things. Liquidity for MLPs is not that great. And some funds won't invest in the sector, simply from a liquidity standpoint. I think those two factors will limit how much capital can ultimately flow to the group. That's why I think MLPs will continue to trade at healthy valuations, but perhaps not tighter than REITs.

TER: A chart in a recent Wells Fargo report showed Merrill Lynch high-yield, investment-grade bonds yielding 7.2%, whereas the Wells Fargo Securities MLP Index yielded only 6.1%. How do you convince an investor seeking yield securities to choose your offering?

MB: I think there are several reasons that an MLP investment could be more attractive than a high-yield bond. First, from a tax perspective, about 80% of the distributions received will be tax deferred until the security is sold. So, relative to the income received from a high-yield bond, more of that investment will go into the investor's pocket on after-tax basis as an MLP. Secondly, because MLPs are equities, there is upside in the price. An investor may or may not have that with a bond, especially if it is held until maturity. Lastly, the distribution can grow with an MLP, but it is a fixed rate with a bond. We're forecasting about 5% medium distribution growth for the MLP sector in 2011 and the next three years. In addition to the current yield, there is growth in that distribution rate.

TER: So, in addition to price upside there is also price downside.

MB: That's correct. It's an equity so the price can go up and down, but the same is true of a bond. High-yield bonds now are trading at spreads to the Treasury that are much tighter than the historical rates. So, you have the same risks as with high-yield bonds—interest rates go up or high-yield credit spreads widen.

TER: In a January 7, 2011 research report, you wrote: "We would continue to own MLPs but would wait for dips before adding positions." How far off are those dips?

MB: It's really hard to predict dips. If there was a good way to predict them, we'd all do it. There are always unforeseen events. You could have a large seller that decides to be in the market and puts pressure on the price. You could have a confluence of secondary equity offerings in a short time span that could create an oversupply or a situation where equity supply is greater than demand. That could create a pullback in the stock. You could have an exogenous event; for example, when Greece had sovereign credit issues last summer. That impacted credit markets and spreads, as well as MLPs, on a short-term basis. There's a whole host of factors that could create these dips.

The reason we recommended continuing to own MLPs and to look for dips is that the underlying fundamentals for MLPs are quite good right now. Regardless of the macro factors that could push valuations up and down in the short term, we still think the MLP sector is very attractive on a long-term basis.

TER: MLPs depend heavily on lines of credit to borrow money for business expansion. The consensus is that interest rates are set to rise somewhat, which would increase the cost of capital for MLPs. Please tell us about that and some other potential headwinds that MLPs could be sailing into this year.

MB: Because MLPs pay out the majority of their cash flow every quarter, they do rely on access to capital markets. Because they invest significantly, either to acquire assets or to build new assets, they do have to access the debt and equity markets relatively frequently.

MLPs also are sensitive to interest rates, though not as much as one would imagine. The correlation between interest rates and MLP price performance is only about 0.4. When there is a sudden spike in interest rates or an unexpected increase in interest rates outside of consensus, MLPs will underperform much like other yield- or spread-based securities. That's certainly a risk. I think a steadily rising interest rate environment will be manageable for MLPs. Those that can grow their distributions more quickly will probably better offset some of the increases in interest rates. For MLPs with limited or no growth in their distributions, you'd expect to see some erosion in price performance as interest rates rise.

Commodity price is another big risk. Oil is now over $90/barrel. To the extent that a number of MLPs have direct or indirect exposure to oil or natural gas liquids (NGLs), which are highly correlated to crude oil prices, a pullback in commodity prices would impact the cash flow. Right now, the correlation between MLP prices and crude oil prices is north of 0.7—the highest correlation of any product or commodity. Certainly that would be another potential headwind for the sector.

TER: MLP general partners (GPs) and gas processors were the best-performing subsectors in 2010. Are those subsectors likely to continue to perform in 2011? What other subsectors do you expect will do well?

MB: I'm not sure the gathering and processing subsector as a whole will outperform. I do think the gathering and processing MLPs that either have good exposure to shale-play development or very high growth rates will probably perform well. We're thinking about the group more thematically. We think you want to own the higher-growth names, and then own the names that have exposure to crude oil and NGLs as opposed to natural gas. That's because those subsectors have a lot of growth around them. Commodity prices are strong. The fundamentals are very good.

In terms of the general partners, I do think you could continue to see outperformance. There were six transactions this year in which an MLP acquired and eliminated a GP. That means there are now roughly half as many publicly traded GPs as there were a year ago. From a scarcity-value perspective, investors who want exposure to the GP asset class have a lot fewer choices. I think you could continue to see those move higher just from a scarcity-value perspective.

TER: What are some of those higher-growth names you mentioned?

MB: I would highlight El Paso Pipeline Partners, L.P. (NYSE:EPB), the pipeline MLP for El Paso Corporation (NYSE:EP), which has been selling pipeline assets into the MLP and will continue to do so as they fund development of its E&P business and other resources that it needs at the parent level. We are forecasting +10% growth per year for the next four or five years at El Paso Pipeline Partners. In 2010, the company grew the distribution 19% and sold assets to the MLP worth $2.1 billion. There's a steady visible growth rate there.

TER: The yield for El Paso Pipeline Partners was 4.9% in 2010 and distributions were $1.64. What are your 2011 projections for El Paso?

MB: We're forecasting a distribution rate of $1.89 and a yield of 5.3% for 2011.

TER: So, there is a little bit of growth on that one.

MB: Yes. The second name I would highlight is a stock we initiated today, Targa Resources Corp. (NYSE:TRGP). This is the general partner of Targa Resources Partners, L.P. (NYSE:NGLS). Due to where it is in its incentive distribution rights (IDRs), the growth rate at the GP is roughly three times that of the underlying MLP. We're forecasting a three-year distribution growth target of about 23%. That robust growth comes from the underlying MLP, Targa Resources Partners. We're forecasting about a 7%, three-year compounded annual growth rate at the MLP level. That's driven by organic expansions of the natural gas liquids infrastructure. Targa is very well positioned in that business. The partnership has a large footprint in the Gulf Coast. As assets are being built to accommodate growing liquids production and demand, we think Targa will be able to grow the distribution at a pretty nice clip. That translates into a roughly 3:1 ratio of growth to the GP.

TER: You just published your top picks for 2011. What are some of those names?

MB: We've already talked about El Paso Pipeline Partners. I would also highlight Enterprise Products Partners, L.P. (NYSE:EPD). Enterprise is involved in the same market as Targa, the NGLs, natural gas pipeline and fractionation and infrastructure markets. The company has a market-leading position in NGL logistics. Based on those same trends in the NGL market, there is growth in liquids production, as well as growing demand for liquids from the petrochemical industry. Enterprise is building its asset base to handle that growing supply and demand. We think you could see distributions grow about 6% per year for the next several years with a yield of about 5.5%. Enterprise is also one of the most liquid names in the sector.

TER: Last year, Enterprise's distributions were $2.33 and the yield was 5.6%. You're saying it's going to be about 5.5%. And what's the distribution going to be?

MB: We're looking for $2.45 for 2011.

TER: You said Enterprise's distributions were going to grow. What are the catalysts for that growth?

MB: The catalysts really are the organic growth projects. As an example, fractionation capacity is very tight right now because NGL supply is up, and you need to fractionate the NGLs to get them to market. Enterprise has a dominant position at Mont Belvieu, Texas, which is the hub for NGL fractionation. As a result of all this pent-up demand, the company is building three new fractionation facilities in Mont Belvieu. Because there's such demand, it's been able to increase its rates by almost double what they have been historically. In addition, what used to be a spot business is turning into a long-term contract business. Shippers are now contracting for long-term agreements to reserve space in the fractionator. That affords Enterprise a long-term, fee-based cash flow stream.

TER: What are some other top picks?

MB: The other one I would highlight is Exterran Partners, L.P. (NASDAQ:EXLP). This one's a little different; it owns compression assets. The general partner is Exterran Holdings Inc. (NYSE:EXH). The story here is that utilization of compression has stabilized and is starting to improve. On top of that, the parent company will be selling assets into the MLP over time to support growth. We think this will create very stable distribution and growth. Our three-year distribution prediction is 6.6%. The stock has a pretty healthy yield of 6.8%. This is a name that hasn't run as much as others but has pretty good underlying fundamentals and should do well over time.

TER: My MLP chart shows a total return of 12.7% from early November to the end of December 2010. That's quite phenomenal; such a return would have outperformed just about anything on the market, certainly in this type of investment. Are there any non-investment-grade MLPs poised to become investment-grade names in 2011?

MB: That's a great question. I don't know if there are any for 2011, but there are a couple of MLPs that have the potential to get there by 2012. One is Regency Energy Partners, L.P. (NASDAQ:RGNC). Its stated goal is to achieve an investment-grade credit rating. The company's been transforming its business by adding pipeline and fee-based cash flows, to the extent that almost 80% of its cash flow will come from fee-based activities, and only 20% from commodity-price exposure. As it grows and achieves critical mass, you could see Regency Energy Partners achieve an investment-grade credit rating by 2012.

Similarly, as Targa Resources Partners grows its business to achieve critical size and to add fee-based cash flow, as well as organic growth projects, you could see it hit investment grade in a couple of years.

TER: Any parting thoughts on the MLP sector as of mid-January 2011?

MB: It's been an extraordinary run. Certainly, the MLP asset class has a higher profile than it probably ever has. You see articles in The Wall Street Journal, there are MLP ETFs, etc. A lot of new funds have been created to own MLPs. So, we still think there should be place in an investor's portfolio for MLPs. Even after the strong run, they still offer a pretty attractive yield. MLPs have good, solid underlying business fundamentals, so we think the future is still very bright for the MLP sector.

TER: Michael, thank you for your time.

Michael J. Blum is a managing director and senior analyst at Wells Fargo Securities covering energy master limited partnerships. He began his Wall Street career in 2000 at First Albany Corp. as an associate analyst covering alternative energy securities, and joined Wells Fargo in 2001. Since 2003, he has been following MLPs and integrated natural gas securities at Wells Fargo. Before joining the sell side, he spent a year as the investor relations manager for a publicly traded Internet startup during the dot-com boom. Michael has been recognized twice as a Wall Street Journal "Best on the Street" winner, ranking in two categories in 2010: No. 3 for the oil and gas producers sector and No. 5 for oil equipment, service and distribution. He also ranked No. 4 for oil equipment, services and distribution in 2007. In 2010, Michael was ranked the No. 1 MLP analyst in the Greenwich Associates survey of institutional investors. In 2009, he was named the No. 1 oil and gas pipelines analyst by Forbes and was ranked as the No. 3 analyst for the master limited partnership sector in a survey conducted by Institutional Investor. Michael graduated magna cum laude from the University of Pennsylvania with a BA in English literature and a minor in economics.

Source: Brian Sylvester of The Energy Report 02/03/2011
February 5th, 2011

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1) Brian Sylvester of The Energy Report conducted this interview. He personally and/or his family own shares of the following companies mentioned in this interview: None.
2) The following companies mentioned in the interview are sponsors of The Energy Report: None.
3) Michael Blum: I personally and/or my family own shares of the following companies mentioned in this interview: None. I personally and/or my family am paid by the following companies mentioned in this interview: None.

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