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Are Midstream MLPs Going Mainstream?

Source: George Mack of The Energy Report (7/7/11)
July 8th, 2011

Judging from fund flows into some of the Master Limited Partnerships (MLPs) he tracks, investors apparently agree with Stephen Maresca, Morgan Stanley's MLP expert, that the midstream sector of the oil and gas industry has gone mainstream. As Stephen tells The Energy Report in this exclusive interview, investors want exposure to the income, yield and total return that the MLPs provide, and they're finding growing revenues and growing free cash flow per share in operators with good management teams, strong balance sheets and assets in growing supply areas that are connected to good market sources for demand. "It's a good time to be involved in midstream plays," he says.

Companies Mentioned: El Paso Corporation - Energy Transfer Equity, L.P. - Energy Transfer Partners, L.P. - Regency Energy Partners, L.P. - Targa Resources Partners, L.P. - Williams Partners, L.P.

The Energy Report: Two surprising discoveries of Marcellus gushers in northeastern Pennsylvania made the news last week, and they certainly highlight the possibilities of that formation. How significant is this from your point view?

Stephen Maresca: Although we don't yet have much detail on these particular gushers, we've been up in the Marcellus and I think the significance of the play is real. It could be a game-changer for gas in North America. It has the potential to become 10%-15% of the total gas supply in the U.S.—obviously a material amount. It could be one of the biggest gas fields we've ever had, period. So it's extremely significant in terms of energy independence, fueling electricity generation from gas-powered plants and filling our energy needs.

The northeast is densely populated, so it's closer to markets with a lot of people and typically a lot of electricity demand. That makes the Marcellus, in general, extremely significant; it's certainly no longer a speculative play.

TER: These two discoveries are said to have potential for 30 million cubic feet per day of production. Would that put further price pressure on gas?

SM: Sure it could, if it proves to be true or proves to sustain itself at that level of production. I don't think it will materially increase what we know is there in terms of supply in the Marcellus, the Haynesville and other basins, but it would add to a situation that already has us fully supplied with gas. I don't know that it would add significant pressure initially to natural gas prices, but one of the reasons gas prices have been relatively subdued is the fact that we have a lot of supply.

TER: You've written about an outsized premium of Master Limited Partnership (MLP) in comparison to C-Corp companies. What are you currently telling your clients about C-Corps versus MLPs?

SM: I think part of the premium is warranted. At one point the MLPs were trading at a valuation premium on EBITDA (earnings before interest, taxes, depreciation and amortization) multiple basis of 60% to C-Corps that had similar assets. Part of that premium is due to the tax advantages of MLPs. They don't pay entity-level taxation. I think another part of the premium is due to investor desire for cash-flow or dividend-paying entities—MLPs are paying a pretty significant dividend yield right now relative to the C-Corps.

In addition, fund flows into MLPs have been pretty strong. I think it's still growing as an asset class. These fund flows come from different areas of the investing community—long-only mutual funds, dedicated closed-end funds, pension allocations and municipality allocations. That type of money flow is outpacing the supply of MLP stocks, so you've seen MLP prices go up just because money that wants an allocation to the sector is coming in.

Right now we're telling clients that the premium has pulled back a bit; it's still there but maybe a little below 55%. Some of the C-Corps are a bit more attractive than the MLPs because they have exposure to the same assets that the MLPs do, a little bit cheaper valuation and they'll still experience the growth in the asset cash flows that the MLPs will. As a result, some of the C-Corps are giving investors a better entry point.

Some of these C-Corps also have interests in the MLPs. They own the general partner or they own some of the MLP stock. That, too, can make them a better entry point into playing the MLP market. Williams Partners, L.P. (NYSE:WPZ), El Paso Pipeline Partners, L.P. (NYSE:EPB) and Targa Resources Partners, L.P. (NYSE:NGLS) are just a few examples.

TER: This is a function of fund flows, of investable dollars as you've just mentioned. But do you also see this as a typical market cycle where investors tend to overshoot at times?

SM: I think it's more of a secular trend than a market cycle. I think the MLP asset class is evolving. It's growing. It's expanding. It's reaching into different pools of capital, a lot of which is permanent. So, I don't think this is a cycle where people are shifting money in and then will shift money out at some point. A lot of the money that's come in has a longer term view on the sector, whether that view is three years or five years. They want exposure to energy infrastructure and they want exposure to the income, yield and total return that the MLPs provide. So I think it's more of an evolution than a cycle.

TER: Over time, whether in a C-Corp or MLP, do investors expect total returns based partly on share price appreciation? Or do they eventually settle for income?

SM: They want both share price appreciation and income. This is a total return sector, and the nice, healthy upfront yield relative to other sectors gets investors to look at it. In the Morgan Stanley coverage universe, the MLP yield is about 6.5%. You can relate that to corporate bonds, which are at 6% or below with the 10-year yield in the low 3% area. Other stocks are yielding 3% or 4%, so MLPs look good. It's not a static yield either, but a distribution that typically grows every year. I think investors are looking not for just the yield but also for the growth and then share price appreciation and total return.

TER: Is there any regulatory risk looming that threatens the tax structure of MLPs?

SM: There's nothing specific afoot in Congress to target MLP taxation, although the headline risk is there and it's real.

There's a very low probability that ultimately MLPs would get taxed, given their importance to the energy landscape and the fact that rates of return are already regulated by The Federal Regulatory Commission. So, I think it's a low risk that anything happens, but we'll continue to monitor it.

What is being talked about, although we've seen nothing tangible in writing yet, is a reworking of the overall tax code to make it simpler. That could include partnership taxation, which wouldn't be specific to MLPs, but also a lot of other pass-through entities, including real estate investment trusts (REITs) and other types of pass-through partnerships. So, that's what's being discussed, with everything on the table given the state of the U.S. deficit.

TER: A chart included in an industry report that you and your colleagues did a couple of weeks ago showed that from the beginning of 2009 to the end of May 2011, the ratio between crude oil and natural gas prices shot up from 5:1 to 20:1 in only 18 months. The ratio makes it look as if natural gas could be a tremendous bargain right now for consumers and may be an arbitrage investment opportunity. Other than demand destruction of gasoline at the pump, why aren't we using more natural gas?

SM: I think we're beginning to use more of it, but it takes a while to shift. We can't all of a sudden make cars and airplanes run on natural gas. We've been dependent on oil for a while and it's hard to change the demand picture that quickly.

The other issue has been a supply situation. Global economic growth—in China and India, for example—has driven a lot of the increase in oil prices. In addition, we've seen constraint in terms of oil supply—the ability to get oil—with countries that have oil undergoing their own geopolitical issues.

On the gas side, it's more of a U.S. commodity. The supply has actually ballooned, considering how much potential supply has been identified, and how much technology and shale gas findings have contributed to the supply picture.

Again, we don't predict or specifically target an oil-to-gas price ratio, but I don't think we'll go back to that 5:1 ratio any time soon. We expect the ratio to remain elevated above its historical level of 10:1. Right now we're at 20:1.

TER: How are you advising investors to play energy?

SM: We think the midstream space is a great risk/reward opportunity. In Morgan Stanley's midstream coverage universe, we look for companies that have good management teams, strong balance sheets, and assets in growing supply areas that are connected to good market sources for demand.

We typically want growth; we think the growth companies will do better over time. On the MLP side, we look at names such as El Paso Pipeline, which I mentioned earlier. We anticipate significant cash flow per share growth from EPB—on the order of 15%–20% for the next two years at least, given asset purchases from its parent, El Paso Corp. (NYSE:EP).

I'd also mentioned Williams, a larger-cap MLP that we like. We think it will benefit from midstream development in the Marcellus region and also in the U.S. mid-continent region. Williams also will benefit from increased liquids production and liquids handling needs—processing, gathering and capacity increases.

A third one in this space that we've been advocating, and will continue to do so, is Energy Transfer Equity, L.P. (NYSE:ETE). This is a general partner stock and has an interest in two separate MLPs—Energy Transfer Partners, L.P. (NYSE:ETP) and Regency Energy Partners, L.P. (NASDAQ:RGNC). We think ETE will benefit from significant capital spent at both of those entities, a combined total exceeding $2B that will flow up to ETE. We're looking at probably upward of 10% cash flow per share growth each year for the next couple of years.

SM: How about C-Corps?

SM: That would be El Paso, Williams and Targa's parent companies.

TER: Is liquidity a concern with El Paso?

SM: I don't think so. For the parent company, the balance sheet has improved significantly over the past 18 months, as they've used asset sale proceeds to begin to pay down debt. They've increased their EBITDA levels since new pipelines have been put into service.

The El Paso MLP, EPB, I think has a very good balance sheet. We see it less than 3.5 times debt:EBITDA. That's a very good number given the strength in the cash flows of those assets, which are long-term contracted natural gas pipelines.

So, no, we don't see liquidity as a concern for either of the El Paso stocks.

TER: Very good. Are you by any chance advising investors to lighten up on oil?

SM: That's a question for our commodity research team, but in the MLP space we're advising clients to invest in companies with growing revenues and growing free cash flow per share. Most of what these companies are building isn't tied to commodity prices, but rather tied to volumes and long-term contracts that provide a fee revenue service to them.

So we've not looked at our ratings in commodity terms. These are diverse companies with exposure to both oil and gas infrastructure assets. It's not as if one company is just an oil company and one company is just a gas company.

TER: Do you have any more thoughts you want to share?

SM: I look toward a good future of capital investment over at least the next three to five years in the midstream sector—and the MLPs specifically—given supplies in different regions that need the proper infrastructure of pipelines, storage, gathering and processing assets to bring that supply to market to be used.

So I think it's a good time to be involved in the midstream sector. MLPs offer a good way to play it from a yield and total return standpoint, given the dividend growth. On the basis of their relative valuations, some of the C-Corps can be even better ways to play it. They get the benefit of the cash-flow growth and the asset upside, but they put up less capital. They're somewhat cheaper valued stocks right now but still have good growth and good total return potential as well.

TER: Thank you so much, Stephen.

Additional Companies Under Stephen Maresca's Coverage
Atlas Energy LP (NYSE:ATLS) Atlas Pipeline Partners L.P. (NYSE:APL) Boardwalk Pipeline Partners LP (NYSE:BWP)
Buckeye Partners LP (NYSE:BPL) Chesapeake Midstream Partners LP (NYSE:CHKM) Copano Energy LLC (NASDAQ:CPNO)
Crosstex Energy, Inc. (NASDAQ:XTXI) Crosstex Energy LP (NASDAQ:XTEX) DCP Midstream Partners LP (NYSE:DPM)
Duncan Energy Partners LP (NYSE:DEP) El Paso Corp. (NYSE:EP) El Paso Pipeline Partners LP (NYSE:EPB)
Enbridge Energy Partners, L.P. (NYSE:EEP/EEQ) Energy Transfer Equity (NYSE:ETE) Energy Transfer Partners, L.P. (NYSE:ETP)
Enterprise Products Partners LP (NYSE:EPD) Golar LNG Partners LP (NASDAQ:GMLP) Inergy LP (NYSE:NRGY)
Kinder Morgan Energy Partners LP (NYSE:KMP) Kinder Morgan, Inc. (NYSE:KMI Magellan Midstream Partners LP (NYSE:MMP)
MarkWest Energy Partners (NYSE:MWE) MDU Resources Group, Inc. (NYSE:MDU) National Fuel Gas Co. (NYSE:NFG)
Niska Gas Storage Partners LLC (NYSE:NKA) NiSource Inc. (NYSE:NI) NuStar Energy LP (NYSE:NS)
PAA Natural Gas Storage LP (NYSE:PNG) Plains All American Pipline (NYSE:PAA) Questar Corp. (NYSE:STR)
Regency Energy Partners LP (NASDAQ:RGNC) Southern Union Company (NYSE:SUG) Spectra Energy Corp. (NYSE:SE)
Spectra Energy Partners LP (NYSE:SEP) Sunoco Logistics Partners LP (NYSE:SXL) Targa Resources Corp. (NYSE:TRGP)
Targa Resources Partners LP (NYSE:NGLS) TC Pipelines LP (NASDAQ:TCLP) Teekay LNG Partners, L.P. (NYSE:TGP)
Western Gas Partners LP (NYSE:WES) Williams Companies, Inc. (NYSE:WMB) Williams Partners LP (NYSE:WPZ)

Morgan Stanley's Stephen Maresca is an executive director covering energy master limited partnerships (MLPs) and diversified natural gas companies. Prior to joining Morgan Stanley in 2008, he spent 10 years at UBS, focusing primarily on the energy sector. He served as associate director in the UBS investment banking energy group from 1998 to 2001, and then, as a director in the UBS equity research division, he covered energy MLPs. Stephen, who worked in PaineWebber's fixed income department from 1997 to 1998, holds a B.S. in accounting from Providence College and has a Chartered Financial Analyst (CFA) designation. He is a member of the New York Society of Security Analysts.

Source: George Mack of The Energy Report (7/7/11)
July 8th, 2011

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1) George Mack 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: Energy Transfer Partners.
3) Stephen Maresca: 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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