John Edwards: Looking at MLPs for the Long Term
Master Limited Partnerships (MLPs) have lagged behind the broader market so far this year and their performance could be tempered until the second half, according to John Edwards, a senior MLP analyst with Morgan Keegan. In this exclusive interview with The Energy Report, Edwards explains why yield spreads aren't driving his conservative forecast.
The Energy Report: In 2010, the Alerian MLP Index (NYSE:AMZ) was up almost 36% and the equal-weighted Cushing MLP Premier Fund (NYSE:CSHAX, CSHCX, CSHZX) was up almost 42%. However, your outlook for 2011 is forecasting returns in the 10% range. What's underpinning your conservative forecast?
John Edwards: A couple of things. Primarily, one of the things we look at is what the yield spreads are on master limited partnerships relative to the 10-year U.S. Treasury. In the past, we've found that is a pretty good predictor of what's likely to happen in the next 12 months. Given the 10-year U.S. Treasury, where the MLP sector is trading at and our outlook for distribution growth, we're targeting a sector yield in the range of 6% to 6.75%, with our bias toward lower end of that yield range. We have a wider yield range than we would have normally because of the macro risks we're facing in the world, particularly sovereign credits, so we're trying to be a little bit more conservative with our expectations going forward.
TER: The yield spreads between MLPs and the 10-year U.S. Treasury is at 290 basis points right now, or 2.9%. That's well below the five-year average of 355 basis points. Why is the gap narrowing? Is that something MLP investors should fear or just keep an eye on?
JE: Yields on MLPs have come down quite sharply during the past two years. Recently, the yield on the 10-year U.S. Treasury has actually come up a little bit. It's not really something we're overly worried about because the yield spread between the MLP sector and the 10-year U.S. Treasury is most commonly between 200 and 249 basis points. It actually occurred more than 700 times when we looked at roughly 3,000 data points over a 14-year history.
We forecast that returns over the next 12 months will be about 10% at that spread. In fact, if we look at the spreads that account for roughly 75% of all the data points, that would be between 150 and 350 basis points. Returns in the following 12 months when we're in those ranges are between 10% and 13.5%. The spreads are nothing to be concerned about. We're well within the most commonly occurring spreads historically.
There is also plenty of buffer, if you will. If yield spreads dropped below 150 basis points, for example, that's something we would need to keep an eye on. Obviously, we have quite a large buffer at this point. We think our return expectations are reasonable in light of that.
TER: MLPs have lagged behind the broader market since December. You attribute that to investors developing a greater appetite for risk. A competitor recently downgraded Magellan Midstream Partners, L.P. (NYSE:MMP) and Regency Energy Partners, L.P. (NASDAQ:RGNC) because MLPs are lagging the broader market. How long should we expect that trend to last?
JE: We did see that a competitor downgraded some of the names that they cover. But the whole thesis behind MLPs is that they are a defensively oriented sector. They are designed to provide investors with predictable returns over the long term. They're an income-oriented instrument. They're tied to assets that are typically contracted for the long term. They provide lots of stability and predictability and have some growth characteristics.
With that backdrop, you would expect MLPs to generally outperform in bear markets and to lag in bull markets. Remember, in bull markets there tends to be rising incomes, rising appetite for risk and rising confidence in economic performance. MLPs are the type of asset that is designed to provide a certain predictable type of income whether the economy is in an expansion mode or in a contraction mode.
MLPs have been lagging the broader market slightly during the past two quarters. The equal-weighted Cushing MLP Index was slightly beat by the broader market in the third quarter and also slightly lagged in the fourth quarter. On the macro front, the Federal Reserve has stepped up their commitment to the economy through an additional round of quantitative easing. Pretty much the whole market was down through the first half. The performance that the broader market was able to achieve for the full year occurred in the second half and most of that occurred in the last month in the year.
Quite frankly, we think equity investors are riding the tailwinds of quantitative easing and their comfort level has increased due to the Republicans taking control of the House. It provides a framework where businesses are more comfortable making capital commitments and hiring. That will contribute to better economic growth because investors and businesses are going to have greater policy predictability coming out of Washington.
TER: One of the larger MLPs, Plains All American Pipeline, L.P. (NYSE:PAA), just bought SG Resources Mississippi, which has a large natural gas storage facility in that state, for $750 million. Can you tell us about that deal and why it's meaningful for Plains All American?
JE: Plains All American is increasing their commitment to the natural gas storage business with that transaction. The company already made some moves to increase its commitment to natural gas storage and this is one more move along those lines. It did pay a relatively high multiple for those assets since Plains is positioning for the long term in the natural gas business. The company is financing the acquisition with units in Plains Natural Gas, which is another MLP that Plains All American controls. The company is also using a loan from Plains to PAA Natural Gas Storage, L.P. (NYSE:PNG).
The bottom line is we ended up raising our cash-flow estimates slightly on Plains. We raised our EBITDA outlook slightly. But we maintained our distribution-growth outlook at approximately 3%-4% over the longer term. We view this acquisition as a way for Plains to position themselves for the long term in the natural gas storage industry.
We think Plains All American, which is rated market perform, is a core holding because it is involved in crude oil storage and transportation terminals, as well as natural gas storage. Investors will pay a little bit of a premium because it's high-quality management. The company has below-average distribution growth. We still believe the company will achieve 9%-10% total returns during the next year. It's definitely a sleep at night type of MLP.
TER: Their storage facility has a lot of room for expansion. It could apparently get up to 70 billion cubic feet (bcf.) Is that in the high range for these kinds of facilities?
JE: The facility has working natural gas capacity of 17 bcf. It's been permitted for 40 bcf. It can potentially be expanded up to 70 bcf. Yes, it's a pretty good size facility. No doubt about that.
TER: Gas processors were second only to MLP general partners in 2010 in total returns, according to your Jan. 4 Industry Notes. Gas processors averaged 63% total returns compared to coal and natural resources, which ranks third at about 41%. Why do gas processors do so well?
JE: Natural gas processors did extremely well. There are a lot of tailwinds that are in play in that market. From a commodity standpoint, natural gas processors benefit when oil prices relative to natural gas prices are high. The reason for that is natural gas liquids prices, which tend to be more tied to oil, have a very good profit margin in processing and associated fractionation of the liquids into the components.
A second factor is that there's real growth in natural gas shale plays that have a heavy concentration of liquids. There have been greater volumes. A lot of natural gas companies have been able to announce additional projects to take advantage of that since the producers need the gas processed and the liquids need a place to be transported to and fractionated.
TER: What are some gas processors that you believe could do well this year?
JE: We recently upgraded Mark West Energy Partners L.P. (NYSE:MWE). We think it has a very strong outlook. The company is investing a large percentage of its capital budget in the Marcellus Shale play. It's building out natural gas processing facilities, as well as fractionation facilities and adding some pipelines along the way. We think the company is going to do very well. We believe it will begin raising its distribution in 2011 as well.
JE: The main thesis here is that we view the MLP sector as fairly valued. We think investors will do better by going with those MLPs that are poised to grow faster. In our view, the companies with the fastest growth are going to be Energy Transfer Equity, L.P. (NYSE:ETE), El Paso Pipeline and Crosstex Energy.
El Paso Pipeline is a classic dropdown story. Its parent, El Paso Corporation (NYSE:EP), has about $12 billion of pipeline that it eventually would like to drop down into El Paso Pipeline. The company is motivated to do that because it wants to get investment-grade ready itself. We think there's a very visible source of growth opportunities for El Paso Pipeline.
We believe Energy Transfer Equity's underlying MLP, Energy Transfer Partners, L.P. (NYSE:ETP), will begin growing distribution in 2011. That would translate to low double-digit growth for Energy Transfer Equity since it's the general partner to ETP and will benefit because of the incentive distribution rights that go with that position.
ETP is one of the highest yielding investment-grade names out there. We think it will restart distribution growth this year. So, there could be a little bit of a re-pricing going on in that play. Albeit, it does face some headwinds given that it's not going to be able to take advantage of basis going forward like it did in the past.
Crosstex is more of a turnaround story. It just resumed distributions in the third quarter. We expect them to grow distributions at about a penny per unit, per quarter through 2011. That translates to about 15%. We also think it's undervalued when you look at it from an enterprise-value-to-EBITDA perspective relative to its gathering and processing peers.
TER: It's not an investment-grade name, however.
JE: It's not an investment-grade name, but we're still looking at probably 15% distribution growth. It's something that trades at a significantly lower enterprise value EBITDA multiple to its peers. It's trading in the sevens and its peers are trading at around 11. We think there's considerable latitude here for upside revaluation for Crosstex.
TER: Tell us about some investment-grade names that should remain solid if not lights-out performers in 2011.
JE: We don't envision any lights-out performers in 2011. As you know from our last interview, the easy money was made in 2009 and 2010. But there are investment-grade names that we think are very solid, including Enterprise Products Partners, L.P. (NYSE:EPD). The main thesis there is it has a solid position in the Eagle Ford Shale play. Plus, it has a huge backlog of investment opportunities for organic growth projects in the neighborhood of $7 billion over the next three years. We think it has very visible growth opportunities for some time. A lot of that opportunity is already priced in, but nonetheless, we view them as a core holding for MLP investors.
We also really like Magellan Midstream. We realize one of our competitors downgraded them today; however, we view them as a mid-single-digit distribution grower at about 6%. It has a rock-solid balance sheet. We think it's an airtight distribution story. We forecast about 11%-12% total returns for several years because of the distribution coverage. It will be able to get some growth out of some of its more recent transactions.
We also like Enbridge Energy Partners, L.P. (NYSE:EEP/EEQ). The company is targeting about 5% distribution growth. We think it's a low-risk platform. It's tied to oil transportation. The company has gotten a little more visible in terms of putting their goals and objectives out there. We think that's going to help that story going forward.
TER: Is there any overhang left from the pipeline leak incident last year?
JE: We actually upgraded the stock on that incident. There was a huge overreaction. It just so happened that the leak at that time occurred in the middle of the BP Plc (NYSE:BP; LSE:BP) fiasco in the Gulf of Mexico, so there was a huge selloff. At the time, it took off about $700 million of market value on an event that the company had considerable insurance for. The deductible was something like $40 million. The company has recaptured most of that. We believe that it will provide pretty predictable returns going forward. It has very modest risk and relatively low commodity risk. We like that story.
On the small-cap side, we like Genesis Energy, L.P. (NYSE.A:GEL) and we like Regency Energy Partners.
TER: Can you give us some parting thoughts on the MLP sector in 2011?
JE: The bottom line is that we are dealing with a sector that's fairly valued at this point. We like investors to focus on growth stories in the MLP sector. We think that means those stories where there's a high degree of visibility. We also think that the general partners are a good place to be in general.
We believe that the gas processors are a good place to be this year. Albeit, we don't view them as core holdings due to their commodity price risk. There have been excellent tailwinds in that subsector of the market. The gas processors could do quite well this year, but investors have to be a little bit more selective due to the higher level of risk. Overall, we think the outlook is good. We probably might lag a bit in the first half, but we think a defensive orientation headed in 2012 is going to be a good place to be.
TER: Thanks for sharing your insights, John.
John D. Edwards, CFA, joined Morgan Keegan in October 2006 as a vice president, covering energy infrastructure master limited partnerships. Prior to joining Morgan Keegan, Edwards was a managing partner of Vektor Investment Group, LLC, where he consulted on energy infrastructure projects and real estate development. Edwards also worked with Deutsche Bank Securities as a vice president and senior analyst covering natural gas pipelines and as an associate analyst covering automotive suppliers. Edwards began his career in the energy industry with Edison International where he worked in regulatory finance, M&A, project finance, and business development. He received his BA from Occidental College in Los Angeles, Calif., and an MBA from California State University, Fullerton. He is also a member of the Financial Analysts Society of Houston.
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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: Enbridge Energy Partners.
3.) John Edwards: 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.
As of the date of this report, Morgan Keegan & Co., Inc. makes a market in CPNO, NRGY, RGNC and XTEX.
Morgan Keegan & Co., Inc. has received compensation for investment banking services from EEP, ETP, GEL, PAA and RGNC in the past 12 months.
Morgan Keegan & Co., Inc. expects to receive or intends to seek compensation for investment banking services from ETE, ETP, GEL, PAA, RGNC and XTEX in the next 3 months.
Morgan Keegan & Co., Inc. managed or co-managed a public offering for EEP, ETP, GEL, PAA and RGNC in the past 12 months.
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