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MLP Risks: What is the Market Thinking?

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Each day, current and prospective MLP investors are faced with a  highly volatile market which is impacted by both fundamental and technical factors.  The technical factors of tax loss selling, fund redemptions and margin sales, are no doubt in play given the recent performance of the asset class, and the number of new investors who have purchased MLP products over the past 24 months.  Fundamental factors, such as 2016 DCF levels and the impact of an expanding set of E&P companies entering the bankruptcy process, provides the market with a range of potential outcomes, each of which may be unique to an MLP's location, assets, and contract structures.   In this article, we will outline the macro risks, and the implied market expectations of how these risks will impact 2016.

 

Energy Producers are beginning to experience the pain from their higher priced hedges expiring, a declining spot market, and scarce capital available to maintain or expand drilling programs. Add to that the potential for credit downgrades as Moody's has put the following 27 IG companies on review, which will be completed in the next several months:

 

 

Canadian:  Encana, Canadian Oil Sands, Baytex, Canadian National Resources, Cenovus Energy, Husky Energy, Suncor

 

US:  Anadarko, Antero, Apache, Denbury Resources, EP Energy, EQT Corp, Hess, Hunt Oil, Kerr-McGee, National Fuel Gas, Occidental, Pioneer Natural Resources, SM Energy, Union Pacific Resources Group, Unit Corp, WPX Energy, Concho Energy, Cimarex Energy, ConocoPhillips, Energen, EOG Resources, Kodiak Oil and Gas, Marathon Oil, Murphy Oil, Newfield Exploration, Noble Energy, QEP Resources, Range Resources, Southwest Energy

 

 

Although only four of these companies have spun out Midstream MLPs, virtually all of them are counterparties to MLP midstream agreements, which means that they may have to reduce spending in order to maintain their investment grade status, which will impact future volumes and commitments.  Banks with energy loans have been less aggressive with their E&P counterparties by way of the semi annual redeterminations and price deck updates.  According to a September survey from Haynes & Boone prior to the Fall redeterminations, producers expected a 39% reduction in their borrowing capacity, but public producers have reported only a 9% reduction so far, according to Enercom.  According to a recent WSJ story, as of November, the amount of loans now classified as "substandard, doubtful or loss", has increased from $6.9B to $34.2B over the past year.  The banks are in a position to call collateral, where the public credit markets will just restrict access to additional public debt.  Given the data, there is a wide spectrum of outcomes if energy prices do not improve, and a lower for longer outlook suggests a When not If scenario for reduced capital leading to lower production.   Although 2015 DCF has held up, it is the future expectations that has crushed units over the past 12 months, so lets now dive deeper into how these conditions may impact midstream Distributable Cash Flows and their ability to maintain and grow their distributions:

 

 

Midstream Contracts Re-negotiations and Cancellations:  This is the area of greatest speculation given the potential for significant cash constraints placed upon producers in 2016.  The location of the assets along with the specific terms of the contracts, which are closely guarded by midstream operators, are what leads to a high level of uncertainty as to what may transpire. In an recent and insightful interview conducted by Deutsche Bank's Kristina Kazarian with J.P Hanson, MD of Houlihan Lokey's Financial Restructuring Group, Hanson outlined the steps related to midstream agreement where the counter party has declared bankruptcy.   The first point to note is that any impact from an E&P bankruptcy will take several months, or longer, to show up in midstream DCF, due to the length of the process.  Such a delay provides MLP management teams with cover to delay any change to guidance or distributions, until the final impact is known.  Hanson highlighted the bankruptcy case of Quicksilver, which had long haul transportation agreement with EnLink and Targa, where midstream contracts were rejected.  Hanson further explains that each type of service will determine how it will be handled in bankruptcy.  A Gathering, Processing and Transmission agreement will be a critical service necessary for the producer to earn revenues, but a long haul pipeline agreement could be canceled, or more easily renegotiated, if alternative routes are available.  In the case of Quicksilver Resources, an E&P which declared bankruptcy in March, Crestwood provides GPT services, which are in the process of being renegotiated, according to Hanson.  Midstream providers may not be able to accommodate all of the requested re-negotiations, so it is likely that the initial contracts that they do modify may be the most significant and do not suggest that other producers will be able to realize the same terms.

 

 

Significant Reductions in Volumes:  The market has been fixated on rig counts as the proxy for future production, but the increasing efficiency and the high number of Drilled but Uncompleted Wells, has made forecasting perilous for most who have offered specific numbers.  While the EIA has a lagging process to provide actual and estimated production data, the market still relies on their metrics to gauge market fundamentals.  If you were to consider only the EIA data as the proxy for 2016 production, the January crude numbers do not look that scary, with January only a 2.3% drop from December production.   The EIA has forecasted that US production will average 8.8MM bpd in 2016, vs 9.3MM realized in 2015, although others have forecasted 8.2MM - 8.4MM with the current price deck.  If we assume all of this EIA forecasted reduction will be in the below basins, production will decline by 10% across the board, with Bakken and Eagle Ford realizing the greatest declines.  However, North Dakota's Mineral Resources Department does not expect Bakken production to fall below 1MM bpd, suggesting that Shale volume declines could be less than 10%.  What neither estimate properly forecasts is the capital constraints that some producers may face, which may impact operations, regardless of historical productivity figures.

 


 

 

 

E&P Bankruptcy:  Clearly, public E&P bankruptcy announcements are increasing with more to follow, impacting investor sentiment.  The filing itself is a concern, but whether the company is reorganized, and with what modified contract terms, is what is of most importance to midstream MLP's.  The majority of units provide a summary of their counter party credit ratings, which gives investor a starting point to assess risk.  However, the pain of contract re-negotiations can be applied even by producers who have not yet fallen into bankruptcy, as indicated by the recent Chesapeake re-negotiation with Williams Partners.  Below is the list of companies which have filed to date, several of which are public companies.  Regardless of how the bankruptcies are handled, an increasing rate will further impact sentiment, for which the impact of any such changes will lag several months, or longer, before they are reported.

 

 


 

 

 

 MLP Management Comments:  Management teams are in a tough position, as they are trying to monitor and assess the impact of the above factors, and provide proper guidance for 2016.  Since Kinder Morgan's about face on their dividend policy, which was not based on any significant change to the cash flows, nonetheless, the market has discounted any statements from MLP management regarding current or future distribution policies.  The following are a few recent management comments intended to increase unitholder confidence: 

 

NGL Energy Partners:  On 12/11, the company released a statement that they are not "contemplating" a distribution cut in 2016, and expect 1.2x - 1.4x coverage in 2017, and will not need to issue public units to fund their $350-$400MM growth capex.  NGL is down -11% since the announcement will a yield of 29.73%.  So you can receive 60% of your principal in distributions by 2017 if management is correct with their outlook.

 

Plains All American:  On 12/8, the company released a presentation deck which stated that no 2016 distribution reduction is forecasted, given their 2016 capital needs and positive fundamental outlook for 2017.  PAA is up 3.8% since the presentation

 

 

In summary, we have a market trading on the belief that lower for longer energy prices will have a significant impact on midstream volumes across all MLP's, and we have MLP management teams, and fund sponsors, pointing out their EBITDA and DCF strength over the past 12 months, and the inventory of new demand projects to be delivered over the next 12-18 months. What we should recognize is that the last 12 months should not relied upon for performance going forward, simply because the variables are very different, and the predictive models are unproven.  

 

So how should MLP investors make decisions going forward?  The first thing is to make sure you fully understand the assets, DCF coverage ratios, leverage, sponsor, cash flows, credit rating and 2016 growth capital expenditures for each unit that you own.  For those who own funds, review the top 10 holdings using the same criteria, and make sure you are comfortable that the fund manager is earning their fee's by avoiding any units which may announce a distribution cut.  Large MLP Fund managers are in a tough spot as there are only so many large cap units to deploy capital with sufficient liquidity, and that safety list of units is getting smaller.   MLPData will be updating the metrics and tables in this report to keep our subscribers up to date.

 

 

 

 

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