Energy Sector Exposure – Dewitt Capital Management Blog

Daves Thoughts of the Week

With the tremendous sell off in MLPs over the last 18 months, one would expect that many of them would have cut their distribution payouts. In that case, fundamental performance would be more aligned with stock performance. However, the opposite is actually true. A little under half of midstream MLPs have announced increased distributions. One midstream MLP suspended its distribution, while another cut theirs by 25%. Meanwhile, a little over 50% of MLPs have kept distributions even with the previous quarter’s. Both of those MLPs had poor financial metrics. The ability of an MLP to maintain or increase its distribution is dependent on its debt level and its coverage ratio.

The coverage ratio is the amount of cash which could be distributed divided by what actually is distributed. The debt is usually measured by debt to EBITDA – the lower the better. In today’s environment, when MLP unit prices are at multi-year lows, the prospect of selling units to finance growth is generally unacceptable. MLP unit prices have followed the price of oil and many MLPs are priced irrationally. We are focused on discovering and investing in MLPs that are undervalued and will continue to pay strong and growing tax deferred distributions for the long run.

Has the market for MLPs provided us with a good entry point?

Now may be a great time to invest in MLPs. These partnerships provide superior yields, have a strong track record of increasing distributions and are poised for continued growth in income.

Historically, these partnerships have generally provided an average yield 2.5 percent higher than that of 10-year Treasury. Today, this gap is even higher, nearing 4 percent, as MLPs offer an average yield of roughly 6 percent. This differential could grow wider, as MLPs should increase their distributions by an average of 6 percent every year.

The entire MLP industry could soon receive a boon, as a Manhattan Institute whitepaper revealed that producers will soon by using big data to determine exactly where to drill, how far down to drill and when to leverage fracking.

The paper referred to this innovative use of information as Shale 2.0, and predicted that the method could double the production of a well when compared to Shale 1.0. Because of this breakthrough in output, areas that have projects with little infrastructure will see their demand for investment continue to rise.

As market participants sink more money into infrastructure, the number of MLPs will likely increase, and existing partnerships will probably expand. In addition, any such trend could help fuel consolidation within the sector.

If the industry experiences growth, MLP investors can expect it to produce rising income. While this potential outcome makes now a good time to buy MLPs in and of itself, investors should also keep in mind that now is a great time to buy because oil prices are historically low.

When this energy source falls in price, it is always a good time to purchase these partnerships. By perusing historical data, investors can observe that when oil prices fall, the Alerian MLP index declines as well, but not as much.

Then, after this initial pullback, the index will recover, because MLPs are transportation systems and get paid a fee for transporting energy sources. Even though these partnerships will see their prices take a hit when oil values fall, they will generate revenue on an ongoing basis as they move energy from point A to point B.

To give an example of how MLPs have held up even as oil prices failed to surge, let’s take a quick look at the period between June 2005 and June 2015. On June 30, 2005, WTI crude traded at $56.50 per barrel, and on June 3, 2015, it had a value of $59.62 a barrel.

As a result, the contract rose roughly 5 percent during that time, while the Alerian index has increased approximately 60 percent. After adjusting for compounded distributions, the total return is 222.1 percent.

While these returns may seem compelling, we at DeWitt are only interested in selecting the best MLPs for our clients, instead of merely taking a passive approach and investing in the Alerian MLP index. Because of this approach, we can potentially generate stronger results than the index, while still ensuring investors have all the tax benefits associated with direct ownership of these partnerships.

Dave’s Thoughts of the Week – Week of May 18, 2015

Before the start of trading on May 13, The Williams Companies, Inc. (NYSE: WMB) announced it would buy its limited partnership, Williams Partners L.P., which trades under the ticker WPZ. Shortly after this announcement, WPZ opened 20 percent higher and WMB opened up 5 percent. This did not surprise us, as we think it is part of a larger trend that we can expect to see grow in the coming months.

The Williams Companies’ recent purchase is an example of general partners consolidating LPs. By doing so, GPs can have one entity instead of two, a situation which creates many cost reductions, improved capital efficiencies and greater ability to make acquisitions. Once a GP completes the process of buying its LP, it will look to acquire other MLPs that fit its structure and growth objectives.

You can expect this consolidation to affect energy transportation needs. The U.S. previously imported oil and natural gas from other nations, which created the need for pipelines going from the shores into the country. However, the nation has shifted to producing its own energy and spreading it out, which has fueled a need for domestic infrastructure. MLPs provide these pipelines, and sometimes the quickest way for a firm to obtain the required infrastructure is to buy an MLP in the area where it wants to grow and then build that partnership up.

Basically, what we are seeing is that the GP buys an LP – which creates a larger entity – and then the next stage involves larger MLPs buying smaller ones.

During our investment selection process, we are looking for smaller MLPs that would be a good fit for the larger players – such as Kinder Morgan and The Williams Companies. More specifically, we are seeking smaller MLPs that hold strong growth potential and exist in areas where the more sizeable partnerships want to expand.

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