Landscape shifts for pipeline operators

For an industry that has a reputation for being safe and steady — and that has made predictability a central component of its pitch to investors — the US oil and gas pipelines sector has had an exciting couple of years. 

Kinder Morgan, the industry’s largest group, reconfigured its corporate structure radically in a $70bn deal in 2014, then cut its dividend 75 per cent last December. 

Energy Transfer Equity, another of the leaders in the sector, spent months pursuing its peer Williams, agreed a $38bn takeover in September last year, then quickly changed its mind and spent months trying to get out of the deal, finally succeeding in June after a court battle. 

While these events were playing out, the market valuations of companies in the sector plunged. Enterprise Products Partners, for example, dropped 50 per cent between September 2014 and February of this year. 

This year, valuations have been bouncing back. Kinder Morgan’s shares are up 69 per cent from their low point in January. 

The past two years, however, have highlighted some fundamental issues with the pipeline companies’ standard business model that remain largely the same as before the crash. The potential for future volatility, depending on oil and gas prices and interest rates, is still there. 

The traditional investment case for pipeline businesses presented them as analogous to toll road operators, charging production and trading companies to use their pipes. As a result, they face very little commodity price risk, it was argued, and can pay out a high proportion of their earnings in dividends. 

The appeal of those high dividends, particularly compelling at a time of low interest rates, was reinforced for many investors by the use of a tax advantaged structure called a Master Limited Partnership. 

The US shale oil and gas production boom of the past decade also created a need for additional pipeline infrastructure, meaning the pipeline operators could offer the prospect of growth as well as income. 

The crash in oil prices that began two years ago has punctured those assumptions. 

Matt Sallee, a portfolio manager at Tortoise Capital Advisors, a fund management company that specialises in energy and invests in pipeline MLPs, says the slump in pipeline companies’ shares was in part a result of generalist portfolio managers selling all energy stocks indiscriminately. 

He acknowledges, though, that there are reasons why pipeline operators are affected by oil and gas prices, including credit risk in their customers. Oil and gas production companies that have gone bankrupt have attempted to drop some of their pipeline contracts, and in one landmark case in New York succeeded. 

Some pipeline companies have other sources of commodity price exposure, such as processing plants that sell the natural gas liquids they collect. Kinder Morgan sells carbon dioxide, used to squeeze extra production out of oilfields, which has become less valuable as the crude price has fallen. 

Net income for 2015 fell 10 per cent at Enterprise Products Partners and 70 per cent at Kinder Morgan, while Williams went from a $2.1bn profit to a $571m loss. 

Those weak results have called attention to a longer-term problem: the rate at which pipeline companies have been distributing cash. 

Kevin Kaiser, an analyst at Hedgeye Risk Management who has been raising concerns about MLPs since before the crash, argues that it is a widespread issue across the sector: cash distributions are unsustainably high. 

“There is this misunderstanding around that these companies are great cash cows,” he says. “If you look into the numbers, they aren’t.” 

There is this misunderstanding around that these companies are great cash cows. If you look into the numbers, they aren’t

Many pipeline companies have capital spending that is higher than the cash they generate from operations. They have to sell shares and borrow money to finance their pay-outs. Energy Transfer Partners, for example, had capital spending of $9.1bn last year and paid out $3.7bn, but earned cash from operations of just $2.7bn. The gap was filled by share issues and borrowing. 

The equity issuance is typically linked to acquisitions that are expected to generate growth. As dealmaking for oil and gas assets overall has slowed since 2014, the US pipeline industry has remained active. 

Borrowings, too, are presented to investors as ways to finance growth. Launching two issues of senior notes to raise a total of $5.5bn last year, Energy Transfer Partners said that one of the purposes was “to fund growth capital expenditures”. 

If the companies are no longer growing, however, those justifications for increased debt and equity issuance become harder to maintain. Kinder Morgan’s dividend cut last year showed that expectations can be self-fulfilling. Investors’ fears that the dividend might be cut drove down the share price, which made raising equity financing more expensive, which meant the dividend had to be cut. 

High yields in the sector, including 6.8 per cent for Energy Transfer Equity and 10.4 per cent for Williams, suggest the market sees a significant risk that other companies will follow Kinder Morgan’s example. 

For now, the inflows of capital are still coming. US pipeline companies have raised $9bn from share sales so far in 2016, compared with $13.5bn in the whole of last year, according to Dealogic. Low interest rates continue to make the high-yielding shares and units look attractive to some investors. 

If they lose their access to financing, though, many companies would face difficulties maintaining their investment programmes, let alone paying their dividends. The supposedly staid pipeline industry could see yet more interesting times.