Capital One Securities is extending its research coverage to the MLP/Energy – Midstream sector, the firm announced in a December 4, 2014 note. Coverage was initiated on ten companies in the MLP / Energy-Midstream sphere, with six receiving an “Outperform” rating.
MLPs and the Dynamic Market
Capital One began its note detailing the current energy environment in the current sub-$70 per barrel world – a world that has seen the S&P 500 Energy Index drop by 10.4% since the beginning of October. The note asks: “Where is a safe haven in this market? Risk aversion is a key investment theme headed into ’15, and as it relates to the energy midstream space, not all MLPs are created equal.” The firm acknowledges no MLP has full immunity from a general energy pull back, but a handful of positive assets, particularly project backlog and a strong balance sheet, are foundations of a strong MLP entity.
“In this type of market, a middle of the fairway midstream MLP we favor will have 75% or more of their margin based on long term, fee-based contracts where they don’t have general direct commodity exposure,” said Charles Marshall, Vice President of MLP Equity Research for Capital One Securities, in an exclusive interview with Oil & Gas 360®.
That includes industry giants like Plains All American Pipelines (ticker: PAA) and Enterprise Products Partners (ticker: EPD). Both companies have a structure with fixed margins and are roughly 80% fee-based, resulting in minimal on cash flows.
“EPD and PAA, given their large and flexible asset base, strong balance sheets, geographic diversity, financial discipline and seasoned management teams, are well suited in this dynamic market,” said Marshall. “These names are a solid investment, especially if you’re risk adverse.”
Exposure to Commodity Price Swings
Capital One’s coverage will concentrate on four midstream MLP subsectors, including diversified/large cap; products and crude; gathering, processing and compression; and general partners. Of the four, the gathering, processing and compression segment is most exposed to commodity volatility, Marshall says. Targa Resources Partners (ticker: NGLS), for example, on a pro-forma basis (assuming it completes the Atlas acquisition), is generally more at-risk because of its 60% fee-based margin, leaving the remaining 40% (percent of proceeds) open to price swings that can be partially offset by hedges.
EPD and PAA also have certain exposure through its processing and marketing businesses, but the contracts and hedges in place allow most of the larger companies to be shielded from a volatile environment. The marketing arm can even capture additional value through arbitrage, contributing to the outperformance we’ve seen from the sector in recent years.
MLPs in the New Oil Market
Despite the “crude oil trench warfare,” as Capital One describes in the note, MLPs stocks generally carry less risk than the share prices of E&Ps. The majority of MLPs consist of pipelines and infrastructure – a business that has generated tremendous project backlog at the request of shale producers. Most E&Ps are taking a conservative approach to 2015 operations, but several industry analysts don’t expect the Saudi price cuts to last through the entire year. Even if the Saudis are in for the long haul, Marshall’s long-term thesis on North American infrastructure and midstream MLPs remains intact
“You’ll see some potential pullback, but that’s not a bad thing,” he said. “If production curtails, it will just elongate North American production growth. The production profile doesn’t need to ramp up through 2018 similar to what we saw between 2009 and 2013. I view this favorably, particularly with the MLP companies. So if we elongate the North American growth curve it will be a net positive for MLPs because it will just extend its growth profile.”
An extension of that growth profile would involve opening the gates for crude exports, a topic that Marshall believes will garner a lot of attention with Republicans now in control of the House and Congress. He proposes a simple barrel for barrel swap with Mexico, providing our southern neighbors with light crude in exchange for heavy crude – the grade used in most U.S. based refineries. “That seems like a good solution to help relieve the light crude supply glut, but the market can’t balance itself without removing such government restrictions,” he said.
The Future of MLPs
The budgets of energy companies have certainly tightened in the crude oil standoff, and MLPs are no exception. Marshall doesn’t expect to see a general pullback on capital expenditures in 2015. Curtailment may hit in 2016, however, and be subsequently offset by consolidation in the industry.
“You’ll see certain MLPs getting squeezed in this environment but that is generally positive for those that were patient,” said Marshall. “PAA and EPD have been pretty smart in a chess match game where they’re competing on the same deals but weren’t willing to open up the wallet and pay the high acquisition multiples. Why buy it when you have a low cost of capital and can build it for cheaper?”
Capital One says it expects future market consolidation to be a key theme, and the patient buyers are in an opportunity to take full advantage of the mergers and acquisitions field. “I wouldn’t be surprised to see Kinder Morgan (ticker: KMI), considering their re-organization and cheaper cost of capital, really flexing its wallet in 2015 and scoop up an MLP or C Corp company,” Marshall predicted.
The Market’s Learning Curve
Due to the association with the oil and gas sector, MLPs have similarly felt the shockwaves of recent market volatility. The Alerian MLP Index swung down sharply in the beginning of October (12%, to be exact), then largely recovered. The index then dropped another 6% with the latest OPEC announcement. This comes even though most MLPs already have long-term contracts in place and are actually forecasting an uptick in capital spending in 2015.
Has the market simply overreacted?
“Absolutely,” said Marshall. “Obviously, tied to energy, it’s hard to not feel the pullback that the entire sector has experienced in the last few months. With that being said, there’s less direct commodity exposure at the MLP level. So has it been overdone? Yes I believe so.”
He explains the asset class, although relatively new, is maturing in nature and has lured more institutional investors to the marketplace. The MLP market has also expanded at a very rapid rate and covers segments outside of the general midstream sector. “There are now upstream, downstream, oil services, LNG, propane, marine transport, coal, and even other non-typical MLPs looking joining the market such as paper stocks,” said Marshall. “I believe it’s just a lack of understanding of the MLP sector from an investor standpoint, which has led to some confusion and overreaction. Maybe that’s something the industry in general just needs to keep educating investors.”
“From a total returns perspective, MLPs as an asset class has historically outperformed the S&P 500, REITS, high yield bonds and the overall commodities. I still think they are a good investment. They’re getting dinged right now just given the sector they’re in but the longer term outlook remains intact and remains a solid investment.”
Capital One Disclosures
Enterprise Products Partners Risk
Our target price is derived via a combination of: (1) our three-stage distribution discount model; (2) an EV/EBITDA multiple on our 2015 EBITDA estimate; (3) a P/DCF multiple on our 2015 DCF estimate; and (4) our forward 12-month target yield. Risks that may impede achievement of our price target include: rising interest rates, potential losses from hedging activities, the level of indebtedness, integration of acquisitions, raising costs of capital to fund acquisitions/organic growth projects, and changes to US tax policy.
Targa Resources Partners LP Risk
|Our target price is derived via a combination of: (1) our three-stage distribution discount model; (2) an EV/EBITDA multiple on our 2015 EBITDA estimate; (3) a P/DCF multiple on our 2015 DCF estimate; and (4) our forward 12-month target yield. Risks that may impede achievement of our price target include: ability to access debt and equity markets, changing commodity prices, weather and other natural phenomena, industry changes, integration of acquisitions, general economic and business conditions, and level of indebtedness.|
Investment Ratings: Capital One Securities, Inc., uses three investment ratings: Overweight, Equalweight, and Underweight. These ratings represent a time frame of twelve months.
Overweight: The stock’s total return is expected to outperform the relevant benchmark over the next 12 months.
Equalweight: The stock’s total return is expected to perform in line with the relevant benchmark over the next 12 months.
Underweight: The stock’s total return is expected to underperform the relevant benchmark over the next 12 months.
Relevant benchmarks: E&P: SIG Oil Exploration & Production Index (EPX). Oilfield Services: Market Vectors Oil Services ETF (OIH). Midstream: Alerian MLP Index (AMZ). REITs: MSCI US REIT Index (RMZ).
Before January 10th, 2014, Capital One Securities, Inc, used four ratings: Strong Buy, Add, Neutral, and Reduce. These were defined as follows:
Strong Buy represented stocks deemed to have the potential to achieve a minimum of 15% upside to the current price in the next twelve months, with more timely price appreciation due to catalysts and/or compelling valuation.
Add represented stocks deemed to have the potential to achieve a minimum 15% upside to the current price in the next twelve months or stocks deemed to have more moderate potential with a low risk level.
Neutral represented stocks deemed to have a greater amount of risk, less timely price appreciation potential, and/or near-term adverse macro conditions that could keep them from reaching full valuation.
Reduce represented stocks deemed to have the potential for a negative return.
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