Michael Blum: Headwinds or Clear Sailing for
Source: Brian Sylvester of
The Energy Report
Noting that 2009 and 2010 provided an "extraordinary run" for
master limited partnerships (MLPs), Wells Fargo Senior Energy MLP
Analyst Michael Blum still sees plenty of potential, including
strong business fundamentals, distribution growth and attractive
yields. Learn what might take the wind out of an MLP's sails,
which sectors are positioned to run ahead of the wind and which
MLPs have set their sights on achieving investment-grade status
in this exclusive interview with
The Energy Report.
The Energy Report:
Michael, a recent Wells Fargo research report said that master
limited partnership valuations looked "full, relative to
historical valuations." Does that mean there's nowhere to go but
Hopefully, there's somewhere else to go. I think what the report
is trying to say is that MLPs look fairly valued, relative to
historical levels. Our outlook is for mid-single-digit total
return, maybe 6% to 8%. We think investors will continue to
receive an attractive yield, but that price performance is
probably going to be choppy for a while. I don't know if that's
necessarily a negative outlook.
On the face of it, relative to other investment alternatives,
if you can get a 6%-8% return, along with the tax advantages MLPs
afford, that's a pretty decent investment. It's not that MLPs are
necessarily going to go down or trade down, but we do think that
the upside in price is limited in the near term.
Is it fair to say that you expect MLPs to go sideways this year
after a relatively impressive 2010?
That's right. The last two years have been a pretty strong run.
In 2010, MLPs generated a total return above 30%; in 2009, they
were up over 50%. I think maybe we'll take a breather this
In that same report, you wrote about the two prevailing camps, in
terms of MLP performance in 2011. One camp believes a new
paradigm is being brought to bear that will revalue MLPs and
drive down yields. You are in the other camp, which believes MLPs
are just going through another cycle, that they are fairly valued
and yields will grow slightly. What explains the different
positions and why do you believe you're right?
There's always been an argument that MLPs, on a risk-adjusted
basis, are mispriced. That's because, relative to their
underlying fundamentals, one could argue that the yield is too
high considering the growth rate. As an example, if you compare
MLPs to real estate investment trusts (REITs)-another yield
product-REITs typically have lower yields. But they also have
lower growth rates in their dividends. Arguably, the fundamentals
are less attractive than the MLP business model. Why shouldn't an
MLP yield less than a REIT, given that it has higher growth
trajectory with better business fundamentals?
The other side of that argument is that MLPs trade at some
discount to their intrinsic value because there are tax,
liquidity and administrative burdens to owning MLPs. The pool of
capital that can own MLPs is more limited because some investors
can't or don't want to deal with the tax issues associated with
owning them. In addition, it's still a relatively small group.
The market cap is right around $200 billion. That's relatively
small in the grand scheme of things. Liquidity for MLPs is not
that great. And some funds won't invest in the sector, simply
from a liquidity standpoint. I think those two factors will limit
how much capital can ultimately flow to the group. That's why I
think MLPs will continue to trade at healthy valuations, but
perhaps not tighter than REITs.
A chart in a recent Wells Fargo report showed Merrill Lynch
high-yield, investment-grade bonds yielding 7.2%, whereas the
Wells Fargo Securities MLP Index yielded only 6.1%. How do you
convince an investor seeking yield securities to choose your
I think there are several reasons that an MLP investment could be
more attractive than a high-yield bond. First, from a tax
perspective, about 80% of the distributions received will be tax
deferred until the security is sold. So, relative to the income
received from a high-yield bond, more of that investment will go
into the investor's pocket on after-tax basis as an MLP.
Secondly, because MLPs are equities, there is upside in the
price. An investor may or may not have that with a bond,
especially if it is held until maturity. Lastly, the distribution
can grow with an MLP, but it is a fixed rate with a bond. We're
forecasting about 5% medium distribution growth for the MLP
sector in 2011 and the next three years. In addition to the
current yield, there is growth in that distribution rate.
So, in addition to price upside there is also price downside.
That's correct. It's an equity so the price can go up and down,
but the same is true of a bond. High-yield bonds now are trading
at spreads to the Treasury that are much tighter than the
historical rates. So, you have the same risks as with high-yield
bonds-interest rates go up or high-yield credit spreads
In a January 7, 2011 research report, you wrote: "We would
continue to own MLPs but would wait for dips before adding
positions." How far off are those dips?
It's really hard to predict dips. If there was a good way to
predict them, we'd all do it. There are always unforeseen events.
You could have a large seller that decides to be in the market
and puts pressure on the price. You could have a confluence of
secondary equity offerings in a short time span that could create
an oversupply or a situation where equity supply is greater than
demand. That could create a pullback in the stock. You could have
an exogenous event; for example, when Greece had sovereign credit
issues last summer. That impacted credit markets and spreads, as
well as MLPs, on a short-term basis. There's a whole host of
factors that could create these dips.
The reason we recommended continuing to own MLPs and to look
for dips is that the underlying fundamentals for MLPs are quite
good right now. Regardless of the macro factors that could push
valuations up and down in the short term, we still think the MLP
sector is very attractive on a long-term basis.
MLPs depend heavily on lines of credit to borrow money for
business expansion. The consensus is that interest rates are set
to rise somewhat, which would increase the cost of capital for
MLPs. Please tell us about that and some other potential
headwinds that MLPs could be sailing into this year.
Because MLPs pay out the majority of their cash flow every
quarter, they do rely on access to capital markets. Because they
invest significantly, either to acquire assets or to build new
assets, they do have to access the debt and equity markets
MLPs also are sensitive to interest rates, though not as much
as one would imagine. The correlation between interest rates and
MLP price performance is only about 0.4. When there is a sudden
spike in interest rates or an unexpected increase in interest
rates outside of consensus, MLPs will underperform much like
other yield- or spread-based securities. That's certainly a risk.
I think a steadily rising interest rate environment will be
manageable for MLPs. Those that can grow their distributions more
quickly will probably better offset some of the increases in
interest rates. For MLPs with limited or no growth in their
distributions, you'd expect to see some erosion in price
performance as interest rates rise.
Commodity price is another big risk. Oil is now over
$90/barrel. To the extent that a number of MLPs have direct or
indirect exposure to oil or natural gas liquids (NGLs), which are
highly correlated to crude oil prices, a pullback in commodity
prices would impact the cash flow. Right now, the correlation
between MLP prices and crude oil prices is north of 0.7-the
highest correlation of any product or commodity. Certainly that
would be another potential headwind for the sector.
MLP general partners (GPs) and gas processors were the
best-performing subsectors in 2010. Are those subsectors likely
to continue to perform in 2011? What other subsectors do you
expect will do well?
I'm not sure the gathering and processing subsector as a whole
will outperform. I do think the gathering and processing MLPs
that either have good exposure to shale-play development or very
high growth rates will probably perform well. We're thinking
about the group more thematically. We think you want to own the
higher-growth names, and then own the names that have exposure to
crude oil and NGLs as opposed to natural gas. That's because
those subsectors have a lot of growth around them. Commodity
prices are strong. The fundamentals are very good.
In terms of the general partners, I do think you could
continue to see outperformance. There were six transactions this
year in which an MLP acquired and eliminated a GP. That means
there are now roughly half as many publicly traded GPs as there
were a year ago. From a scarcity-value perspective, investors who
want exposure to the GP asset class have a lot fewer choices. I
think you could continue to see those move higher just from a
What are some of those higher-growth names you mentioned?
I would highlight
El Paso Pipeline Partners, L.P. (
, the pipeline MLP for
El Paso Corporation (
, which has been selling pipeline assets into the MLP and will
continue to do so as they fund development of its E&P
business and other resources that it needs at the parent level.
We are forecasting +10% growth per year for the next four or five
years at El Paso Pipeline Partners. In 2010, the company grew the
distribution 19% and sold assets to the MLP worth $2.1 billion.
There's a steady visible growth rate there.
The yield for El Paso Pipeline Partners was 4.9% in 2010 and
distributions were $1.64. What are your 2011 projections for El
We're forecasting a distribution rate of $1.89 and a yield of
5.3% for 2011.
So, there is a little bit of growth on that one.
Yes. The second name I would highlight is a stock we initiated
Targa Resources Corp. (
. This is the general partner of
Targa Resources Partners, L.P. (
. Due to where it is in its incentive distribution rights (IDRs),
the growth rate at the GP is roughly three times that of the
underlying MLP. We're forecasting a three-year distribution
growth target of about 23%. That robust growth comes from the
underlying MLP, Targa Resources Partners. We're forecasting about
a 7%, three-year compounded annual growth rate at the MLP level.
That's driven by organic expansions of the natural gas liquids
infrastructure. Targa is very well positioned in that business.
The partnership has a large footprint in the Gulf Coast. As
assets are being built to accommodate growing liquids production
and demand, we think Targa will be able to grow the distribution
at a pretty nice clip. That translates into a roughly 3:1 ratio
of growth to the GP.
You just published your top picks for 2011. What are some of
We've already talked about El Paso Pipeline Partners. I would
Enterprise Products Partners, L.P. (
. Enterprise is involved in the same market as Targa, the NGLs,
natural gas pipeline and fractionation and infrastructure
markets. The company has a market-leading position in NGL
logistics. Based on those same trends in the NGL market, there is
growth in liquids production, as well as growing demand for
liquids from the petrochemical industry. Enterprise is building
its asset base to handle that growing supply and demand. We think
you could see distributions grow about 6% per year for the next
several years with a yield of about 5.5%. Enterprise is also one
of the most liquid names in the sector.
Last year, Enterprise's distributions were $2.33 and the yield
was 5.6%. You're saying it's going to be about 5.5%. And what's
the distribution going to be?
We're looking for $2.45 for 2011.
You said Enterprise's distributions were going to grow. What are
the catalysts for that growth?
The catalysts really are the organic growth projects. As an
example, fractionation capacity is very tight right now because
NGL supply is up, and you need to fractionate the NGLs to get
them to market. Enterprise has a dominant position at Mont
Belvieu, Texas, which is the hub for NGL fractionation. As a
result of all this pent-up demand, the company is building three
new fractionation facilities in Mont Belvieu. Because there's
such demand, it's been able to increase its rates by almost
double what they have been historically. In addition, what used
to be a spot business is turning into a long-term contract
business. Shippers are now contracting for long-term agreements
to reserve space in the fractionator. That affords Enterprise a
long-term, fee-based cash flow stream.
What are some other top picks?
The other one I would highlight is
Exterran Partners, L.P. (EXLP)
. This one's a little different; it owns compression assets. The
general partner is
Exterran Holdings Inc. (EXH)
. The story here is that utilization of compression has
stabilized and is starting to improve. On top of that, the parent
company will be selling assets into the MLP over time to support
growth. We think this will create very stable distribution and
growth. Our three-year distribution prediction is 6.6%. The stock
has a pretty healthy yield of 6.8%. This is a name that hasn't
run as much as others but has pretty good underlying fundamentals
and should do well over time.
My MLP chart shows a total return of 12.7% from early November to
the end of December 2010. That's quite phenomenal; such a return
would have outperformed just about anything on the market,
certainly in this type of investment. Are there any
non-investment-grade MLPs poised to become investment-grade names
That's a great question. I don't know if there are any for 2011,
but there are a couple of MLPs that have the potential to get
there by 2012. One is
Regency Energy Partners, L.P. (RGNC)
. Its stated goal is to achieve an investment-grade credit
rating. The company's been transforming its business by adding
pipeline and fee-based cash flows, to the extent that almost 80%
of its cash flow will come from fee-based activities, and only
20% from commodity-price exposure. As it grows and achieves
critical mass, you could see Regency Energy Partners achieve an
investment-grade credit rating by 2012.
Similarly, as Targa Resources Partners grows its business to
achieve critical size and to add fee-based cash flow, as well as
organic growth projects, you could see it hit investment grade in
a couple of years.
Any parting thoughts on the MLP sector as of mid-January
It's been an extraordinary run. Certainly, the MLP asset class
has a higher profile than it probably ever has. You see articles
The Wall Street Journal,
there are MLP ETFs, etc. A lot of new funds have been created to
own MLPs. So, we still think there should be place in an
investor's portfolio for MLPs. Even after the strong run, they
still offer a pretty attractive yield. MLPs have good, solid
underlying business fundamentals, so we think the future is still
very bright for the MLP sector.
Michael, thank you for your time.
Michael J. Blum is a managing director and senior analyst at
Wells Fargo Securities
covering energy master limited partnerships. He began his Wall
Street career in 2000 at First Albany Corp. as an associate
analyst covering alternative energy securities, and joined Wells
Fargo in 2001. Since 2003, he has been following MLPs and
integrated natural gas securities at Wells Fargo. Before joining
the sell side, he spent a year as the investor relations manager
for a publicly traded Internet startup during the dot-com boom.
Michael has been recognized twice as a
Wall Street Journal
"Best on the Street" winner, ranking in two categories in
2010: No. 3 for the oil and gas producers sector and No. 5 for
oil equipment, service and distribution. He also ranked No. 4 for
oil equipment, services and distribution in 2007. In 2010,
Michael was ranked the No. 1 MLP analyst in the Greenwich
Associates survey of institutional investors. In 2009, he was
named the No. 1 oil and gas pipelines analyst by
and was ranked as the No. 3 analyst for the master limited
partnership sector in a survey conducted by
Michael graduated magna cum laude from the University of
Pennsylvania with a BA in English literature and a minor in
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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:
2) The following companies mentioned in the interview are
The Energy Report:
3) Michael Blum: 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.
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