As I noted in
Reaching for Yields with MLPs
, few investments are better than a master limited partnership ((
)) with a long history of consistently boosting its distributions
to unitholders. Steady Eddies such as Enterprise Products Partners
) have generated enormous wealth for unitholders over the long
But older MLPs don't necessarily offer the best distribution
growth potential. In many cases, MLPs grow distributions at the
fastest rate in their first two years as public companies. And
there's nothing like rapid growth in distributions to drive strong
price appreciation and total returns.
For example, in Williams Partners LP's (
) first two years as a public company, the firm boosted its
quarterly payout from $0.35 to $0.575, thanks to a series of asset
drop-downs from its general partner, Williams Companies (
). These deals helped the stock soar 80 percent from the close on
its first full day of trading.
Sunoco Logistics Partners LP (
) enjoyed a similar pop. The refined-products pipeline giant
increased its payout 23 percent in its first eight quarters as a
public company, and the stock soared 100 percent. It pays to keep a
close eye on initial public offerings ((IPO)).
Because distribution growth attracts investors, most MLPs are set
up to generate rapid growth in their early years. Of course, not
all MLP IPOs are winners: The investment landscape is littered with
the wreckage of small MLPs that never managed to establish a
sustainable business model or reach critical mass. Others expanded
too quickly and took on too much leverage and commodity risk; many
of the worst offenders got crushed during the 2007-09 bear
As with any MLP, the key is to look at the underlying business
and the likely growth avenues. Here's a look at the prospects for
one of biggest MLP IPOs in 2010.
Chesapeake Midstream Partners LP (
) was the most anticipated MLP IPO in recent memory, primarily
because the MLP's general partner ((GP)), Chesapeake Energy Corp (
), is one of the largest independent exploration and production
(E&P) firms operating in U.S. unconventional natural gas and
oil fields. CEO Aubrey McClendon has talked about taking a
midstream gas MLP public for years, so investors have awaited this
IPO for some time.
The 2008-09 financial crisis temporarily shelved plans for an IPO
of Chesapeake Energy's midstream division, but improved credit
conditions and solid demand for MLPs prompted the company to file
its first registration statement for Chesapeake Midstream in
McClendon and his team appear to have picked an opportune time
for the IPO; the units commanded prices at the top end of the
projected range, suggesting strong demand from institutional
investors. And since the IPO at $21, the units have climbed to $25,
indicating that the secondary market is also interested in the new
Fundamentals support the market's enthusiastic reception of
Chesapeake Midstream; the new IPO offers lower-than-average
business risk and superior growth potential.
A Strong, Growth-Oriented GP
The GP manages the day-to-day operations of an MLP's assets and
makes key decisions on acquisitions and organic expansion projects.
Investing in an MLP whose GP doesn't have unitholders' best
interests in mind often entails its fair share of pain. Fees paid
to the GP called incentive distribution rights ((IDR)) underscore
point: High IDRs can make it tougher for the MLP to raise capital
for future growth prospects. (I discuss GPs and IDRs at length in
Strong Parents Make Healthy MLPs
Here are a few questions to ask when evaluating an MLP's GP.
Is the GP wholly owned by a private-equity
Private-equity firms often hold GP assets for a relatively
short time and may look to sell at an opportune time.
Is the GP an operating company with assets suitable for
In drop-down deals the GP sells assets such as pipelines or
gas-processing facilities directly to the MLP. Drop-downs are
usually highly accretive to cash flow and allow the MLP to
immediately boost its distribution payouts.
What is the IDR structure and in which tier is the
As noted earlier, IDRs are a fee paid by the limited partners
((LP)) in an MLP (for the most part, that's us) to the GP. IDRs
are usually related to the size of the distributions paid to LP
unitholders; the GP's take typically rises as distributions
increase. Such a structure incentivizes the GP to grow the
business, but high IDR payments early in an MLP's life can
stunt its growth.
What is the GP's ownership stake in the MLP?
GPs often own a significant proportion of the MLP's limited
partnership interests when the MLP is first listed. Over time,
the GP usually sells off its LP stake to raise capital. That
being said, GPs that retain a significant stake in the LP are
usually more sensitive to unitholders' interests.
Is the GP in a position to help the MLP when credit
This was a key question to ask in 2008-09. Some GPs shored up
the finances of the MLPs they sponsored by temporarily
suspending IDR payments, providing direct loans or offering
some sort of guarantee that the distribution wouldn't be
How experienced is GP's management team?
This is the most basic question investors can ask of any
company. An experienced management team like the ones in place
at Enterprise Products Partners LP (
), Kinder Morgan Energy Partners LP (
) and Linn Energy LLC (
) is preferable.
On all of these points, Chesapeake Midstream and its GP score
Chesapeake Midstream owns nearly 3,000 miles of gathering
pipelines in two key regions: the Barnett Shale around Fort Worth,
Texas and an area collectively known as the Mid-Continent that
includes the Permian Basin, Anadarko and Granite Wash plays.
These assets are small-diameter pipelines that connect
individual gas (or oil) wells to processing facilities and,
ultimately, the interstate pipeline network. In addition to gas
gathering, Chesapeake Midstream also provides ancillary services
such as compression and treating. The latter process involves
removing carbon dioxide from raw natural gas.
Chesapeake Energy drills actively in all of these regions. The
company has spent north of $1.5 billion on midstream energy assets
over the past few years because it needs gathering, treating and
compression capacity to transport the gas, natural gas liquids
((NGL)) and oil it produces. Because these assets are integral to
Chesapeake Energy's operations, the GP is incentivized to ensure
that Chesapeake Midstream remains healthy.
Chesapeake Energy's motivation for spinning off these midstream
assets is clear. First, holding these assets in an MLP structure is
far more tax efficient. Second, the IPO brought Chesapeake Energy a
substantial influx of capital, funds the firm can use to grow
production. Meanwhile, capital raised by Chesapeake Midstream can
be used to build out additional infrastructure to support
Chesapeake Energy's drilling operations.
Drop-down transactions should drive distribution growth at
Chesapeake Midstream over the next few years. The MLP's portfolio
doesn't include Chesapeake Energy's extensive midstream assets in
the Marcellus Shale of Appalachia, the Haynesville Shale of
Louisiana and East Texas, and the Fayetteville Shale in Arkansas,
among other regions. The gathering system owned by Chesapeake
Midstream serves about 3,500 natural gas wells that produce about
1.532 billion cubic feet of gas equivalent per day, but Chesapeake
has stakes in over 40,000 wells whose daily output amounts to 2.6
billion cubic feet of gas.
And this growth forecast isn't idle speculation. Management
anticipates as many as two drop-down transactions of $250 to $500
million worth of assets in each year going forward.
With around $750 million available on its credit facility and
the potential to raise low-cost cash in the debt markets,
Chesapeake Midstream should have no trouble financing deals of that
size. And as part of the partnership agreements, Chesapeake
Midstream has the right of first refusal on any midstream assets
that Chesapeake Energy chooses to sell.
Some analysts have expressed concern about Chesapeake Energy's
debt load and subpar credit rating, questioning whether depressed
natural gas prices will constrain the GP's ability to secure
financing. These fears are largely unfounded.
Chesapeake Energy has set a goal of working its way back to an
investment-grade credit rating. Actions speak louder than words,
but the bond markets appear to be putting faith in the company.
This graph tracks the price of Chesapeake Energy 6 7/8% due Nov.
15, 2020 (CUSIP: 165167BUO). As you can see, these bonds have
appreciated steadily to the point that the current yield stands at
roughly 6 percent, about 330 basis points (3.3 percent) above the
current yield on a 10-year U.S. Treasury note. A year ago this
spread was more than 480 basis points. Falling spreads to
Treasuries is a sign of improving sentiment. Although the
Chesapeake Energy's bonds still don't command a yield spread that's
typical of investment-grade credits, the trend is heading in the
right direction--even if natural gas prices aren't cooperating.
In addition, Chesapeake Energy has partnered with major
international oil companies on many of its key fields, a move that
significantly reduces the out-of-pocket investment required to
develop the plays.
Chesapeake Energy's acreage in the Barnett Shale is far and away
the single most important source of volumes for Chesapeake
Midstream. These properties are developed as part of a joint
venture ((JV)) with Total (
). Under the terms of the deal, Chesapeake Energy sold Total a 25
percent stake in its Barnett Shale interests in exchange for $800
million cash and an agreement that Total will fund $1.45 billion
worth of future drilling and completion expenses in the field. In
other words, Chesapeake got cash and what amounts to a free ride on
most of its expenses through 2012.
Given the backing of a giant like France-based Total, worries
about Chesapeake's ability to fund drilling in the Barnett Shale
are vastly overblown.
Finally, Chesapeake Energy has maintained a 41.5 percent
ownership stake in Chesapeake Midstream, further aligning the GP's
interests with unitholders.
Asset Risk and Commodity Exposure
natural gas gathering and processing business
tends to entail significant exposure to commodity prices.
Typically, gathering is sensitive to drilling activity; the more
wells being drilled in an area, the greater the demand for new well
hook-ups. Gatherers often earn a fee for hooking up new wells to
their systems and are remunerated based on the amount of gas
transported. Robust drilling activity translates into strong
Frenzied drilling in key U.S. shale plays despite low gas prices
reflects superior economics in certain plays and the urgent need to
secure leaseholds through production. But activity in these fields
should pull back a bit in coming months. Aubrey McClendon noted in
Chesapeake Energy's second-quarter conference call that the firm
would focus on drilling in liquids-rich plays until the price of
gas recovers to more than $6 per million British thermal units.
All of these developments at the GP level won't affect on
Chesapeake Midstream's ability to pay distributions. Roughly
three-quarters of the MLP's cash flows will come from its gathering
operations in the Barnett Shale. These volumes are covered under
long-term gathering agreements signed with the Chesapeake
Energy-Total JV. Here are some of the key terms.
A fixed fee for every 1,000 cubic feet of gas gathered and
treated from the Barnett Shale acreage. At the beginning of every
year, this fee automatically increases 2 to 2.5 percent.
The JV has agreed to dedicate all gas produced from existing and
future wells in the Barnett Shale to Chesapeake Midstream.
The JV has agreed to minimum volume commitments through mid-2019,
and these commitments increase by 3 percent every year. In other
words, the MLP will receive a certain contractually guaranteed
minimum whether or not the gathering system is used. Not only
will this minimum increase, but the volume-based fee will rise
The remaining 25 percent of cash flow come from Chesapeake
Energy's Mid-Continent operations. This gathering agreement
resembles the one covering the Barnett Shale, with one notable
exception: No minimum volume is set.
This omission is less of an issue in the Mid-Continent, an NGL-
and oil-rich region where Chesapeake Energy likely will increase
its output to take advantage of superior economics.
Distribution Growth Potential
has yet to announce its first quarterly distribution.
But the MLP indicated that it would pay distributions equal to
about $0.3375 per unit per quarter ($1.35 per year). This is the
minimum quarterly payout set forth in the registration statement.
The first payment would be prorated because the MLP will be
publicly traded for only two months in the third quarter. Expect
the partial third-quarter distribution to be around $0.225 per
unit. Based on the current price and an annualized payout of $1.35,
units of Chesapeake Midstream yield roughly 5.5 percent.
Note that most brokers' websites and sites like Yahoo! Finance
won't display the correct yield until the MLP declares a full
To forecast potential distribution growth, let's examine the
MLP's IDR Tier structure, listed below:
To start, Chesapeake Midstream will be in the Tier 1 threshold,
meaning that 98 percent of any distribution goes to the holders of
the LP units. This scaled structure, which requires less growth in
total cash flows to boost the payout to unitholders, often enables
new MLPs to grow their payouts at a faster rate than mature rivals
as it takes less growth in total cash flows to produce a rise in
the payout to LP unitholders.
And the GP is incentivized to grow distributions as quickly and
sustainably possible; the higher the distributions paid to
unitholders, the higher the percentage received by the GP.
An example will flesh this idea out more clearly. Williams
Partners LP offered a similar value proposition when it went public
in 2005. The GP, Williams Companies, owned a large number of assets
appropriate for drop-down transactions. The MLP hit the top end of
its Tier 1 payout in two quarters, exceeded its Tier 2 payout in a
year and hit its Tier 3 payout just two years after the IPO.
Although it's by no means a sure thing, Chesapeake Midstream
could enjoy a similar growth rate, assuming that the GP drops down
about $500 million in assets each year. If Chesapeake Energy sticks
to its word, the MLP could pay out $0.3875 per quarter by mid-2011
and $0.4225 per quarter in early 201--an annualized growth rate of
roughly 15 percent.
Chesapeake Midstream likely will end 2010 with an annualized
yield of about 5.5 percent, less than the 6.2 percent average of
the benchmark Alerian MLP Index. However, a lower-than-average
yield is justified by fee-based gathering contracts that limit
exposure to commodity prices. The potential for the distribution to
grow at a double-digit rate also mitigates a lower yield.
Contango ORE: An Intelligent Gold and Rare Earth