There's no denying 2015 has been a challenging year for the Energy sector, particularly master limited partnerships (MLPs). Some investors have been watching MLPs' performance with bated breath, hoping for a rally, only to have their hopes dashed as the onslaught of bad news continued, stock prices continued to feel the pressure of falling oil, and the future of their dividends began to be called into question. Then, there was last week's implosion at Kinder Morgan ( KMI ), and we all know how that turned out (for more info. on KMI, or in case you've been living under a rock for the past week, see below).
It's funny -- I planned this Q&A with Albert Alfonso the week before last, when there were hiccups at KMI and it seemed trouble was brewing, but before the dividend cut announcement. Albert's a long-time contributor to Seeking Alpha, and he tends to be the voice of reason rising above the din, especially when things blow up like KMI did last week. Apparently, my decision to reach out to him was prescient, because in light of recent events, it seems like now is the perfect time to check in with someone who follows the energy and MLP sectors closely, to get their take on what's really going on, to sort the facts from the chaos, and find out where the opportunities lie and how investors can best position themselves going into 2016.
Seeking Alpha: You cover the MLP and oil & gas sectors quite regularly. There has been a lot of weakness in these sectors -- in fact, I read here that 2015 is the worst year ever for MLP returns -- and a ton of dividend cuts this year, for obvious reasons. It seems investors are optimistic about MLPs' performance in 2016 -- 38% in a poll at MLPguy.com say that they predict MLPs will outperform the S&P 500 by 10% or more. Do you agree, and are you more optimistic about MLP returns in the coming year?
Albert Alfonso: Unless we see a big rally in the next two weeks, 2015 will go down as the worst year ever for MLPs. This is crazy when you think about it. The Alerian MLP ETF ( AMLP ) is down a massive 41% YTD. Many individual MLPs are doing far worse, down 50%-60%, some are even under their 2008 great recession lows.
Regarding dividends, there have not been that many cuts yet. The only large midstream MLP to cut was Kinder Morgan ( KMI ). (KMI is not technically an MLP, however. It is a C-corp, although pretty much all analysts use MLP metrics to value it. In other words, EBITDA and DCF are more important than GAAP earnings.) The exception here are the upstream MLPs (these are oil and gas producers) have all been forced to cut or eliminate their dividends.
I do believe this sector is in store for a rally. While 2008 was the previous worst year for the sector, down 35%, the following year 2009 was the best, with the sector up 66%.
Furthermore, besides the upstream MLPs, almost all the midstream MLPs have not seen their cash flows impacted much due to lower oil prices , even KMI.
SA: What are your favorite stocks in the MLP/oil & gas sectors, and why? Are there specific stocks you'd recommend steering clear of altogether, and why?
AA: It depends on an investor's risk tolerance. In terms of lower risk oil and gas producers, ConocoPhillips ( COP ) is one of my favorites. The company has a plan to survive and thrive in a low oil price environment by cutting costs and focusing on margins. The lower cost structure will serve it well once oil recovers.
Phillips 66 ( PSX ) is also a great growth name. The refining arm is doing great due to wide margins and the discounted oil here in the US. PSX also has a fast growing MLP in Phillips 66 Partners ( PSXP ) where it has been able to dropdown assets. There is also the chemical business, CP Chemical, which is a joint venture with Chevron (CVX). Both companies are investing a ton of money into that business to take advantage of low natural gas prices .
For the midstream MLPs, that sector is in chaos. I have argued that the entire "MLP model" may be in peril. There is tons of value to be had. However, many MLPs will need to tackle the question of how to fund their capital budgets. Most have used equity sales, with only a few using internal cash flow. A few other MLPs may follow KMI in lowering their dividends if equity prices remain low. Others that have less leverage could use debt, though that is only a short-term fix.
I also like the refinery MLPs: Northern Tier Energy (NTI), Alon USA Partners (ALDW), CVR Refining (CVRR). Unlike the midstream MLPs, these do not have a fixed dividend. Rather, they have variable distribution policies, so the dividends can vary greatly quarter to quarter. On average, these three have returned over 15% in cash per year.
I would stay clear of the deeply indebted natural gas plays such as Chesapeake Energy Corp. (CHK) and SandRidge Energy (SD). Unlike oil, which is down more due to sentiment than fundamentals, there is actually a huge natural gas glut here in the US. While natural gas exports could help lift prices, there is simply way too much of it.
SA: Bluntly, what the heck is going on at Kinder Morgan? There are dissenting opinions here on Seeking Alpha, whether you're bullish or bearish on the stock. You came out with a fairly balanced article earlier this month. I get the impression you like the stock, but is it fair to say KMI seems a bit shaky at the moment, and clearly unable to follow through on the big dividends it promised when it consolidated? You've written that the market reaction is unjustified, given the fundamentals and the current downtrend in oil & gas. What should investors do now -- hold on tight and wait for better days ahead?
AA: I discussed KMI a bit above. Let me go into more detail.
KMI has always paid out most of its cash flow to shareholders. Growth has been funded by using equity and debt. This financing model, which I refer to as the "MLP model," worked great for more than a decade. KMI was able to build out a huge asset base. It is the fifth-largest energy company in the US by EV.
However, the MLP model only works if the share price is high. When KMI's stock tanked, it no longer made sense for them to keep selling equity -- the cost of capital was too high.
This led to a vicious cycle: The low share price led to questions as to how KMI would fund its growth projects. This called into question its dividend growth, further hurting the share price.
What sealed the deal for the dividend cut was KMI's high debt load. The company took on a ton of debt in 2014 to merge its various MLPs together. The cash spent here was not deployed into new assets, so leverage went up as EBITDA stayed more or less flat.
KMI has always had an investment grade rating, though just barely. After KMI bought a 50% stake in the highly leveraged Natural Gas Pipeline Company of America "NGPL," Moody's was worried that KMI may need to bail out this subsidiary and assume its debt, which would have raised leverage, hence they lowered the "credit outlook" to negative, which usually means a credit downgrade was in play.
KMI was in a bind. They needed to grow without increasing debt or using equity. Hence, the company was forced to tap into its own internal cash flow to fund growth. The dividend was cut 75%. The dividend is now just 22% of the 2016 DCF, versus 90% in 2015. Capex is now fully funded with DCF with the excess going towards lowering debt. In other words, KMI abandoned the MLP model.
Paradoxically, the market rewarded KMI for doing this. The stock has outperformed the other midstream companies since cutting the dividend. Furthermore, Moody's raised the credit outlook back to stable.
SA: Linn Energy (LINE) (LNCO) is another stock you write about quite frequently. For those who might not regularly follow you on Seeking Alpha, could you give us a rundown on your thoughts for that stock, and what investors might keep an eye on there going into 2016?
AA: LINE is a basketcase. The company used mostly debt to expand rapidly in 2013/2014. There were signs that their business model was not working when they were forced to issue way too much equity to buy Berry Petroleum. In addition, the company was not able to hit its DCF targets when oil was high.
After oil prices fell, LINE's cash flows were drastically reduced. Without its hedges, LINE would likely be bankrupt right now as it is very much cash flow negative at current oil and gas prices.
EBITDA has also fallen, so leverage is up. LINE has needed to ask its lenders for covenant relief. If this were not enough, liquidity has fallen as the credit facility borrowing base has been slashed due to lower oil prices.
LINE can probably survive through the end of 2017 due to its hedges. Though they would need oil and gas prices to be much higher after that.
SA: Any other thoughts for investors?
AA: Anything energy-related has been sold off this year. As the saying says, one should buy when there's blood in the streets. Many of these stocks are cash-rich, even at current oil prices. Avoid names that have too much debt or non-investment grade ratings.
Furthermore, for the midstream MLP investors, focus on cash flow, not dividends. Understand that dividends are just one of the ways to use incoming cash. Some of these companies may need to use this cash for other reasons and focus less on the dividend going forward.
Now it's your turn to weigh in. Do you have any MLP stocks in your portfolio? What are your plans for them going forward? Did you own any KMI? What did you do after the div cut announcement? Did you expect such a deep cut? Are you eyeing any energy stocks for 2016?
Since last week's biggest story in our space was (obviously) KMI, I'm going to include a list of some of the articles covering the dividend debacle, in case you missed them, or want to catch up on the latest developments:
Kinder Morgan: Yet Another Barron's Hit Piece by Albert Alfonso
Kinder Morgan Is Now Dead Money Walking by David Alton Clark
Kinder Morgan: A Dividend Growth Post-Mortem Discussion by Adam Aloisi
Will Cutting Kinder Morgan's Dividend Pay Dividends? by Chris DeMuth Jr.
Kinder Morgan - Money For Nothing, Dividend Growth For Free No More by Oil and Gas Investments Bulletin
Kinder Morgan: Even With A Dividend Cut, Junk Bond Status Is Likely by Transcend Event Drive Research
Kinder Morgan: I Told Me So! by Mike Nadel
MLP Investors Fear Contagion As Kinder Morgan Slashes Its Dividend 75% by George Schneider
How Do You Value Kinder Morgan After The Dividend Cut? by Albert Alfonso
Kinder Morgan Dividend Cut Leaves Behind A Bitter Taste by Dividends Are Coming
Kinder Morgan: Irrational Panic Or Realization Of Reality? by Richard Zeits
I Was Wrong: The Impact Of Kinder Morgan's Dividend Cut by Michael Boyd
Kinder Morgan: Dividend Cut Sets Up Buying Opportunity by Jordan Flannery
One more thing... For those who want to reach me and may not know the best time to do that, I'm based on the West coast. My office hours are Monday-Friday, 9 am to 6 pm, Pacific Standard Time. Those are the times you are most likely to get a response from me by email, and/or that I'll be online posting articles. Also, just a gentle reminder: time spent reading and responding to emails is less time that I have to review and post your articles. Thanks in advance for your patience and cooperation.
See also International Paper: Ripe For Gains And Yielding A 4.67% Dividend on seekingalpha.com
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