Wednesday, May 13, 2009

Pipeline MLPs; Arbitrage opportunities in the oil patch

techiedan: Ah yes, Wish. And that would be me...and I presume, you! How long can this go on? Beats me, but I'm going to enjoy it while it does!

Indefinitely; although the actual payouts are highly dependent on what oil sells for (there is likely to be little diminution of actual pipeline activity, but their take is in part determined by the price of oil or gas). Normally, these pay around 10%; the current higher return is due to everyone expecting the payout to drop and the current difficulty of rolling over loans originally slated for pipeline expansion, etc. Avoid those MLPs with big debt loads.

Arbitrage opportunities in the oil patch

by Justin Perucki, Morningstar | 18 Mar 09

We believe we've found a potentially lower-risk return booster.

A few weeks ago, Magellan Midstream Partners MMP announced they are acquiring their general partner (GP) Magellan Midstream Holdings MGG . The transaction is an all-unit offering at a 25% premium based on the previous day's close. The 25% premium coincidentally is the same premium MarkWest Energy Partners (MWE) paid to acquire its GP last year. There are a number of GPs that are publicly traded, and the Magellan transaction led us to investigate the pipeline space for investment ideas. We believe we've found a low-risk medium-reward investment opportunity.

First, some quick background: due to a 1980s-era tax law, energy-related infrastructure entities are allowed to be formed as master limited partnerships, or MLPs. An MLP is similar to a REIT or an S-Corp. MLPs pay no corporate taxes. Instead, taxes are the unitholders' responsibility. MLPs are highly cash-generative enterprises with somewhat limited reinvestment opportunities. As a result, they distribute a large percentage of their cash flows to unitholders.

An MLP usually has a general partner, or GP, that manages its operations. The GP usually takes a 2% cut of the cash flow before it is distributed to limited partner (LP) unitholders. In addition, GPs usually hold incentive distribution rights (IDRs), which entitle them to an increasing cut of the cash flow depending on the LP per-unit distributions— in other words, they are MLPs on steroids. Something to watch for as a GP owner is the sustainability of the distribution, as the IDRs work both directions (i.e., if LP per-unit distributions fall, GP distributions fall even faster).

Many GPs are publicly traded, including Buckeye GP BGH , NuStar GP Holdings NSH , Enterprise GP Holdings EPE , Energy Transfer Equity ETE , and Magellan, to name a few. Because of IDRs, GPs should trade at a premium. In other words, their yields should be lower than their corresponding LPs— as long as you believe that cash flows will rise over time. Therefore, when this relationship is violated, you may be presented with an arbitrage opportunity: buy the GP and short the LP. Theoretically, the faster the growth, the larger the yield differential should be.

However, there is not a large price discrepancy between a number of publicly traded GPs and LPs. This lack of differentiation partially drove the Magellan and MarkWest transactions we mentioned earlier.

Morningstar's head pipeline analyst Jason Stevens points out that these transactions are beneficial to the LP: they eliminate incentive distributions, which reduces the entity's cash cost of capital and increases the potential rate of distribution increases. They also slash duplicative overhead expenses from operating two different entities. Finally, they help remove any uncertainty surrounding the carried interest debate.

Our favorite name to execute a similar transaction is the NuStar complex— the GP NSH and LP NS . The key factors are as follows: The distribution coverage ratio is strong, at 1.25 times. Because the LP will likely be issuing shares to consummate such a deal, having sufficient cash flow to pay the additional distributions is critical.

There's no debt at the GP level. At first glance, Energy Transfer looks like an even more likely candidate to eradicate the discount of its GP shares— ETE— given ETE trades at a discount to the LP ETP. However, ETE has a debt load that would either have to be assumed by ETP or paid off. The debt can't be assumed because it would limit ETP's distributable cash flow, and it can't be paid off because ETP doesn't have the cash lying around. The clean balance sheet of NSH thus makes a takeout more feasible.

Chairman Bill Greehey is notorious for taking advantage of mispriced assets. For example, as CEO of Valero VLO he rolled up small independent refineries during the dog days of the 1990s. He initiated the spin-off of NuStar from its former parent Valero. We don't think this is a large driver of a takeout, but it adds to our confidence.

Another attraction we have with NuStar is its overall business model, which has historically enjoyed stable cash flows. The most attractive part is its interstate refined product pipelines. These pipelines have consistent volumes and are able to raise pricing annually based on the PPI. However, if there's a decline in PPI, NuStar would be required to reduce its fees, which may occur in 2009.

A greater concern would be a drop in volumes. We have already seen a significant drop in refined product demand last year— 4% for gasoline, 5% for diesel, and 6% for jet fuel. With the economy completely rolling over and unemployment rising, we should see further demand destruction in 2009. However, gasoline prices have fallen significantly, which should stem declines.

One aspect of this trade that we like is that the GP doesn't need to be taken out to win. If the LP can increase distributions, GP unitholders will benefit due to the IDRs. The company, however, is planning to rein in distribution increases over the near term in light of the economic weakness.

We view this trade as relatively low-risk with medium reward. As long as distributions are not cut, your cash carry is simply the yield spread between the GP and LP units— about 1% (for purposes of structuring this transaction, you'll short NS and long NSH at equal dollar amounts). However, you must also account for the opportunity cost of your capital. If you plan to park your money in a money market fund, the opportunity cost of your capital is relatively low, at maybe 1%-2%. However, if you see other attractive opportunities in the market, this cost can be very high. For simplicity's sake, let's just call it 10%— the theoretical "long-run" return profile of the stock market. Therefore, the total cost to you in this case is about 10% + 1% = 11%.

The return profile is also relatively simple. If future transactions follow the Magellan Midstream model, you stand to gain 25%. The sooner a potential transaction happens, the higher the annualized returns. If the deal happens in exactly one year, at a 25% premium, annualized cash returns are 24% (25% - 1% cash carry), and annualized excess returns would be 25% - 11% = 14%. If it happens in three months, the annualized cash returns are 96%, and the annualized excess returns are 56%. These are not hit-it-out-of-the-park numbers, but it's not bad at all for a low-risk transaction.

Alternatively, distribution growth can resume, in which case the yield differentials should return to semi-historical levels. Over the last two years, NSH's yields were on average about 2%-3% lower than NS's. If one year from now the yield spread climbs to 2.5%, this trade should return about 20% in cash and 9% in excess of total costs.

Investors considering this trade should also be mindful of the tax implications of investing in MLPs. Given the anticipated shorter holding period of this investment, we don't believe tax carrying costs will be significant.

Warren Buffett, in a shareholder letter written 20 years ago, mentioned he uses "...arbitrage as an alternative to holding short-term cash equivalents...At such times, arbitrage sometimes promises much greater returns than Treasury bills and equally important, cools any temptation we may have to relax our standards for long-term investments." Given the uncertainty in the market and near 0% short-term interest rates, we think this opportunity is not a bad place to park some cash.

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