By now it's pretty well known that the low interest rate environment has pushed investors into dividend-paying equities in the hunt for yield, and that Master Limited Partnerships (MLPs), which must pay out 90% of their profits in the form of distributions, have been a major recipient of investor interest. But what many investors may be overlooking in their focus on yield is that a new breed of non-traditional MLPs are cropping up that are set to offer both income and growth through capital appreciation that will deliver superior total returns.
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As described in Master Limited Partnerships Still Have Room to Deliver, the creation of the MLP structure grew out of the Tax Reform Act of 1986, which allowed companies to pass all income, losses, gains, and deductions onto limited partners without corporate taxation in an attempt to help incentivize the investment in energy infrastructure. The majority of traditional MLPs tend to focus on midstream assets such as pipelines and storage in which they can secure long term contracts for fixed fees that are typically not tied to the price of the underlying commodity.
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But there are a growing number of companies that operate upstream (such as drillers) or downstream (such as gas stations) that are choosing the MLP structure, and it is these "non-traditional" MLPs that might afford the better investment opportunity in coming years. Given their shorter history, less reliable income stream, and greater sensitivity to the underlying commodity price, these companies tend to offer higher yields to compensate for the greater risk. Additionally, and what I think might be more important, is that as investors get more comfortable with these non-traditional MLPs, they should start to be awarded similar premium valuations which will translate into capital appreciation or increased share price in coming years.
Let's take a look at three:
"Dropping Down" Into Seadrill Partners
Seadrill Partners (SDLP) was created in October 2012 by "dropping down" four offshore drilling rigs from parent Seadrill Limited (SDRL) into the MLP structure. By managing growth through the drop downs of existing assets it can eliminate the risk associated with new build construction and start-up speculative projects. At this point the parent Seadrill Limited has a fleet of 67 rigs with an average age of just 2.75 years, one of the youngest in the industry. This not only makes them more efficient, but also offers the technology needed for deep water drilling.
Analysts expect three to four rigs per year to be dropped down over the next five years; last week the company added a fifth rig to its portfolio. This controlled expansion should be sufficient to grow distributions by 6-7% annually while maintaining a 5.75% yield. This would translate into a 12% total return. But I think the business model offers several aspects that could lead to a greater capital appreciation.
Seadrill's current contracts are with the majors, such as Exxon Mobile (XOM), Chevron (CVX) and Total SA (TOT) and have an average 3.8 years remaining for some $3 billion in secured revenue stream. Any new rigs added will likely come with a minimum of a 5-year contract in place. The stability and predictability of revenues should provide investors with confidence which in turn will lead to higher valuation.
The trend in rig day rates has been steadily higher over the past five years. Following the swoon during the fiscal crisis and briefly during the BP (BP) gulf oil spill, day rates have recovered sharply and resumed the longer term uptrend. Just in the past two years, rates have increased some 50% to $625,000 per day. But note, Seadrill rates average just $530,000. The trade-off of these below-market rates is it limits re-contracting risk.
Through the managed dropped down approach, Seadrill should be able to benefit from the general uptrend over time. Of course this can cut both ways, and if oil and gas prices were to decline, so would rates. But I'm of the belief that energy prices, even with the natural gas revolution here in the US, will maintain current levels or work higher. This is a good way to gain exposure to the energy sector with leverage to higher prices and an increase in deep-water drilling backstopped by an attractive yield.
Fill Up at Lehigh Gas Partners
Lehigh Gas Partners (LGP), a wholesale distributor of motor fuels to gas stations and truck stops, went public in October 2012 at $20 and is currently trading around $25 per share. The company owns and leases real estate used in the retail distribution of motor fuels and currently has 345 sites mostly in the Northeast and Central Valley of Ohio.
It has close ties to Lehigh Gas-Ohio, LLC from which assets are dropped down and then leased to a third party. For example, it recently acquired 19 sites in the Cleveland market which it in turn leased to 7-Eleven who will rebrand the locations and manage the convenience store operations.
Lehigh collects the leasing fee and also has a separate 10-year contract to continue to supply fuel to the sites. This combination should provide stable cash flow and leaves Lehigh relatively insulated to commodity price. It does, of course, have some exposure to real estate and flucuating driving volumes.
The company recently reported its first full quarter earnings asa publicly traded MLP and took that opportunity to boost its distribution by a 3.4% increase to $1.81 per unit. This translates into a very healthy 7.6% annual yield.
The company's access to low-cost capital -- it recently increased the size of its credit facility by $75 million to $324 million and amended certain terms of the agreement to allow for greater leverage and flexibility with regards to acquisitions -- should provide a wide-open field for it to both increase the density of its properties, which would improve margins, and expand its footprint, which would provide the leverage and diversification of scale.
Hi-Crush Partners (HCLP) is a producer and supplier of monocrystalline sand, a proppant used by drillers to enhance the recovery rates of hydrocarbons in hydraulic fracturing operations in oil and natural gas wells. The company went public in August of 2012 at $17 a share and quickly traded up to a high of $23 one month later. But it then ran into trouble in November when Baker Hughes (BHI), one of its only four customers, decided to bail on its contract. That sent shares down to as low as $13.30. While it has not replaced that business, its recent earnings report was solid enough, and the remaining contracts seem secure, with an average of over three years remaining, to give investors confidence to bid shares back to its current $21 level.
Still, that event highlighted the risk of having such a concentrated portfolio; Hi-Crush had just one facility in Wisconsin. Last week management went out and acquired privately held D&I Silica for $125 million. While the assets it's acquiring don't come with any sand reserves, D&I is a distributor; it more than triples the potential addressable market. It also moves Hi-Crush up the value chain in a step toward a more vertically integrated model. As a distributor, D&I Silica adds new customers while deepening Hi-Crush's relationships with its current customers. While most of the sand that D&I procures is already supplied under long-term contracts, the deal does open up possibilities for Hi-Crush to eventually leverage these assets into supply deals for its sand once these existing contracts roll off.
As far as its existing business Hi-Crush has a clear competitive advantage thanks to being the low-cost producer of frac sand. Its sand reserves are shallow and therefore can be surface mined without require the blasting and heavy equipment needed for underground mines. Also, unlike some competitors, its processing and rail loading facilities are located on-site, which eliminates the need for on-road transportation, lowering product movement costs.
While it may take some time for the D&I transaction to really bear fruit, it does lay out a growth path, which will now include expansion into Bakken, Permian, and Eagle Ford production basins. Management has promised that distribution will increase by double digits in 2014, but until it gets a few more stable quarters under its belt, I'd take that promise with a grain of sand.