The April 11, 2011 edition of Time magazine featured a cover article highlighting the emergence of shale gas and its future impacts on the US and the world.  The article certainly addresses the difficulties of drilling for natural gas, or any hydrocarbon for that matter, in populated areas or in areas of the country that are accustomed to being consumers rather than producers.  More importantly, in our view, the article lays out the issues surrounding global energy.  Mainly the growing demand by industrializing nations such as Brazil and India, the tragic accident at the Japanese nuclear site in Fukushima, and the ever increasing turmoil in the middle east.   Each of these issues lean the US toward supplying more of its own energy which now exists in a recoverable form of shale.  In fact, key updates in the US Energy Information Agency’s Annual Energy Outlook (“AEO”) 2011 include a significant update of the technically recoverable U.S. shale gas resources, more than doubling the volume of shale gas resources assumed in AEO 2010, and while also adding new shale oil resources. 

Increasing sources of supply have brought natural gas prices down into a prolonged $3-4 range as demand has been stagnant in the face of industrial demand destruction (closures of US factories) and limited growth in natural gas fired power generation.  Analysts feel that this pendulum is about to swing in the favor of gas as growth in the power generation, transportation, and industrial sectors will lead to an increase in natural gas demand.  According to Pearce Hammond, Director and Co-Head of Exploration & Production at Simmons & Company International, on the power generation side gas demand could increase by 9 billion cubic feet per day (“Bcf/d”), a 37.5% increase to 2009’s average demand of 24 Bcf/d , by 2020 as aging coal plants are retired, electricity usage increases, nuclear generation declines or stalls due to earthquake- and tsunami-related fallout in Japan.  Further, the economics for replacing gasoline and diesel with natural gas in transportation continues to also make more sense.  If just 8% of the oil products used in vehicles were replaced with natural gas, demand would increase by 1 Bcf/d.

Growth

The natural gas supply and demand fundamentals provide MLPs ample growth opportunities for the construction of midstream assets.  CCC is seeing similar market dynamics for crude oil as Canadian Oil Sands volumes continue to grow along with new US Oil discoveries in the form of oil shale.  The Bakken, Eagleford, and other oil shales have led to an uptick of 27% in US oil production in the lower 48 states from the lows of 2007 - 2008.  Similarly due to price advantages, the demand for natural gas liquids (ie – ethane, propane) has increased within the petrochemical industry, which uses the liquids as a feedstock to form plastic derivatives.

The shift in supply and demand market dynamics point towards new projects and increased volume throughput on existing assets.  According to the EIA, US energy infrastructure will need $150 - $200 billion of growth capital expenditures over the next ten to twenty years with $35 billion already announced by the MLPs.  To put this in context the current market cap of all MLPs is approximately $230 billion.       

Healthy Access to Capital Markets

Source: Wells Fargo MLP Monthly

*Through March 31, 2011

 

MLPs got off to a fast start in 2011 raising $17.3 billion in capital to fund growth.  In terms of perspective, MLPs raised $34.8 billion in debt and equity in all of 2010 (Source: Wells Fargo MLP Monthly).  This healthy access to capital markets is an essential piece to the MLP value proposition as the MLP industry needs access to capital at affordable rates to fund projects that are accretive to the unit holders.  In terms of debt, MLPs raised $8.4 billion at an average coupon rate of 5.53% across investment and non-investment grade MLPs.  The average coupon rate was 4.75% for investment grade and 7% for non-investment grade.  Each of these metrics is 100 to 200 bps lower than historical averages (Source: Barclays Capital).  In terms of equity, MLPs raised $8.9 billion surpassing 2009 YTD total in the first quarter.  One particular MLP raised $718 million in the largest public secondary offering in the history of the sector.  These proceeds were used to fund a large acquisition.

MLP Valuation

MLPs as an asset class over the past 1 and 3 years have provided investors with one of, if not the best risk adjusted rate of returns of any asset class.  This has led many to question whether or not they missed the opportunity in MLPs or that valuations may be excessive.  We like to remind folks that the risk adjusted returns have been equally as impressive over the last 5, 7, 10 and 15 years.  While no doubt the current valuations do not provide investors the same entry point that existed in the beginning of 2009, we believe the value proposition represented by the asset class is still extremely compelling.  To that point, CCC would like to mention a few of the metrics we are constantly evaluating to give us a better sense of where things are in relation to historical valuations.

 

In terms of spreads, MLPs are trading at 250 bps spread to the US 10-Year Treasury compared 312 bps average.  While below the average it should be noted that MLPs most frequently trade at a 200 to 300 bps spread to the 10-Year treasury. 

 

   Source: Barclays Capital

 

Similarly, in terms of spread, MLPs are trading at 154 bps spread to the Barclays Capital High Yield index.  Again, MLPs trade most frequently at a 100 to 200 bps spread to high yield indexes.

   Source: Barclays Capital

 

In terms of multiples, MLPs are trading 13.7x Price/DCF which compares to a 10-yr average of 11.5x.  EV/EBITDA multiples are currently trading at 12.9x compared to 10.8x historical averages.  By way of historical context, MLP’s as an asset class have recently traded at similar valuations during the time periods of   Q4 2004 and Q3 2005.  The annualized rate of return had one purchased them then would have been 16% and 14%, respectively.  Furthermore, MLPs traded above the Price / Distributable cash flow average of 11.5x for extended period of times as seen from the 4th quarter of 2003 to the 2nd quarter of 2008 where MLPs traded at or above 11.5x.

Source: Factset, Partnership Reports, and Wells Fargo Securities, LLC estimates

First Quarter Activity

Additionally within the quarter, we saw substantial activity within the MLP sector.  One significant point of interest was the announced acquisition of Duncan Energy Partners by Enterprise Product Partners on February 23, 2011.   Duncan Energy Partners was originally formed to purchase mature, low growth assets from Enterprise, who would invest the proceeds into higher growth acquisitions or organic projects.  In return for lower growth Duncan was originally structured to pay a higher yield.  Two of the original assets sold to Duncan happened to be located in Louisiana and South Texas home to the prolific Haynesville and Eagleford shales, respectively.  Duncan also was structured with no incentive distribution rights giving it a cost of capital advantage over Enterprise.  Enterprise eliminated that advantage when it consolidated its GP eliminating its IDRs.  Duncan now served Enterprise no purpose in capital raising and owned assets strategic to Enterprise’s growth.  We feel this is positive for Enterprise going forward as it is finally streamlined into a single entity after consolidating TEPPCO, the GP, and now Duncan over the past 2 years.  We feel this will allow management to focus on the growth of the single entity versus the management of several publicly traded entities.

The first quarter of 2011 also saw 3 MLP IPO’s with another MLP IPO pricing on April 20^th.  Each of the IPO’s priced in Q1 were very well received, pricing above the original range.  This would be highlighted by the IPO of KMI which proceeds were $2.9 billion making it the largest IPO in MLP history.

Best Regards,

 

The information contained herein is based solely upon the opinion of the Advisor and is not to be construed as investment, legal, or tax advice.  We make no warranties with regard to the information and disclaim any liability arising out of the reliance upon such information. Information contained herein is subject to change without notice in reaction to changing market conditions.

 

(c) Center Coast Capital Advisors

www.centercoastcap.com