Energy

Should MLPs Drop Their Incentive Distribution Rights?

Paul Ausick

Published: January 20, 2016 11:55 am

Last Updated: January 13, 2020 2:49 pm

Benchmark West Texas Intermediate (WTI) crude oil for February delivery fell to $27.32 a barrel early Wednesday morning, a 12-year low, and the price shows little sign of turning around. As the price of crude oil has tumbled for the past 18 months, one of the hardest hit segments of the energy sector has been the midstream business, those pipelines that move the hydrocarbons from the wellhead ultimately to market.

Midstream master limited partnerships (MLPs) got hammered in 2015. The Alerian MLP index showed a price drop of nearly 37% and a total return decline of nearly 33%. Observers have suggested a few reasons for this: transportation volumes are down because demand is down; higher interest rates will cost the MLPs more in borrowing costs, affecting investor yields; and, finally, the toll-road analogy is breaking down.

Midstream companies typically sign contracts requiring shippers to pay for the volumes they’ve agreed to, whether or not they actually ship anything. These “take or pay” contracts have long been one of the attractions of MLPs, but the story is falling apart a little. If energy producers are going out of business, they obviously do not have either anything to ship or any money to pay the MLP. Even if a producer remains in business though, the take-or-pay contract may expire (very bad news) or the producer may seek to renegotiate the take-or-pay deal (not as bad, but not good). An MLP that maintains a hardline on price may lose the customer to bankruptcy or even to another MLP in some place. The take-or-pay deals are just not as solid as the MLPs want investors to believe they are.

This feeds the central problem MLPs face: growth. Without growth the companies cannot raise distributions. And because the fees MLPs charge for transportation are regulated, the companies can’t just raise them and must, instead, keep expanding either through organic growth or acquisitions. Growth also affects the MLPs’ access to cheap capital for more expansion.

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