Energy Business

Why Credit Suisse MLP Downgrades Not as Bad as They Sound

VTTI Energy Partners L.P. (NYSE: VTTI) was downgraded to Neutral from Outperform. The $24 target price suggests a total return of about 36%, but there is also a lack of trading liquidity.

Western Gas Equity Partners L.P. (NYSE: WGP) was downgraded to Neutral from Outperform. It was downgraded along with the next Western, as the total return outlook is in line with its coverage.

Western Gas Partners L.P. (NYSE: WES) was downgraded to Neutral from Outperform, and the target fell to $53 from $56. The lower total return outlook falls in line with the firm’s coverage.

Columbia Pipeline Group Inc. (NYSE: CPGX) was downgraded to Underperform from Neutral. This one ran up amid takeover speculation, but that has reportedly stalled. Credit Suisse feels it is near fair value relative to its impressive backlog of organic projects.

Magellan Midstream Partners L.P. (NYSE: MMP) was downgraded to Underperform from Neutral. Magellan was said to have presented a safe alternative to higher beta midstream names, but the valuation looks stretched.

ONEOK Partners L.P. (NYSE: OKS) was downgraded to Underperform from Neutral.

There is something key here for the leveraged ETFs. The so-called right yield or yield spread was said to be about 6.5% yield at $60 to $70 oil and 5.5% to 6% at $80 oil. The “correct” EV/EBITDA multiple was indicated about 12 to 13 times at $90 to $100 oil and about 10 times at $30 to $40 oil, although clearly neither condition is deemed sustainable.

Counterparty risks and contract renegotiation risks are now front and center for investors and MLPs alike. The balance sheet strength focus is now a priority, as is the risk of distribution viability. A look at the history reveals a stronger correlation between multiples and the price of oil than most analysts and investors thought. Compared to other sectors, MLPs appear slightly expensive versus utilities but cheap versus exploration and production.

John Edwards said:

In light of the severe downturn, the viability of the MLP model as well as valuations has faced significant challenge. The accepted wisdom before the downturn was that the models were robust enough to withstand industry cycles and that pipeline and processing plant cash flows had a degree of insulation from the industry cycle due to the long-dated nature of fee based contracts. But the prolonged downturn has challenged the robustness assumption on account of counterparty risks and contract renegotiation risks. Balance sheet strength, liquidity, and distribution coverage have become a more important priority. Valuation assumptions have also been challenged. The DDM valuation model has less viability as a valuation tool if the distributions are subject to disruption as does yield spread analysis. Valuation models such as EV/EBITDA and P/DCF showing relative indifference to distribution policy are being resurrected as a way to look at the sector. We believe that the customary assumption of MLP industry yields in the 6’s will be a long time before being revisited owing to the stronger coverage, thicker equity requirements needed to withstand cycles of the future. Management teams that have already positioned for this have seen their equity hold up a lot better during this current cycle.

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