During the past two years, upstream master limited partnerships (MLPs) were among the best market performers in the MLP universe, generating total returns (quarterly distributions plus unit-price appreciation) of 37% in 2006 and more than 55% in first-half 2007.
However, since that time, upstream MLPs tracked by Wachovia Capital Markets LLC have plummeted 45% in value versus a 15% market decline for the firm’s overall MLP Index—dipping 11% during the first two months of 2008 alone versus a slide of 3% for the total Wachovia MLP Index and a loss of 8% for the S&P 500.
So what’s gone wrong? “The premium valuations afforded to upstream MLPs at the (mid-2007) peak may have been too rich,” says Yves Siegel, senior analyst for Wachovia Capital Markets in New York.
“In our view, E&P MLPs should trade at some discount to midstream MLPs to reflect their depleting asset base, direct commodity-price exposure and limited trading history or track record.”
Nevertheless, with most upstream MLPs now trading below the value of their reserves, has the market-valuation pendulum swung too far?
Siegel believes it has and that recent market weakness in this sector has been primarily fueled by a substantial equity overhang generated by PIPE (private investment in a public entity) deals completed in 2007 rather than fundamentals.
The analyst therefore views the recent period of market digestion as a unique opportunity for long-term-oriented investors to build positions in quality E&P MLP names at a significant discount. His top picks: EV Energy Partners and Quest Energy Partners.
Michael Blum, another senior Wachovia analyst, notes that, since the bulk of 2007 acquisition financing by upstream MLPs was completed using equity, these entities are well positioned to access short-term debt financing as a source of further growth through acquisitions. “On average each (E&P) MLP has $130 million of available borrowing capacity.”
But even absent acquisitions, upstream MLPs could still grow distributions modestly in 2008 “as the flurry of 2007 acquisitions has left most partnerships with a significant inventory of drilling locations,” he says.
Wachovia senior analyst Sharon Lui estimates that E&P MLPs, even without making acquisitions, should generate solid distribution-coverage ratios of 1.3 to 1.4 during 2008-09.
“In fact, given the 60% increase in crude prices and 15% increase in natural gas prices over last year, we would argue that fundamentals have strengthened and most upstream MLPs are currently generating more cash flow on their base assets than when they went public.”
Commodity prices, she says, would have to drop to $70 per barrel for oil and $5.50 per million Btu for gas for a sustained period before affecting current distributions.
Siegel adds that the decrease in planned IPOs for upstream MLPs this year could also have positive ramifications for existing E&P MLPs, as the decrease would help alleviate the equity overhang weighing on the sector.
Also, with fewer MLPs, competition for mature reserves would be reduced, he says. In addition, E&P C-Corps that were originally planning on forming their own MLPs might instead sell assets targeted for such partnerships to existing upstream MLPs.
Says Siegel, “We would expect upstream MLPs to trade at a slight premium to E&P C-Corps to reflect their tax-efficient flow-through structure, a lower-risk business model and limited investment risk as excess cash flow is paid out to unit-holders.”