Focused on Yield? The New Breed of MLPs You Might Be Overlooking
Companies like Seadrill, Lehigh, and Hi-Crush are set to offer income and growth through capital appreciation that will deliver superior total returns.
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.
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 (NYSE:SDLP) was created in October 2012 by “dropping down” four offshore drilling rigs from parent Seadrill Limited (NYSE: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 (NYSE:XOM), Chevron (NYSE:CVX) and Total SA (NYSE: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 (NYSE: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.
The information on this website solely reflects the analysis of or opinion about the performance of securities and financial markets by the writers whose articles appear on the site. The views expressed by the writers are not necessarily the views of Minyanville Media, Inc. or members of its management. Nothing contained on the website is intended to constitute a recommendation or advice addressed to an individual investor or category of investors to purchase, sell or hold any security, or to take any action with respect to the prospective movement of the securities markets or to solicit the purchase or sale of any security. Any investment decisions must be made by the reader either individually or in consultation with his or her investment professional. Minyanville writers and staff may trade or hold positions in securities that are discussed in articles appearing on the website. Writers of articles are required to disclose whether they have a position in any stock or fund discussed in an article, but are not permitted to disclose the size or direction of the position. Nothing on this website is intended to solicit business of any kind for a writer's business or fund. Minyanville management and staff as well as contributing writers will not respond to emails or other communications requesting investment advice.
Copyright 2011 Minyanville Media, Inc. All Rights Reserved.