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Swank Capital | Commentary

The market continues to be concerned with slowing global growth and European sovereign debt contagion.  With stock correlations and volatility at elevated levels, “risk assets” have generally suffered across the board.

While MLPs lagged utility equities in the third quarter, they exhibited defensive characteristics to a degree, aided by attractive yields and alleviated concerns around tax policy changes.  Key drivers that negatively affected MLP performance included lower crude oil prices (-17%) and rising high yield credit spreads.  We continue to diligently monitor a host of such drivers and have tried to balance the improving opportunity set for infrastructure build-out with macro fears in large part tied to hard-to-predict policy action. 

Before we get into some of the quantitative factors we follow, here is an update on the fundamental landscape from which several MLPs are benefiting.  Rich Kinder, Chairman and CEO of bellwether Kinder Morgan, said on the 2^nd quarter KMP/KMI earnings call: “the long-term opportunities for midstream energy infrastructure development, in my judgment, have never been better during the 30-plus years I have been in the business.”  Further, at a recent midstream industry conference, a speaker from Bentek, a widely followed energy market analytics company, said the industry is only at the front end of the crude oil/NGL infrastructure build-out curve. This should give you a sense for why it is so frustrating to have to temper our bullishness given what is happening with European sovereign debt issuers and holders.

Kinder Morgan Inc. (KMI), which is the general partner of Kinder Morgan Energy Partners (KMP), recently announced the acquisition of El Paso Corp. (EP).  EP has been one of our “high conviction” names.  Highlighting the value of the tremendous pipeline franchise at El Paso and the general partner stake in El Paso Pipeline Partners (EPB), KMI will pay a 37% premium over the October 14^th closing price for EP.  Separately, we think there is a positive valuation read-through for Williams Cos. (WMB), which owns the general partner interest in Williams Partners L.P. (WPZ).  Ultimately, KMI will be a pure-play general partner of two “drop-down” stories, KMP and EPB.  Kinder Morgan management guided to a projected average 12.5% dividend growth through 2015 at KMI (up from a previous 10% target), 7% annually at KMP over the next several years (up from a previous 5% target), and 9% at EPB through 2015.    

Turning to select quantitative drivers we are monitoring, we remain keenly aware of NGL pricing and “frac spreads”—key factors that slammed those partnerships with gathering/processing businesses back in 2008. Frac spreads remain at historically high levels, indicating the continued strong demand for natural gas liquids by petrochemical companies and other end users.  Ethane as a feed-stock continues to have an economic advantage over crude-based naphtha—but with the softening global economy, we are watching this very carefully. 

Another critical issue for MLP price performance in 2008 was the freezing of the capital markets (at least for lower quality issuers). High yield credit spreads have increased and are modestly above average, but are nowhere near as high as during the depths of the 2008 financial crisis.  MLP yields are generally correlated to high yield credit spreads. Looking specifically at select MLP debt, again we see spreads (particularly large-cap CDS spreads) have increased, but are not at alarming levels. For new issuances, MLP capital markets are still open.  However, while still in line with historical averages, secondary equity offerings in the third quarter were understandably down (in dollars) sequentially.

In the debt market, investment grade debt issuance (in dollars) was higher in the third quarter versus the second quarter, while high yield offerings were down along with widened spreads. The MLP yield spread to the 10-year Treasury is attractive—well above average, but within a normal range. 

After the recent pullback, cash flow multiples also appear more attractive.  MLPs are currently trading at 13.2x price to DCF.  This is almost exactly in-line with the long term historical average of 12.9x since January 2001. Additionally, MLPs are attractively priced relative to other yield-oriented asset classes. 

On balance, we remain cautious, not making huge individual bets, limiting our holdings to high conviction names and moderating exposure to economically sensitive stocks.  Additionally, while we are certainly focused on fundamental research (and are looking forward to the upcoming earnings season), we are even more mindful of market technicals in this kind of environment characterized by extreme volatility and high stock correlations. 

While U.S. economic data has improved of late, it is difficult to be much more optimistic until we see signs of real reform (not just rumors or suggestions) from policy makers in Europe and the U.S.  Further, the Eurozone is quite possibly already in a recession.  Who knew that the world’s investment community would be almost singularly focused on the political outcomes of the 17 individual Eurozone members?    

Of course, Europe is not the only macro issue we are anxious about.  Political gridlock reigns in the U.S.—the Super Committee is fast approaching its November 23^rd deadline, and does not look to be making much progress.  Did we mention that it seems the U.S. wants to start a trade war with China?  You get the idea…these are fun times we live in.

Jerry Swank

Managing Member

November 2011

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