Given the collapse in MLP prices over the last six months virtually any explanation is worth considering. Operating results continue to be unremarkable – Kinder Morgan (KMI) reported 4Q15 financials last week. Their full year 2015 results were 4% lower than their budget; two thirds of the miss was in their CO2 business which is sensitive to the price of crude oil. Overall they generated $7.6BN of EBITDA versus a budgeted figure of $7.9BN. Their Distributable Cash Flow of $4.7BN was 7% higher than in 2014. In April KMI was at $44, and closed the year at under $15.

But operating performance has never come close to justifying the performance of MLPs recently, hence we have cast around for other explanations. The rigidity of the investor base is, we think, an important cause (see The 2015 MLP Crash; Why and What’s Next). Another frequently raised concern is that the rates MLPs earn on their pipelines will be reduced, either because loss-making E&P companies will renegotiate terms or because they’ll fail and a bankruptcy court will impose a lower rate. Although there’s very little history of this, the views of the investor who chooses not to buy MLPs can be more useful than those of the MLP seller, and this issue is being raised more frequently.

It sounds plausible that if the company filling a pipeline with hydrocarbons at one end is losing money, the pipeline owner should care. A pipeline’s immobility requires reliable customers. An E&P company that is unwilling or unable to use previously contracted capacity can cause problems for the pipeline owner as well as for the customer at the other end awaiting receipt of the product.

The U.S. has 192,396 miles of liquids pipelines of which roughly a third each move crude oil, Natural Gas Liquids (NGLs) and refined products. There are over 302,000 miles of natural gas pipelines. There are over 240,000 miles of Gathering and Processing (G&P) lines – often single individual pipes to a single well. These are both narrow and numerous. There are nearly 2.2 million miles of natural gas distribution lines from utilities to residential and commercial customers. Historically, their utilization has been remarkably reliable. While Gazprom occasionally uses its power as a supplier to further Russia’s foreign policy objectives, it’s hard to think of an example where a domestic commercial dispute has impeded the flow of product. Once pipelines are built, they are used with a high degree of predictability. The Federal Energy Regulatory Commission (FERC) governs all natural gas pipelines (other than G&P) and all other pipelines that cross state lines. Interestingly, the thrust of regulation has largely been to limit the power of the pipeline operator, since a customer on the receiving end of a pipeline has few plausible choices if he’s suddenly faced with a price hike. Although a single pipe is immobile and obviously creates a symbiotic relationship with its customer, it’s part of a network which makes the product mobile, affording its owner substantially more flexibility on where to send product than the customer has on where to obtain it. Part of FERC’s role is to control the ability of MLPs to exploit this. Security of supply requires predictability of income. Pipeline projects are cancelled before breaking ground if insufficient commitments are in hand to assure its financial viability. In 2013 Kinder Morgan cancelled the $2BN “Freedom” pipeline that was intended to transport crude oil from West Texas to California for just this reason. The Field of Dreams approach is not widely used.

There isn’t a long history of broken pipeline contracts from which to draw examples. Disputes are hard to find, probably because there’s so little legal ambiguity. Last year an Indian steel company, Essar Steel Limited, lost a case in Minnesota federal court when their acquisition of a local steel company led them to break an agreement with Great Lakes Gas Transmission Limited Partnership to take their supply of natural gas (used in steel production). Essar’s contention that the global economic crisis invalidated the contract was rejected by the court, which awarded $32.9 million to the plaintiff.

FERC has authority over many potential disputes. In 2015 Buckeye Partners reached agreement following a long-running dispute with several airlines over the rates they were charging to deliver jet fuel from New Jersey to three New York area airports. FERC oversaw the agreement and approved its resolution.

It can be useful to think of pipelines as networks of tributaries from individual plays feeding into processing centers and then into large-capacity trunklines on their way to population centers, power stations, refineries, export facilities and other users. Recently, “farther from the wellhead” has guided the investment recommendations of some, and it makes sense that a G&P network supporting a new, high cost crude oil baisin involves a totally different risk than a natural gas pipeline running into New York City to supply a power station’s electricity production.

Pipelines that are “demand pull,” in that they’re paid for by the end-user (such as a refinery or power station) are less risky than “supply-push”. In addition, 75% of hydrocarbon production in the U.S. is done by investment grade companies, so performance risk ought to be limited. Take-or-pay contracts assure the pipeline operator of revenue regardless of whether the E&P company uses the capacity. Like virtually all U.S. commercial contracts, they are enforceable. None of these seem to represent significant risk of changing contract terms. The place to look for problems is close to the wellhead where a bankruptcy judge is overseeing a failed E&P company’s obligations. However, bankruptcy need not impede the flow of product, since the bondholders could continue operations with a reduced cost of capital having shed the equity holders. While it’s conceivable that a struggling E&P company could seek to renegotiate a contract with the threat of shutting in the well, the problem of weak prices is one of excess supply. Other producers would presumably be willing to use capacity albeit not necessarily in the same place.

2015 saw 41 energy companies file for bankruptcy representing $16BN in debt. So far there are few reports of any meaningful consequences for the MLPs that provide their infrastructure, although there are reported instances of contracts being renegotiated. Williams Companies (WMB) and Chesapeake (CHK) have agreed on lower rates for natural gas transportation in Ohio and Louisiana in exchange for higher future volumes, but this is not a typical case: CHK spun out their midstream assets into Access Midstream with unusually lucrative contracts probably because they were more highly valued by Access investors than their cost as reflected in CHK’s valuation. WMB subsequently acquired Access Midstream. In Pennsylvania, leasehold contracts have been challenged by the state on behalf of many landowners who have seen their royalty checks for drilling leases slashed. But it seems so far to be an isolated case. In another interesting case brought to my attention by Ethan Bellamy of RW Baird and also Dick Flex (see comment on right panel), Quicksilver Resources , which is in bankruptcy, continues to send natural gas through Crestwood Midstream’s (CEQP) G&P network, although Quicksilver is seeking to renegotiate their agreement and has used bankruptcy to reject contracts with other G&P firms. Bankruptcy doesn’t have to lead to a cut in production. Kinder Morgan’s recent results did include a $45 million credit charge in their Terminals business due to two failed coal companies. Of course this reflects the shift away from coal towards natural gas, a trend for which MLPs including KMI are well positioned.

Moreover, demand is not the problem. Last year in the U.S., natural gas production of around 80BCF (Billion Cubic Feet Per Day) was 4BCF higher than in 2014. Exports are expected to double this year. Auto sales were a record 17.5 million with gas-guzzling pick-ups and SUVs representing half of this. Cheap hydrocarbons are producing a demand response.

While MLPs have always paid attention to the credit profile of their customers, there is increased focus on this area from investors. We’ll continue searching for examples of the likely impact on an MLP when its E&P customer fails.

A poorly designed MLP product Crashes

This could almost be the topic of a second blog post: last week UBS announced the mandatory redemption of two exchange-traded notes that were designed to provide MLP exposure leveraged 2:1. The results have been predictable, and the notes (ticker: MLPV and MLPL) duly performed as designed. MLPV fell from $22 last Summer to under $5 at which point the abovementioned mandatory redemption was triggered. The more seasoned MLPL reached $75 at the MLP peak in August 2014 and recently touched $10. Incidentally, the management of vehicles such as these requires selling MLPs when they fall and buying them when they rise to maintain constant leverage, the type of behavior that has exacerbated the sharp moves in the sector recently and causes a permanent loss of capital for the investor. The clients of UBS were poorly served indeed.

We are long BPL, CEQP, KMI and WMB