One of the major expected drivers of MLP growth over the coming decade will revolve around the US natural gas story. In the past five years, natural gas production in the US has grown by 11.4 billion cubic feet per day (Bcfd) — a gain of more than 20%. Over that time frame the US surged ahead of Russia to become the world’s largest natural gas producer. In 2013 US production expanded once again to a new record of 66.5 Bcfd, which accounted for 20.5% of the global natural gas supply. Yet despite the surge in production, US proved natural gas reserves have risen by 86% since 2000.

The gains in US production were primarily a function of the pairing of hydraulic fracturing with horizontal drilling, which turned a huge volume of natural gas resources into natural gas reserves for the first time. (The difference is that a resource refers to a deposit in place, while the reserve refers to the amount that is technically and economically recoverable).

There are at least three areas of opportunity for MLP investors resulting from this surge in US gas production. The first, and safest avenue of profit is in partnerships that are building out natural gas infrastructure to connect major gas-producing areas like the Marcellus Shale to major population centers, or to terminals that are being built to export liquefied natural gas (LNG). The list of partnerships involved in transporting natural gas is long, but includes such names as Energy Transfer Equity (NYSE: ETE), Enterprise Products Partners (NYSE: EPD), Kinder Morgan Energy Partners (NYSE: KMP), and Boardwalk Pipeline Partners (NYSE: BWP). These partnerships tend to yield in the 3-6% range, and for the most part have relatively stable distributions (BWP being a notable recent exception with a drastic distribution cut earlier this year.)

The second, and riskier, option is to buy MLPs engaged in natural gas production. While these tend to have some portion of their output hedged against sharp price fluctuations, they retain much more exposure to the ups and downs of natural gas prices than the midstream partnerships, which function as toll collectors. EV Energy Partners (NASDAQ: EVEP), Atlas Resource Partners (NYSE: ARP), BreitBurn Energy Partners (NASDAQ: BBEP) and Memorial Production Partners (NASDAQ: MEMP) are some of the upstream (oil and gas production) partnerships in the US shale plays.

The third and most speculative category of MLP that should benefit from expanding US natural gas production is engaged in building and operating LNG export terminals, or in the operation of ships that carry LNG. As US LNG exports ramp up in the years ahead, partnerships that own fleets of special LNG carriers, like GasLog Partners (NYSE: GLOP), Teekay LNG Partners (NYSE: TGP) and Golar LNG (Nasdaq: GLNG) should flourish.

To understand why there is a rush to build LNG export terminals in the US, note that the shale gas boom has depressed natural gas prices in the US. This has helped create enormous price differentials in the past five years between US natural gas prices and liquefied natural gas (LNG) prices in Europe and Southeast Asia.  

In 2013 Japan was the fifth largest natural gas consumer in the world despite paying over $12 per million BTUs more than the spot price in the US. This has created a big incentive to ship US natural gas to markets in northeast Asia and Europe.

Cheniere Energy (NYSE: LNG) created the Cheniere Energy Partners (NYSE: CQP) master limited partnership to own assets such as its Sabine Pass LNG export terminal under construction on the Louisiana/Texas border, as well as another LNG terminal in Corpus Christi. Cheniere has signed up a number of customers in Asia and in Europe to take advantage of the price differentials, and was first to obtain approval from both the Department of Energy (DOE) and the Federal Energy Regulatory Commission (FERC). The Sabine Pass facility is expected to be in service by late 2015 or early 2016.

Dominion Resources (NYSE: D) has filed the preliminary registration with the Securities and Exchange Commission (SEC) for Dominion Midstream Partners LP. Among the partnership’s assets would be Dominion’s LNG import terminal at Cove Point, Maryland, as well as a preferred equity interest in a proposed $3.8 billion LNG export terminal at Cove Point.  

The biggest risk in the LNG export partnerships is that unless US natural gas production continues expanding at a rapid pace, it is almost a certainty that these export facilities will help drive US natural gas prices higher. This in turn will decrease the price differentials, and the appeal of these facilities. But first movers like Cheniere Energy Partners should enjoy several years of operation with limited competition.  

(Follow Robert Rapier on Twitter, LinkedIn, or Facebook.)

Portfolio Updates

Kinder Morgan Earns a Shrug   

Kinder Morgan’s (NYSE: KMI) key operating affiliate and the main source of its income, Kinder Morgan Energy Partners (NYSE: KMP), kicked off the MLP earnings season last week by reporting slightly worse than expected distributable cash flow, providing the expected distribution and pledging to meet or beat its annual operating and financial targets.

Now for the news that apparently mattered more: when asked again on the post-earnings conference call about the possibility of a “transaction to reduce Kinder Morgan’s cost of capital,” shorthand for a long-suggested KMP buyout of its general partner KMI, founder Richard Kinder offered what may qualify as his loudest non-denial yet.

“Let me just say that we’re always exploring operational and strategic opportunities to enhance the value for our investors, including myself. And that includes, among other things, evaluating potential combinations of Kinder Morgan companies. But as I’ve stated in the past, any such transaction or combination would have to be on terms negotiated between the companies and mutually agreed upon,” he said.

A buyout would end KMI’s siphoning off of nearly half OF KMP’s cash flow via incentive distribution rights, presumably at the cost of comparable near-term dilution via additional KMP unit issuance. While a merger wouldn’t likely have a major redistributive effect for current KMP cash flow, it would at least ensure that future investments are financed equitably, with all beneficiaries paying the same price via equity issuance and the accumulation of debt.

But a deal like this seems more likely after the May 2017 expiration of warrants that could dilute KMI’s share base by nearly 30%, if they were exercised, which they would be if KMI’s share price topped $40 at that point. If KMI’s price could just bump along in the high 30s until then, providing Kinder and other insiders most of their return via the 4.6% dividend yield until the warrants expired worthless, it would make a subsequent buyout of KMI much more lucrative.

Which brings us back to mundane near-term matters like distributable cash flow. KMP reported distributable cash flow of $1.23 per unit before items, up just a penny from a year ago.

Segment earnings were up $141 million year-over-year, with natural gas transportation delivering more than half the growth, keyed by strong results at Tennessee Gas Pipeline (increasingly a two-way link following recent investment to accommodate the flow of Utica gas to the Gulf coast) as well as last year’s Copano acquisition.

But increased incentive payments to KMI cost an extra $48 million, interest and administrative costs increased by $18 million and sustaining capital spending was $29 million higher. That left distributable cash flow up a modest $56 million year over year, which had to be divvied up among a weighted average of 457 million of limited partner units, up from 413 million a year ago.

So while KMP declared the expected $1.39 per unit distribution representing a 5.3% increase year-over-year and a 6.7% current yield, quarterly distribution coverage declined to 88%. The partnership had always projected a shortfall during the seasonally weaker second and third quarters, and still expects to fully cover its distributions on an annual basis. But Hedgeye’s critical analyst was quick to point out that a year ago the distribution coverage was stronger at 93%.

This mostly reflects last year’s major ramp in capital spending, which has yet to fully pay off given the multi-year nature of many of the biggest projects, even as KMP has already absorbed some of the cost via increased unit issuance, including more than $1 billion in at-the-market equity offerings in the last six months.

There are many reasons to expect these investments to ultimately pay off, including rapidly growing demand for the transportation of natural gas from north to south. Kinder Morgan is bullish on additional near-term opportunities to move the production surge from the Marcellus and the Utica to the Gulf coast for use in new petrochemical complexes there as well as future liquefied natural gas (LNG) export terminals.

Perhaps more importantly for the near term, the recently rebounding unit price of KMP and share price of KMI held firm in the face of the lackluster quarterly accounting, with KMI reaching levels last seen nearly a year ago before Hedgeye began its negative campaign. This despite the fact that short interest in the stock has increased some 75% in that time.

The upshot is that plenty of skeptics remain willing to pay a healthy cost to short this MLP family, but they have seen some of the past year’s gains on this bet reverse sharply since March, and both KMI and KMP have now reclaimed their 50- and 200-day moving averages in a reflection of that recent momentum.

Although the warrants and heavy equity issuance may well cap near-term upside, Kinder Morgan’s assets are undeniably poised to benefit significantly from the longer-term energy trends. KMI remains the #5 Best Buy below $40. KMP is a Buy below $90.

— Igor Greenwald