Source: Enlink Midstream Partners
Kinder Morgan's recent announcement that its slashing its dividend by 75% was a bombshell that potentially calls into question the entire business model of midstream MLPs. When faced with such uncertainty and fear investors in EnLink Midstream Partners (NYSE: ENLK), and its general partner EnLink Midstream LLC (ENLC +0.00%) might be questioning the safety of their own payouts or 12.1%, and 8.1%, respectively. To shed some light on this issue let's look at the four most important facts that will determine whether or not EnLink Midstream's distributions survive potentially rock bottom energy prices in 2016 and beyond.
Distribution coverage ratio: the first line of defense
The easiest way to see whether a MLP's payout is sustainable in the long-term is with the distribution coverage ratio or DCR. As long as it's above 1.0 the likelihood of a distribution cut is greatly reduced.
Source: EnLink Midstream earnings releases, author chart
As you can see, even before the oil crash began in Q3 of 2014 EnLink Midstream Partners's DCR had a habit of hovering dangerously close to 1.0, and thus lived on the cusp of sustainability. EnLink Midstream LLC was in a better position since its cash flow is derived from its 27.5% ownership of its MLP plus 100% of its incentive distribution rights.
However, over the last two consecutive quarters EnLink Midstream Partners was able to seemingly stabilize its DCR at 1.05, mainly due to DCF growth from $4.35 billion in drop downs from its sponsor Devon Energy Corp. (DVN +5.19%). This seems to give hope to EnLink Midstream investors that perhaps its distributions may be safe despite low energy prices persisting for several years.
However, that might not necessarily be true and to understand why we need to examine EnLink Midstream's contracts more closely.
Contract mix is key to understanding commodity risk
The midstream MLP business model is predicated on a toll booth business model with distributable cash flow or DCF protected by long-term, mainly fixed-fee contracts. Indeed 95% of EnLink Midstream Partners' gross margin is fee-based, however that doesn't necessarily make its DCF immune from volatile energy prices.
That's because low energy prices mean that oil and gas producers are slashing spending and 2016's production is likely to decline. This creates secondary commodity risk to various midstream MLPs, including EnLink, Energy Transfer Partners (ETP +0.00%), and Enable Midstream Partners.
Now EnLink Midstream does have 80% of its cash flow secured by minimum volume commitments or MVCs, which compares favorable with Energy Transfer Partners' and Enable Midstream', who only have 51%, and 53%, of their respective volumes, and margin protected in this manner. In fact, Energy Transfer Partners' "hidden" volume exposure to commodity prices is 39% of the reason its DCF/unit collapsed 62% in the last quarter.
Given how Enable Midstream Partners' DCR is so close to potentially requiring a distribution cut, even that 20% exposure to commodity risk might be enough to cause its DCR to dip below 1.0, potentially resulting in a payout cut in 2016 or 2017. That's especially true given that about 50% of Enable Midstream Partners' gross margin is derived from Devon Energy.
Should Devon Energy or Linn Energy -- which is also a major customer which EnLink Midstream has firm volume contracts -- get into trouble they may end up having to default on their payments or renegotiate away those MVCs, which expire on their own in 2018.
Linn Energy especially represents a potentially substantial risk to EnLink because the oil producer is drowning in an ocean of debt that could result in its eventual bankruptcy should oil prices stay too low for too long.
Outgrowing 2016's oil and gas production declines is vital...
The best way for EnLink Midstream to protect its distribution is to continue growing quickly so DCF growth can hopefully offset any declines in next year's volumes. Towards that end the MLP just announced the $1.55 billion acquisition of Tall Oak Midstream LLC.
EnLink expects this acquisition to result in around $200 million in annual Adjusted EBITDA growth -- 33% -- over the next two years. Better yet, management expects the deal to be accretive to EnLink Midstream's DCF so should help sure up its DCR as soon as the deal closes in Q1 of 2016.
...and access to growth liquidity is paramount
Source: Morningstar, EnLink Midstream Partners 10-Q, 10-K, author calculations, author's table
Midstream MLPs have three sources of growth funding: debt, equity, and excess DCF. With EnLink Midstream's DCR so close to one, and its units now so cheap as to give it no access to equity markets, debt is the remaining liquidity source left to it. Luckily its total liquidity of $1.35 billion should allow it to keep growing next year; hopefully securing its distribution.
Bottom line:
EnLink Midstream remains a potentially good long-term income investment with 2016's DCF growth potentially minimizing the probability of a payout cut. However, investors need to realize that the MLP does have signifigant commodity risk and thus remains one of the more speculative midstream MLP investments available today.
