Are the Prospects of Midstream LPs Starting to Crumble?

Reuben is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Miners used to use canaries as an early warning system for poisonous gases. Essentially, if there was something in the air that might kill a human, it would likely kill the bird first. This is where the saying “canary in the coal mine” comes from. Is ONEOK Partners (NYSE: OKS) plan to drop a pipeline project a canary in the midstream LP “coal mine?”

Infrastructure Problems
The United States has an infrastructure problem across many industries. Roads, electric lines, and pipelines are but a few examples. The money to upgrade the first two hasn't been easy to get, but the later of that group has actually seen a great deal of investment in the last few years. Indeed, the demand for new pipeline assets has been backed by the private money to pay for those assets.

New pipelines, expansions of existing mid-stream assets, and the purchase and sale of such businesses between companies have led to a boom in the mid-stream Limited Partnership space. Not only have existing companies been able to grow aggressively, but new entrants have had plenty of room to join the game. So long as the demand for pipelines remains strong, the risk of overbuilding is likely to be low.

Eventually Every Rally Ends
However, overbuilding will likely be a problem at some point. Such overbuilding is rampant in just about every hard asset related business. For example, real estate investment trusts (REIT) often have to deal with oversupply born of too many new buildings of a particular property type. One of the reasons that overbuilding can be so damaging is the long lead times for such projects, since a building can take years to go from drawing board to built. Office, hotel, and apartment building supply is a frequent topic for REIT management teams to discuss.

The same is true of mid-stream assets, but how do you tell before it's too late in this recently hot sector? One clear sign will be when a large number of new pipelines are built without firm commitments from customers. Over the last few years, pipeline companies like industry giants Kinder Morgan (NYSE: KMP) and Enterprise Products Partners (NYSE: EPD) have generally only undertaken projects that customers have agreed to use in advance of the construction. For shareholders such asset growth is wonderful, it's a virtual guarantee for increased revenue and distributions.

When customers no longer line up to use new capacity, however, the industry will have a material problem on its hands. But when it has become that obvious, it may be too late. Indeed, markets will react quickly and infrastructure LPs will likely have fallen by then. What you need to look for is a canary.

So while oversupply doesn't seem to be an issue right now, ONEOK Partners' move to cancel a nearly $2 billion project because there was a lack of demand could be an early warning sign. The Bakken Crude Express Pipeline was to transport 200,000 barrels a day of crude oil from the Williston Basin to Cushing, Oklahoma. In this situation, it seems that the ability to transport oil via trains has been sited as the reason for lack of demand. Still, it shows that there are clearly limits to demand and that LPs may be reaching those limits.

It's Complicated
That said, there are complicated dynamics involved in this decision. For example, the pipeline was to end in Cushing. Cushing is already facing a glut of oil and, as a result, low sales prices. Producers certainly don't want to move more oil to a location where they will get low returns. So where a pipeline is heading is important in the demand equation. It is also nice to see that ONEOK canceled the project instead of pushing ahead without firm commitments. This will likely spare unit holders a great deal of financial pain.

Is the Canary Dead or Not?
The quick answer is that the canary probably isn't dead yet. However, this is a clear indication that location matters materially more now than it did a few years ago. So management teams need to pay particular attention to market needs when examining new projects.

Some Companies with Good Records
The aforementioned industry giants Kinder Morgan and Enterprise both have massive and diverse asset basses and great histories of growth. Although Enterprise is probably at bit pricey with a yield just a little above 5%, Kinder's 6% plus yield is probably reasonable.

Energy Transfer Partners (NYSE: ETP) is another large player worth looking at. Its units have been held back by two main factors. First, a stagnant distribution has left some wondering about the safety of the disbursement and management's focus on company growth over unit holder returns. Second, a massive acquisition has only recently been completed and could pose material integration risks. That said, the growth projects undertaken in recent years are expected to start baring fruit soon, which should lead to a resumption of distribution growth. Moreover, the integration of the newly acquired Sonoco Logistics, has yet to pose a problem. Energy Transfer should probably be priced in line with Kinder.

ONEOK, for its part, with a sub 5% dividend yield is probably best avoided for now.


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ReubenGBrewer has positions in Enterprise Products Partners L.P. and Kinder Morgan. The Motley Fool has no positions in the stocks mentioned above. Motley Fool newsletter services recommend Enterprise Products Partners L.P. and ONEOK Partners, L.P.. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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