Traditionally, investment decisions and recommendations are based on available and easily accessible financial information such as company financials, corporate presentations, and management guidance. However, as we saw with the Boardwalk Pipeline Partners LP, loss of $3 billion in market value in a single day, deeper analysis is often needed to really know the current and future health of a company and more accurately guide investment decisions.
Last year, Boardwalk Pipeline Partners’, a Master Limited Partnership (MLP), surprise cut in distribution caused a massive wave of selling, leading to a 45% decline in unit price; a loss of almost $3 billion in market value in one day. Could an event of this proportion been prevented with more comprehensive data sets, correlations and asset-level intelligence and insight?
To understand pipeline MLP’s at a deep level, investors must first understand the basics of how these companies make money. Let’s use Boardwalk as an example. Boardwalk Pipeline’s operating revenue comes primarily from three large interstate natural gas pipelines (Gulf Crossing, Texas Gas, and Gulf South). These pipelines are built to move natural gas from high supply areas, to high demand areas. The difference in regional supply and demand cause a pricing differential called a “basis spread.” When a basis spread exists, producers in high supply areas (where prices are typically lower) are incentivized to buy pipeline capacity to move their gas to areas of lower supply where it can be sold at a higher price. Similarly, end users of natural gas are incentivized to buy pipeline capacity to attain gas from high supply areas where prices are lower. As long as significant basis spreads exist between receipt and delivery points, the pipeline will be able to sell transportation space.
Basis spreads are constantly shifting as energy economics change. Figure 1 from Boardwalk’s latest presentation outlines the changes in Henry Hub (Louisiana) basis spreads from 2009-2015. In 2009 (indicated in purple), natural gas was significantly discounted in places like Texas ($0.17-$0.46) and Oklahoma ($0.62) compared to Henry Hub (Louisiana). Conversely, in areas of higher demand and lower supply like the Northeast, gas was selling for a premium of $0.31. Pipelines like Boardwalk’s, which moved gas from discounted markets like Texas and Oklahoma could easily contract their pipeline capacity. However, in the past few years, the shale drilling boom has created significant movement in spreads. Massive amounts of drilling in the Marcellus and Utica began to drive down Northeast spreads, which turned negative versus Henry Hub in 2013. Additionally, areas like Texas and Oklahoma saw their spreads flatten as some producers slowed production and moved to more economical areas like the Northeast. As basis spreads shrank or reversed, it was no longer economic to move gas along some of Boardwalk’s traditional routes.
Boardwalk’s CEO warned of this risk a full quarter before the distribution cut and stock price meltdown. In the Q3 2013 conference call he stated, “The development of relatively new unconventional shale basins, especially the Marcellus, has and continues to reorder traditional flows of gas and interstate commerce, resulting in declining basis differentials across our pipeline systems. This declining basin differentials have put pressure on the value of transporting natural gas, which we have seen negatively impact our transportation revenues. When contracting this year and in the previous two years, we have seen reductions both in the rates we’ve been able to obtain under firm and interruptible transportation agreements and in the total amount of capacity that we’ve been able to contract.”
Although the comment is concerning, it provides no forward guidance as to the severity of the financial impact. Investors showed a muted response to the warning, only selling shares off three percent. The lack of selling indicated investors were either not concerned or unable to quantify the risk. To accurately measure the financial impact, investors needed to dive even deeper and complete an asset level contract analysis for each pipeline. Specific details on every contract for regulated interstate pipelines is publicly available using federal and state sources. In the case of Boardwalk, several of their contracted delivery points and transport routes were at extreme risk due to changing market dynamics. For example, the northeastern delivery point of Texas Gas Pipeline (Lebanon delivery) had previously delivered a significant amount of gas from the Gulf Coast to interconnecting pipelines which fed the markets in the Northeast. With the basis spread reversal in the Northeast, it was no longer economical to have gas transported all the way to the Northeast from the Gulf. Figure 2 illustrates the traditional flows from Texas Gas (black) coupled with the push back from the Marcellus and Utica (red) on the Lebanon hub. Additionally, Figure 3 shows the attrition rates for contracts with the Lebanon delivery point was nearly 100%.
Given the shifting supply dynamics of the Northeast and the rate of contract attrition at the Lebanon delivery point, it should not have been a surprise that revenue would be significantly reduced going forward as contracts continued to expire. Additionally, west to east routes along Boardwalk’s Gulf South Pipeline were put under similar pressure as basis differentials between Texas and the Gulf Coast flattened. A contract analysis of the Gulf South system showed several delivery points and routes with significant renewal risk during the same period. Looking ahead, renewal risk on Texas Gas and Gulf South has been mitigated by some attractive expansion projects starting next year. However, Boardwalk’s third interstate pipeline, Gulf Crossing has significant renewal risk in the future. Large contracts for that pipeline begin rolling off in 2019 between two markets that have seen basis spreads tighten significantly. Additionally, supply outlooks for the basins the pipeline was originally targeted to serve have shifted significantly from when the contracts were originally signed.
While the Boardwalk story is a very prominent example of how an evaluation of fundamental energy data can forewarn of a major issue, the following are other examples that are currently unfolding in markets these MLP’s serve:
Only after analyzing MLPs at an asset level with deep commodity expertise can investors truly understand the potential risks and upsides. Gathering and processing systems, exploration and production, oil and NGL transport as well as other logistical energy assets are laced with risk that many investors have not explored at the necessary depth. Investors not using both deep and thorough financial drivers as well as commodity expertise are exposing themselves to significant risk of another Boardwalk-type event.
By Jim Simpson, East Daley