Description

Thesis

·         9% + yield for a strong credit. Risk is diversified across commodities and geographies with no near-term maturities

·         Self-funded growth capex program will improve the credit profile over the next several years

·         The MLP structure means a significant amount of cash is paid as common equity distributions. In a stressed case a reduction or elimination of these dividends provides significant flexibility

·         Only reasonable impairment case is an extreme downside scenario in energy markets

Situation Overview

This is not the sexist idea, but  it’s a safe 9%+ yielding name that should be solvent in any reasonable scenario. The Crestwood Equity Partners Class A Preferred shares have a face value of $9.13 /share and pay a quarterly cash dividend of $0.2111. Currently they trade around $9.25 for 9.12% yield.  These preferreds were recently listed on the NYSE after trading OTC for a few years.  While the  issue size is $650mm there was almost no volume when shares were OTC listed. Only recently has trading volume increased such that liquidity should be sufficient for smaller funds. The preferreds are non-callable and distributions are cumulative at 11.25% if not paid. There are no IDRs and management and insiders own about 30% of the common units.

Business Overview

Over 80% of EBITDA is from Crestwood’s gathering and processing (G&P) segment.  Gathering and processing businesses own transportation systems used to move raw energy products (crude oil, natural gas and natural gas liquids) and wastewater from the origin point at a wellsite to a main storage facility, processing plant, or shipping point. Often during transport natural gas is passed through compressor stations to provide for better transportation and storage.

This segment’s largest assets are crude, gas and produced water gathering assets in the Bakken and rich gas gathering systems and processing plants in the powder river basin. Most of the acreage Crestwood services is solidly profitable at current energy and is in areas with few logistical issues. There is minimal customer concentration and most of Crestwood’s counterparties are well capitalized and focused on growing production.

Over 90% of revenue for the G&P segment is from long-term fixed fee or take-or-pay contracts. Most agreements specify a fixed fee per unit of volume with annual CPI / CPI+ escalators (although a significant portion of the business is simple take-or-pay capacity) . Since these assets require significant upfront capex, producers will generally enter into long-term contracts for gathering and processing services. Generally, these contracts specify that any production within a certain geographic area will use the contracted system. Such agreements can also require a specified number of wells are completed or a certain minimum volume level will be paid for. Once the upfront investment has been made, the additional cost to attach a new well in the same area is small and as such returns on incremental capex are high.

The remaining business consists of the Storage and Transportation segment which owns four natural gas storage facilities in the northeast and a large crude-by-rail terminal and the Marketing Supply and Logistics segment which supplies seasonal propane and butane to the northeast.

9%+ Yield for a Strong Credit

CEQP is a BB- credit and the company’s recently issued 2027 bonds yield 5.1%. On next year’s numbers CEQP is levered about 3.6x or 5.3x through the preferreds. The company has committed to long-term leverage under 4.0x which given the trading multiples for G&P assets means there will always be significant asset coverage for the preferreds. There are no material debt maturities until 2023 and the company has significant liquidity available under their revolver.

The market value of the common units is $2.8B . On a $6B EV this implies that firm value would have to decrease by 47% before the preferred starts to be impaired. Considering that the current market for MLPs / energy stocks is not exactly frothy, a decrease in firm value of this magnitude would a necessitate a massive and unexpected change to the earnings power of this business.

CEQP generates significant cash flow which is used for growth capital and to pay distributions to unitholders. However, in a stressed case both dividends and growth capex can be suspended which would provide significant flexibility to wait out a downturn in the energy market.  As shown below, the preferred distributions are covered 4.4x and if Crestwood were to suspend common and preferred dividends they could repay 20% of their debt per year.

Figure 1: Strong Cash Flow Supports Credit

Self-funded Growth Capex Will Improve Credit Profile

Over the next several years, CEQP intends to invest $100-$150mm per year in growth capital. The company believes these organic growth investments can be done at a 5-7x EBITDA multiple. Looking at the company’s assets and past projects these estimates appear reasonable.  Unlike many MLPs this growth capex will be entirely funded from internally generated cash flow. Between these  growth investments, prior investments ramping up and price escalators, CEOP should de-lever by 0.2-0.3x per year.

Diversified Exposure

As shown below, Crestwood’s exposure is fairly diversified by both production area and commodity. The terminal and marketing segments provide additional diversification. As such, an issue with a single market or production basin is unlikely to impair this investment.

Figure 2: Exposure by Geography and Commodity

U.S. Energy Production is Growing

Despite the current issues in the energy markets, all estimates expect US energy production to grow for the foreseeable future. Significant reductions in drilling costs over the last several years and improvements in transportation infrastructure have significantly lowered the cost for U.S. shale production and now producers are profitable in most commodity price scenarios.

Figure 3: Growing U.S. Energy Production(EIA estimates)

Production in CEQP’s primary areas specifically is expected to grow. Higher volumes are forecasted in the major production areas for at least the next several years.

Figure 4: Production for CEOP’s Largest Basins (Wells Fargo estimates)

Key Risk

Payments are based almost entirely on volume meaning there is no direct commodity price risk. There is also minimal credit risk since wells cannot produce without the gathering systems. Even if a large customer went bankrupt, this customer (or any new owner of the assets) would have no choice but to honor their contract if they wanted to continue to operate the wells. We saw this in certain recent bankruptcies (such as Energy XXI) where lessors were unable to reject gathering and processing contracts during bankruptcy.

Well production declines over-time. As such, cash flow will decline unless new wells are completed. Producers will only drill new wells if commodity prices make these wells profitable. Thus while these business do not have any direct commodity price exposure, commodity prices are a risk to the extent prices impact drilling activity.

Downside Case

For this investment to become impaired production volumes would have to fall significantly. CEQP’s customers need crude oil prices of about $45-$50 per barrel to earn an economic return on new wells. Even if prices fell below these levels it would take time for production to fall as drillers with hedged production continue to drill and other producers take time to adjust capex budgets. I’ve seen estimates that suggest for production to fall over the next two years would require oil prices below $40.

If absolutely no new wells were drilled, CEQP’s earning would fall about 5% per year. As such, even in a downside commodity environment, it will take some time for production to fall and even if production falls it will take time for earnings to fall enough to impair the preferred.  Thus the true risk here is a deep and prolonged decrease in energy prices greater than what we saw in 2016 or even 2009. The breakeven cost for CEQP’s  is broadly in-line with most U.S. production and lower cost than many global production centers. As such, if CEQP’s customer stopped production it is fair to assume that a significant amount of global production has been curtailed. This downside scenario would thus require a large decrease in global demand which there is no reason to expect.

Catalyst

Delevering, increased liquidity