The Renaissance Of Pipelines And Our Sell Discipline

This is the final excerpt from IMA’s winter letter.


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Pipelines are undergoing a renaissance today, but it’s not the one you think. The previous renaissance of shale oil and natural gas development was anything but a good outcome for this industry. Capital-intensive industries, contrary to common opinion, don’t benefit from increased demand for their product. Increased demand attracts competition. In a capital-intensive business it is very difficult to increase your capacity just a little. These industries don’t work that way, and here is why: Larger investments bring lower costs on a per-unit basis. But when everyone does this it also brings lower prices (revenues) per unit.

To make things more complicated, the pipeline industry is structured as master limited partnerships (MLPs). MLPs are mostly owned by retail investors who hold them to get one shiny object – yield. These companies generate enormous cash flows, while maintenance capital expenditures – basically, the expenses of maintaining their pipelines – are relatively small (10-20% or so of their cash flows).

To grow cash flows, once a company has an established pipeline network, it can do any number of things: It can raise prices for transporting products in its pipelines. It can make small investments to improve the interconnectivity of its pipelines, thus increasing the value of the pipelines to its customers, which also brings higher prices. It can send more products through its pipelines (of course, they are limited by capacity). There are probably a few other small things it can do, and we are sure these companies did them. A company can also do big things – build new pipelines, for instance. Improvements in oil and natural gas extraction technologies brought an enormous amount of petrochemicals to the surface, and they need to be transported.

Here is the problem. Since their investors were attracted to dividends, these companies would pay out most of their cash flows in that form, and whatever cash flows were left they’d put into new projects; but those cash flows were not enough, so… yes, they’d borrow a lot of money. But even borrowing was not enough, so they would pay large dividends and then issue shares (MLP units). They’d pay 6% dividends and then turn around and issue 3% of new shares. Retail investors were delighted to collect 6%, ignoring the fact that the pie now needed to be shared with 3% more shareholders (the stock price would decline 3%).

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I am not a journalist or reporter; I am an investor who thinks through writing. This and other investment articles are just my thinking at the point they were written. However, investment research is ...

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William K. 1 week ago Member's comment

Thanks for a whole lot of insight and some rather useful information. And good writing besides.