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Temptation to increase distributions could threaten oil, gas MLPs' credit

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Temptation to increase distributions could threaten oil, gas MLPs' credit

While oil and gas pipeline operators have largely retained investment-grade credit ratings by imposing capital discipline on their balance sheets in the past several quarters, an S&P Global Ratings analyst said the temptation to prematurely grow shareholder payouts could derail that progress.

As midstream master limited partnership stocks lagged in 2017, some MLPs modified distributions to retain more cash at the top and pivot toward self-funding their equity needs. Industry experts expect this trend to continue through 2018, alongside partnerships' increasing structural simplification through either converting to corporations or eliminating general partners' incentive distribution rights.

Still, S&P Global Ratings' Michael Grande emphasized that it could take just one management team to reverse the headway pipeline companies have made since the commodity price downturn that began in 2014. "At some point, someone's going to say, 'Hey, we're going to increase our distribution by X amount,' and they see a bump in their price, and what I would worry about as a credit analyst is if others follow suit … and companies get overextended again," he said in an interview.

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While Grande noted that there is no evidence that such a turnaround is on the horizon, he said the midstream sector must keep its nose to the ground to avoid raising distributions too fast and too soon. "You've seen this in the past when there's been a correction, and then what happens is people could … forget about that discipline," he explained. "The biggest threat [to midstream credit] is overreaching and becoming more aggressive to compete with other midstream players."

In a report released Feb. 6, Grande and other S&P Global Ratings analysts warned that while they anticipate that midstream companies will continue to reduce their leverage, the high cost of equity could lure the industry toward relatively cheaper debt and reinforce the equity rates that have pushed MLPs to avoid capital markets.

"With debt pricing at low levels, from a cost-of-capital perspective it's more advantageous to issue debt. However, if that's the case, leverage will continue to inch higher until either the cost of equity improves or the unit or stock price appreciates," they wrote. "More recently, equity investors have rewarded companies with stronger balance sheets, and so if a company's financing plan is more debt weighted, that would continue to pressure its cost of equity."

S&P Global Ratings and S&P Global Market Intelligence are owned by S&P Global Inc.