This means that there is a risk that when oil prices rise above $50 we’ll see U.S. production actually start rising again which could cap the ultimate long-term price of oil, hurting the financial health of this debt-laden industry and limiting Enterprise’s ultimate growth potential.
For example, oil and gas prices are already up to $47.5 and $2.95 (3), respectively. And in recent months the recovery in energy prices off its January 2016 lows has resulted in a steady rise in drilling rigs.
In fact, just last week Baker Hughes Incorporated (NYSE:BHI) reported the number of rigs drilling in the U.S. rose by 20, the largest weekly increase in two years. That puts the current rig count up nearly 50% off its lows and might signal that U.S. shale producers, eager for additional cash flow to service their debts, might end up stalling the recovery at much lower prices than otherwise would have occurred.
While that’s not necessarily a bad thing for Enterprise in the short to medium-term, since its assets would see growing demand, it might make it harder for oil & gas producers to find sufficient low cost funding in coming years, since banks are less likely to lend money at attractive rates if oil prices remain around $55 to $60 for several more years.
Enterprise is better positioned to take on this risk than many of its peers thanks to its focus on investment-grade rated customers who are more likely to be able to pay their contracts, but it’s still something to pay attention to.
That’s especially true if interest rates continue to rise, as they have sharply over the last few weeks. This brings me to the second major risk for Enterprise, rising interest rates.
Fortunately Enterprise’s massive scale and best-in-the-industry BBB+ credit rating means that it isn’t likely to be priced out of the debt markets in the coming years. After all, the MLP has been steadily growing since 2004 and management has successfully navigated interest rates as high as 6.25%. Furthermore, over 90% of Enterprise Products Partners’ debt has fixed rates, and the average maturity of its debt is 17.1 years.
But we have to remember that as an MLP, Enterprise Products Partners pays out the vast majority of its cash flow as distributions and thus must periodically turn to equity markets to raise growth capital.
If interest rates rise steadily over the next few years, then the massive amounts of yield-starved capital that fueled the MLP boom of the last few years could end up shrinking substantially.
For example, currently the Federal Reserve is forecasting interest rates rising by 2.75% through the end of 2020. That would likely mean investors would be able to buy long-term Treasuries (risk-free bonds) with yields of 5% to 6%.
This in turn would mean that Enterprise, with its current 6.4% yield, would be far less attractive. Rather it’s likely that investors would demand a higher risk premium for its units, meaning an 8% to 9% yield. That could result in higher costs of capital going forward, as well as higher dilution, which makes future payout growth harder to achieve.
Dividend Safety Analysis: Enterprise Products Partners
We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend.
Our Dividend Safety Score answers the question, “Is the current dividend payment safe?” We look at some of the most important financial factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more.
Dividend Safety Scores range from 0 to 100, and conservative dividend investors should stick with firms that score at least 60. Since tracking the data, companies cutting their dividends had an average Dividend Safety Score below 20 at the time of their dividend reduction announcements.
We wrote a detailed analysis reviewing how Dividend Safety Scores are calculated, what their track record has been, and how to use them for your portfolio here.
Enterprise Products Partners has a Dividend Safety Score of 52, which indicates that its payout is reasonably secure. However, the company’s score is relatively high compared to most MLPs, which require special analysis.
That’s due to the nature of the MLP industry, which is massively capital intensive, as well as the business model of MLPs, which is based on paying out most DCF (EBITDA minus maintenance capex) to investors and funding growth with external capital.
In other words, traditional metrics such as EPS and free cash flow (EBITDA minus all capital expenditures), aren’t necessarily the best metrics to use when determining how safe the payout is.
This is because GAAP earnings require a company to account for non-cash charges such as depreciation and amortization of its assets (MLPs have significant fixed assets).
