An ongoing uncertainty in financial markets has led investors away from new startups and into more established companies. Energy, however, remains the one bright spot on the market for initial public offerings (IPOs), with several new spinoffs taking off, while other newly public companies have languished.

In particular, energy's midstream master limited partnerships (MLP) attract investors, and for several reasons. In general, midstream operations are characterized by stable cash flows and strong growth potential.

"That's what MLP investors are looking for," says John Sherman, president and chief executive of Inergy Midstream LP.

“We identified assets that we believed would collectively generate stable cash flows and also have sufficient scale to enable Inergy Midstream to grow through acquisitions and internal growth projects…” — John Sherman, president and chief executive, Inergy Midstream LP

In today's financial environment, the market is seeing some of the lowest interest rates in years, and with the latest announcement from the U.S. Federal Reserve, many investors don't expect to see a significant change in rates until 2014. As a result, they are looking for investment vehicles that offer them both steady income at attractive yields and some potential for growth. MLPs that offer both will attract investors, Sherman says.

Inergy Midstream LP is the youngest of the new midstream IPOs, going public in mid-December 2011 with an initial price of $17 per unit. The unit has done well since then, returning about 20% through mid February. During the same time, the broader Standard & Poor 500 index rose half that much.

Different investors

The formation of the new MLP gives Inergy LP, the parent company, a vehicle for attracting investors with different investment objectives. Previously, Inergy LP was a hybrid company with operations in propane distribution, natural gas storage and transportation. "In the long term, those businesses have different characteristics that attract different investors," says Sherman.

From an investment perspective, Inergy LP's propane business behaves more like a utility, which draws yield-oriented investors. The natural gas and transportation business is more-growth oriented, which attracts investors whose focus is on overall returns. Forming a separate subsidiary MLP (Inergy Midstream LP) allows Inergy LP to unlock the embedded value of that midstream business not fully reflected in the parent's valuation and relieves some of the future growth capital funding requirements of the midstream business from the parent's balance sheet. With the establishment of Inergy Midstream LP, Inergy LP has established a vehicle to finance its high growth midstream natural gas and transportation business with a better cost of capital.

"In addition to this cost of capital benefit, we also paid down some of the debt at the parent level," Sherman says. Inergy LP used the net proceeds of about $290 million from the IPO, plus a reimbursement for capital expenditures attributable to the assets of Inergy Midstream LP of about $80 million, to pay off $370 million in outstanding debt.

Inergy LP, the parent, owns 75.2% of the outstanding limited partnership units of Inergy Midstream, all of the incentive distribution rights, and the managing partner of the subsidiary, which allows unit holders in Inergy LP to participate in the future growth of Inergy Midstream.

Management operates the business so that Inergy Midstream's value is not directly impacted by fluctuations in commodity prices. "This is not just a gas storage business that is dependent on the forward curve for natural gas prices. It is an integrated platform for natural gas storage and transportation which is an integral part of the overall natural gas infrastructure in the northeastern U.S.," he says.

Inergy Midstream

Inergy LP management carefully chose which assets to place into Inergy Midstream. "We identified assets that we believed would collectively generate stable cash flows and also have sufficient scale to enable Inergy Midstream to grow through acquisitions and internal growth projects—a prerequisite for a company valued, in part, on its ability to pay and increase distributions over time,"Sherman says.

In particular, Inergy LP was looking for assets with stable cash flows in the natural gas and NGL storage and transportation business. "The real benefit to creating Inergy Midstream is to have a pure play midstream MLP that has the 'crown jewels' of the previous structure for the benefit of all investors," he says. Inergy Midstream's assets also have a strategic location, with close proximity to production in the Marcellus and close to key natural gas markets in the northeast.

Inergy Midstream's four gas facilities are regulated by the U.S. Federal Energy Regulatory Commission. In addition to its current set of assets, Inergy Midstream keeps an eye open for additional strategic assets that it could acquire.

Inergy Midstream LP’s flagship natural gas storage asset, Stagecoach Storage, is a high-performance, multi-cycle gas storage facility in Tioga County, New York. Shown here is the compressor hall and manifold piping at Stagecoach. Source: Inergy Midstream LP

"We frequently monitor the marketplace to identify and pursue complementary acquisitions, with a particular focus on assets that would strengthen our franchise position in the Northeast or facilitate our entry into attractive new geographic or product markets," he says.

In addition to third-party acquisition opportunities, Inergy Midstream also keeps its eye open for additional assets from its parent, Inergy LP.

"Although Inergy LP is under no obligation to make acquisition opportunities available to us, it has a significant economic stake in us and a strong incentive to support our growth," he says.

Inergy Midstream's income comes from fee-based cash flows that are virtually 100% contracted, and closed the IPO with a total debt to EBITDA (earnings before interest, taxes, depreciation and amortization) ratio of less than 1.

Looking forward, Inergy Midstream expects about a third of its revenue in 2012 to come from pipeline transportation activity, all on long-term contracts. Also, the storage assets are close to the key market for natural gas and liquids in the northeast. The region's gas consumers expect to see increasing supply from the growing production in Marcellus even as demand for natural gas slowly builds in the Northeast, he says.

The company trades at a better equity cost of capital than the parent. Currently, its units trade with an equity yield of about 7%. Given the location of its assets, the fee-based nature of its cash flows, strong balance sheet and strategic location, "We would expect Inergy Midstream to trade with better debt and equity costs of capital over time," he says.

The business plan and its first quarter results have drawn a favorable reaction from analysts. Barclays Capital gave it an overweight rating and a $23 per unit price target. The overweight rating means it is expected to outperform the expected total return of its peers during the next 12 months. The new Inergy Midstream LP is expected to return 16.2% during the next 12 months, compared with a return of 12.9% for the sector of comparable MLPs, according to Barclays.

Other analysts agree the new midstream MLP shows great promise. Putting Inergy's northeast storage and pipeline assets into a stand-alone entity will allow the market to value the high quality fee-based assets separately, which should warrant a higher multiple, says John Musgrave, a senior research analyst and portfolio manager at Swank Capital LLC. "Inergy LP's northeast storage and terminaling business was not being fully valued because it was bundled with a propane business that had fallen on some hard times," he says.

Tesoro Logistics

Another recent midstream IPO that has also done well despite challenging times for newly public companies in other sectors is San Antonio-based Tesoro Logistics LP. Tesoro Logistics president Phil Anderson believes one of the reasons for the firm's recent success stems in part from the location of its assets, which are close to some high growth areas. "There has been substantial growth in and around the Bakken," he says.

Tesoro Logistics went public in April 2011, opening with an initial trading price of just above $23 per unit. Since then, its value has climbed more than 40% as the Standard & Poor's 500 index has risen only 2% in the same timeframe. Its assets include crude oil gathering lines, product terminals transportation and storage in the western U.S. The MLP is a growth vehicle for Tesoro Corp's logistics business.

Forming a subsidiary MLP gave Tesoro Corp. a few advantages that it did not previously have and it formed the MLP because it hoped to grow in key areas, including logistics.

Tesoro Logistics' crude oil gathering system is the sole source of supply to Tesoro Corp's North Dakota refinery and benefits from the rapid expansion of the Bakken crude oil production. Tesoro Logistics also has eight refined product terminals in the western U.S. and storage facilities for refined products and crude oil and short-haul pipelines supporting Tesoro Corp's refineries.

"Unlike the rest of the refining business, logistics is a very stable cash flow business. Logistics gives you unique access to markets and other commercial opportunities in the marketplace," he says.

If Tesoro wants to be a key player in the competition for logistics assets, it has to recognize that market is dominated by MLPs, Anderson says. To compete with them, Tesoro Corp. felt compelled to form an MLP of its own. The cost of capital is lower for MLPs than refiners, allowing the market to assess the cash flows from that structure at a much higher ratio than it would from a traditional refining company. As a result, MLPs have good access to equity markets and other sources of capital.

"Establishing an MLP entity really was part of a goal to be able to play in the logistics marketplace without being at a disadvantage from a cost of capital standpoint," Anderson says. Another reason behind the new MLP is that Tesoro Corp. had a significant amount of pipelines and storage facilities associated with its seven refineries, assets which fit perfectly into an MLP.

Cost of capital

"We can benefit as we move those assets to an entity that has a lower cost of capital and a higher valuation multiple," Anderson says. Part of Tesoro Logistics' business strategy is to secure long-term, fee-based, inflation-indexed contracts with shippers. It provides critical infrastructure to its general partner, Tesoro Corp. Its strategy for growth is through organic growth prospects, optimization opportunities and dropdown assets from Tesoro Corp.

That strategy has served it well. Tesoro Logistics recently reported fourth-quarter 2011 net income of $11.5 million or $0.37 per basic limited partner unit. That expected distribution represents a 7% growth from the distributions announced in the first quarter only six months earlier.

"In the competitive landscape of MLPs, that growth would be considered growth on a full year basis—and we did that in half a year," he says.

MLP investors have told Tesoro Midstream's management that they want exposure to the resources generated from unconventional oil and gas plays. "When we talk to investors, the feedback we get is that they want exposure to some of these rapidly emerging plays in the shale areas, especially liquids," he says. "The investors see rapidly growing opportunities. They have encouraged us to be aggressive about investing in our business. They are ready as investors to put significant money into the space. There is a strong appetite on behalf of investors to participate in the whole area."

Tesoro Corp. has announced it will drop down its Martinez Crude Oil Marine Terminal into Tesoro Logistics, a move which should add an estimated $8 million of EBITDA annually to the MLP. The Terminal has a projected volume of 70,000 barrels (bbl.) per day, a wharf capacity of 145,000 bbl. per day and storage capacity of 425,000 bbl.

Tesoro Logistics' revolving credit facility is expected to finance the dropdown, which is expected to close early in second-quarter 2012.

Potential dropdowns

In addition, Tesoro Corp. has a list of other assets that it could drop into the MLP over time. Some of the other dropdown growth opportunities include product terminals in Kenai, Alaska, Anacortes, Washington, and Martinez, California. Tesoro Corp. also has pipelines in Los Angeles, California, and Kenai, Alaska, and marine terminals in Anacortes, Washington, Martinez, California, and Long Beach, California.

Going forward, Tesoro Logistics plans to double the volume of its existing Bakken business. In addition, it hopes to grow terminal volumes by Tesoro's marketing expansion and increased third-party businesses. All told, it plans to invest $100 million through 2013, including $15 million of previously announced projects. An estimated $60 million will be used to expand its high plains system and $40 million to expand its West Coast terminals.

The additional capital will allow Tesoro Logistics to grow system volumes to more than 100,000 bbl. per day by 2013. Growth at its Mandan, North Dakota, refinery is expected to be 10,000 bbl. per day by mid-2012 and Anacortes refinery by 30,000 bbl. per day by yearend 2012.

It expects to grow its trucking volumes to 35,000 bbl. per day and to increase its terminal volumes by more than 40,000 bbl. per day by the end of 2013, both through optimization of current assets and expansion of those assets.

The additional investments and optimization should translate to stronger operating cash flows. Tesoro Logistics has told investors it optimization efforts and organic growth projects should grow EBITDA to over $90 million by 2013, up 72% from the IPO, once it fully implements its growth and optimization plans. Its base business generates $53 million in annual EBITDA.

Since its IPO, Tesoro Logistics has added $8 million in annualized EBITDA by improving the utilization of its assets. In addition, it has announced projects expected to add over $30 million of annual EBITDA.

"Those MLPs that have visible growth are the ones that will enjoy a better share price performance," Anderson says. "The market really understood the business plan that we put together. The folks that follow the sector understand the opportunities in and around the Bakken."