The energy industry is a sea of possibilities. We are regularly bombarded with information on new technologies, regulations, and business dealings. One such development is the revamped Master Limited Partnership (MLP).
The MLP vehicle began in the ‘80s, died down, then re-emerged with the likes of Apache Petroleum Co., Linn Energy, and Kinder Morgan. This re-emergence began with midstream companies, but is now well on its way into the upstream sector.
The “new” E&P MLPs have predictable, low decline curves, seasoned management teams, and a commitment to hedging commodity price exposure. With the significant growth of the hedging markets in recent years and the growth and success of the MLP vehicle, Linn Energy and its followers have started E&P MLPs. The current E&P opportunity set comprised of the estimated $1.5 trillion value of mature producing properties in the US is larger than the US midstream sector.
Terry Matlack, Tortoise Capital Resources’ managing director, voiced his thoughts on the trend. “Recently, we have seen the reemergence of MLPs that are mostly focused on production. These companies have experienced management teams, assets with long reserve lives, low natural decline rates and multi-year hedging strategies which lessens commodity price volatility. Like midstream companies, upstream MLPs have current income plus growth potential which investors find attractive. Additionally, these companies often have low amounts of leverage, providing steady cash flow to equity investors.”
Mike Telle of Bracewell & Giuliani sees the move into the upstream market as a natural evolution. “I think as the market has come to accept the MLP as a very attractive type of investment vehicle and sponsorships have begun to see more and more financial benefits from doing it, the industry has just evolved,” he said.
Quantum Energy Partners’ managing director Scott Soler believes E&P MLPs will become a major portion of the MLP space. In his presentation earlier this year at the 2007 MLP Investor Conference in New York, he stated, “The running room for the vehicle’s use and growth for E&P assets is substantial.”
He mentioned that between the years 1981 and 1987, right at 30% of the MLPs in existence were upstream MLPs. This time around he believes the percentage could be even higher given the “more prudent management of the types of assets being placed into and well-hedged in these MLPs.”
According to Soler, current market capitalization of the first six E&P MLPs is roughly $4.5 billion with a current combined enterprise value of about $5.0 billion.
Common MLP structures
MLPs are limited partnerships whose interests (limited partner units) are traded on public exchanges just like corporate stock (shares). Publicly-traded partnerships can be set up as limited partnerships (LPs). These have general partners, which are entities. The board is at the GP level, so the public doesn’t elect directors. The GP manages the partnership, generally has an ownership stake in the partnership, and is eligible to receive an incentive distribution. The traditional MLP approach is a limited partnership with a GP that is a wholly-owned subsidiary of the sponsor. The LPs provide capital, have no role in the partnership’s operations and management, and receive up to 90% of cash flow distributions.
Another option is the limited liability structure (LLC). Here there is no GP and the board is elected by the public. When going the LLC route, you have to be willing to have the majority of your board made up of independent directors. Many companies don’t want to do that. “They want to keep control because they’re integrating it with the whole company,” said Baker Botts partner Joshua Davidson.
Another negative is that the LLC structure is very new. Some of the protections of the MLP are not present. For example, there is no concept of maintenance capital, whereas in other structures you have to set aside money to replace reserves on a long-term basis. “I don’t think the structure is bad, but think some people are using it in a bad way,” said EnerVest CFO John Walker. For some, it could be seen as a ‘take the money and run structure.’ The reason being some financial sponsors don’t care about unitholders over time. “They don’t have to take subordinating units and don’t worry about anything but getting money and getting out,” he warned.
Ultimately, the company considering an MLP structure must look at what it is trying to accomplish economically. What is the strategy for the assets? What kind of cash flow does the company generate? How big is the company?
Advantages of the MLP structure
Due to its partnership structure, MLPs generally do not pay income taxes. Thus, unlike corporate investors, MLP investors are not subject to double taxation on dividends. “MLPs are flow-through vehicles. Traditional E&P companies are S-corps. They pay tax and dividends. If you have flow-through, the entity itself pays no tax. It’s only taxed at the individual investor level. That’s the biggest draw,” explained Walker.
In addition, the elimination of double taxation effectively lowers the partnership’s cost of capital. This, in turn, enhances the partnership’s competitive position in the pursuit of expansion projects and acquisitions. The partnership can derive more value than a corporation from an identical acquisition or pay more for acquisitions and realize the same accretion that a corporation could only achieve at a lower purchase price.
“Since there’s no federal income tax, there is more money available for value enhancement of distributions. In addition, the distributions are quarterly, reliable for most part, and trading price has been increasing,” said Davidson.
“When you have a big company and you can pull out assets and put them in a separate vehicle, often you increase the value of the entire enterprise because it has its own investor base, research analyst, and following,” he continued.
Another reason he said, is that “74% of oil and gas wells are crummy wells and very mature wells like that with limited upside potential are best held in more a tax efficient vehicle like an MLP - if you structure it and plan it on the right basis.”
Soler points out another incentive for E&P management teams to place assets into the MLP vehicle. “Publicly-traded E&P companies are currently valued for 4-5x EV/EBITDA vs. 9-12x EV/EBITDA multiples for publicly-traded E&P MLPs. The majority of assets owned by publicly traded C-Corps are mature, lower decline rate assets, many which could be revalued on a distribution yield basis and resultant multiples that are much higher,” he stated.
Additionally, the pool of assets that are candidates for E&P MLP ownership is significant. Quantum Energy Partners estimates that nearly $270 billion assets in North America are PDP (proved, developed, producing) assets, many which technically qualify for MLP treatment.
Who pays taxes?
Because the MLP is a partnership and not a corporation, the partners in the business - the LPs (unitholders) and the GP - are required to pay tax on their allocable share of the partnership’s income, gains, losses, and deductions, including accelerated depreciation and amortization deductions. The amount of taxes allocated to each LP is determined by several factors including the LP’s percentage ownership in the partnership when the investment was made and price at that time.
While the investor eventually pays taxes on the units when they are sold, investors receive higher cash payments than the amount upon which they are taxed, creating an efficient means of tax deferral. According to Merrill Lynch, the tax-deferred portion of the cash distributions serves to reduce an LP unitholder’s cost basis in an MLP, and when the MLP is sold, that income is recaptured.
Wachovia Securities estimates the taxable income passed on to investors often is only 10% to 20% of the cash distribution, while the other 80% to 90% is deemed a return of capital and subtracted from the original cost basis of the initial investment.
As with any business dealing, there are risks and concerns to be addressed. “First it’s very expensive to create,” said Walker. Secondly, because setting up an MLP is setting up a separate entity, a fair amount of accounting and Sarbanes-Oxley considerations must be addressed.
Once these initial tasks are completed, the work continues. “The company must be focused on making it work. Too many people think that the finish line is when you get it in place. The finish line is 5 to10 or 15 years from now,” said Walker. Those that put these in place or are contemplating them as the ‘flavor of the month,’ are “listening to investment bankers giving them bad advice,” he continued. The company must think about where it will be in 5 to10 years, not simply, ‘am I getting a premium valuation for my assets this minute.’
Once in place, growth is dependent on the company’s ability to access external capital. MLPs pay most of their cash to unitholders, so they must continually access the debt and equity markets to finance growth.
Another specific risk to upstream MLPs is commodity price exposure. These companies hedge a lot of that production, typically 75% to 80%, according to Davidson. His worry is what happens with the hedges wear off. Depending on where prices are at the time, the company could buy security for a few years, but what about the long term?
While the majority of E&P MLPs do not have incentive distribution rights (IDRs), and those that do operate at lower levels than non-upstream MLPs, a few, including EV Energy Partners, may chose to utilize the method. These IDRs are another thing to consider.
“A primary downside is the incentive distribution rights (IDRs) paid to the general partners. MLPs are structured with a general partner and limited partners. The general partner operates the company’s assets while the limited partners own interests in the partnership. With incentive distribution rights, the general partner is encouraged to grow the distribution paid to the limited partners by receiving an increasing percentage of the total distribution paid as the distribution grows,” commented Tortoise Capital’s Matlack.
Conflicts of interest with the GP
When the GP of the partnership and the parent company that owns the GP are controlled and run by the same management teams, the independence and legitimacy of the MLP structure may be questioned. Things to watch are the price at which the MLP is acquiring assets from the GP, and the aggressiveness of the GP in increasing the distribution to achieve the 50/50 split level rather than assuming a more conservative growth strategy that ensures the long-term sustainability of the cash distribution.
Then there is always the potential for management to place the interests of the parent corporation or the GP above the interests of the LP unitholders. In the evaluation of opportunities, management teams must decide whether to put assets in the LP or, instead, take them to the GP and drop assets with lower risk, and thus a lower return, into the LP.
Another problem is the possibility that an upstream MLP will have to compete with the GP or one of its subsidiaries for resources. For example, who gets first rights to scarce and expensive resources like drilling rigs?
To avoid these potential conflicts, a good management team must be in place. That being said, even good management teams, when stretched too thin, can run into trouble. This is true when a company spins-off just one MLP. The current lure of MLPs has already enticed the creation of multiple MLPs by one company. Pioneer, for example, is working on two. “Multiple MLPs from one company have to be managed carefully to avoid conflict of interests,” said Davidson.
A severe economic downturn
Energy demand is closely linked to overall economic growth. A severe economic downturn could reduce the demand for energy and commodity products, which could cause lower earnings and cash flow. Walker believes that companies with a 5% or 6% yield for example, buying assets at PV 5 and 6, are a “recipe for disaster.” To him, it indicates the company expects all the reserves in that asset to give them a 5% return. What happens if interest rates go up? What happens if oil and gas rates go down? He says he doesn’t expect MLPs to pay much more than what the market was last year or the year before, and worries about companies not being able to sustain distributions.
The ability to sustain distributions through hard times is a concern echoed by Davidson. “Are people going to reserve enough cash flow to continue to drill even at a lower price environment? If they don’t they’re going to run out of money from the wells to pay distribution.”
Many MLPs have been able to grow cash flow and distributions by making accretive acquisitions. Difficulties in locating attractive acquisition targets or integrating future acquisitions could negatively affect future cash flows. MLPs borrow a lot of money to make acquisitions. One potential downfall would be the “inability to make accretive acquisitions,” Davidson said. “They need to make acquisitions or do capital projects and if they don’t do them, that would be bad,” he continued.
Many MLPs have been able to grow cash flow and distribution by investing in organic expansion projects. If these projects are not kept within budget and on schedule, future cash flow growth could be affected. Davidson notes seeing trend toward shorter reserve life and lower reserve production ratios. To him, this could potentially be an area of concern going forward.
Rising interest rates and an adverse regulatory environment could also negatively affect MLPs. As seen in 1998-99, MLPs, like many other institutions, have underperformed during periods of rising interest rates. With interest rates currently at all-time lows, an increase in interest rates could adversely affect MLPs’ performance in the near term. As far as the regulatory environment, “The nuclear bomb would be if Congress revoked this tax treatment and taxed MLPs as corporations,” stated Davidson.
MLPs originated in 1986 as an act of Congress set to promote energy supply just as the oil market crashed. Upstream MLPs have not resurfaced until now because of problems with structure. Distribution levels were too high given the depleting nature of the business, companies were taking on too much debt, and the general partner interests were often promoted at the expense of limited partner interests.
These businesses had assets that depleted and were therefore not well-suited to an entity that essentially distributed all of its cash flow. Without reinvestment, these MLPs were essentially self-liquidating partnerships and were unable to sustain their distributions.
It wasn’t until January 2006, when Linn Energy’s MLP went public that the trend as we see it today began. Linn Energy is often seen as the first E&P MLP. Many see it as the catalyst that started the transformation of how mature producing oil and gas properties are owned and capitalized in the US, similar to how Kinder Morgan led a shift in the way pipeline assets are owned inside MLPs.
Some industry figures, Walker included, consider Apache Petroleum Co. (APC) the country’s first MLP. APC, with Apache Corp. as its general partner, was born in 1981 through a consolidation of interests in 33 of Apache’s oil and gas programs formed between 1959 and 1978.
The consolidation of those previously illiquid program interests into a market-traded MLP provided investors with a rare combination of opportunities: more efficient operations; liquidity; tax shelter; cash flow; potential for market appreciation; and the opportunity for future growth through drilling and/or acquisition. This MLP has evolved over time and is now Cimarex in a different form.
Regardless of who was first, the MLP vehicle has taken off in the upstream sector. Atlas America Inc. had been involved in the energy industry since 1968, but entered the MLP forum when it formed Atlas Energy Resources LLC in June 2006 to own and operate nearly all of its natural gas and oil assets, as well as its investment partnership management business.
Atlas Energy Resources was one of the first six E&P companies formed as MLPs to provide a tax-advantaged financial structure for investors. The company recently purchased DTE Energy’s oil and gas business for $1.225 billion. Unconventional gas plays such as DTE’s have gained popularity among investors as reserves in mature areas have dried up and as new technologies have allowed access to previously untapped properties.
Other companies past the initial stages of MLP structuring include Abraxas Petroleum Corp. and EnerVest.
Abraxas formed its MLP, Abraxas Energy Partners LP, pursuant to which Abraxas contributed certain assets located in South and West Texas. The general partner, Abraxas General Partner LLC, is wholly-owned subsidiary of Abraxas.
Abraxas sold an approximate 53% interest in the partnership in a private placement offering for $100 million. Abraxas sold $22.5 million of its common stock in a private placement offering to several purchasers of the Partnership units.
“Earlier this year, we realized there was a unique opportunity to recapitalize Abraxas on much better terms than we currently had with our existing debt, and thus, we embraced and acted upon the opportunity to form a master limited partnership,” commented Abraxas president and CEO Bob Watson.
Tortoise Capital Resources invested $7.5 million in the Abraxas MLP. “This investment further demonstrates the trend of mature upstream assets moving toward the MLP structure,” said Tortoise Capital president, Ed Russell. “In our view, upstream MLPs will continue to have an advantage attracting assets due to their lower cost of capital. The ability to attract assets should continue to drive distribution growth for upstream MLPs.”
While EnerVest made the determination more than 5 years ago to get into the MLP structure, it took some convincing to get the needed backing. “When we started talking to investment banks in New York four years ago, they didn’t want to talk to us. They talked about failures in the ‘80s. We gave them the research on why they failed and why ours was different, but there was no interest,” Walker said.
The company, along with Credit Suisse First Boston, studied the early MLP structure and Canadian Royalty Trusts to determine how the company could succeed. By September of 2006, EnerVest had raised $550 million.
The next wave
With the success of the pioneers comes what will more than likely become a wave of new MLPs. Dallas-based Pioneer Natural Resources Co. has approved a plan to form two new publicly-traded MLPs.
It is anticipated that the first MLP will initially acquire an interest in a portion of Pioneer’s long-lived proved developed reserves in the Spraberry field in West Texas. The company expects $250 million of the partnership units to be offered to the public, subject to market conditions.
The second MLP is expected to acquire an interest in a portion of Pioneer’s gas reserves in the Raton Basin field in southern Colorado. Another $250 million partnership units are expected to be offered to the public during 2008.
Pioneer will be the general partner of each of the MLPs and hold a majority ownership in the units of each of the MLPs. Pioneer will continue to operate and own a partial working interest in the assets that will form the MLPs.
Encore Acquisition is also working on its MLP spin-off. The MLP is expected to own certain Wyoming oil and natural gas properties to be acquired from subsidiaries of Anadarko Petroleum and certain legacy oil and gas properties currently owned by Encore.
Another company considering the MLP vehicle is XTO Energy. It is in the process of reviewing its entire portfolio of producing properties, including a $2.5 billion producing property it recently acquired, for selective inclusion in a master limited partnership with an initial capitalization of greater than $500 million.
“In today’s marketplace, we believe an opportunity exists with the MLP structure to further enhance the captured value of a portion of XTO’s exceptional property base,” said Bob R. Simpson, chairman and CEO.
Shortly before this issue went to print, Petrohawk and TETRA Technologies announced they were throwing their hats into the MLP ring.
Petrohawk will file with the SEC in the third quarter, with a $150 million to $225 million offering being made in the fourth quarter. SEC rules prohibit the company from talking too candidly about its plans, but it is known that either Petrohawk or one of its subsidiaries will be the general partner of the MLP, to be named HK Energy Partners LP, and will own a majority stake at the close of the IPO.
The company plans to sell its Gulf Coast division, and will concentrate its efforts on developing and expanding its mid-continent natural gas resource-style activities, including tight-gas development in North Louisiana and East Texas and in the Fayetteville and Woodford shales.
Woodlands, Tex.-based TETRA Technologies, a service company to the upstream E&P sector, intends to form an MLP in which it will place the majority of its Compressco Inc. subsidiary assets. Geoffrey M. Hertel, president and CEO of TETRA, said, “Creating an MLP out of Compressco is a continuation of our ongoing strategy to unlock and create value for our stockholders, from our assets.”
Thus far, the boom in E&P upstream company MLPs has no end in sight. For the companies implementing them and the companies considering them, the benefits far outweigh the risks. To them, the risks are manageable if the internal management affairs are properly structured. “The incentives of the sponsor (general partner) and the common unit holders are very much aligned. If the company does well, the limited partners do well and the general partner does well,” said Davidson.
Without proper management and true regard for the risks, however, some MLPs may drown. These will likely be the ones starting out with too much debt, or too much drilling and not enough discipline. Despite the risks, we’re in a ‘darling of the market’ state of mind, and MLPs are “moving at such a force right now with everyone viewing it favorably it almost doesn’t matter,” concluded Walker.
While Merrill Lynch economists are calling for today’s low interest-rate environment to continue and project energy MLPs’ cash distribution growth to continue and average 5% to 8% over the next several years, time will tell which companies will thrive and which erred by riding the MLP wave unprepared.
Canadian ties to US MLPs
Before a special hearing of the House of Commons Standing Committee on Finance in January, Jim Flaherty, Minister of Finance, stated that Canada’s government intends to proceed with the Tax Fairness Plan that was announced October 31, 2006.
“I am not prepared to sacrifice the interests of millions of hard-working Canadians who pay their taxes and play by the rules so that a select group of special interests can enjoy a tax holiday,” he said.
It is estimated that the federal revenue loss in 2006 was near $500 million - and being shifted to ordinary taxpayers and other tax-paying corporations - due to the special tax advantage for income trusts.
Canada’s “Income trusts” - or publicly-traded flow-through entities (FTEs) have been a major trend in Canadian business, much like MLPs are in the US. These entities represent over $200 billion in market capitalization.
While these decisions offer corporations short-term tax benefits, the fear of the Canadian government is that they are creating an economic distortion threatening the country’s long-term economic growth resulting in billions of dollars less revenue the federal government has to invest in personal income tax relief, as well as the provinces and territories.
It is expected that with the new Tax Fairness Plan, a more appropriate tax regime will be introduced for FTEs. Their tax treatment will be more like that of corporations, and their investors will be treated more like shareholders.
Specifically, certain distributions of FTEs’ income will be subject to tax at corporate income tax rates. Those distributions will - like the dividends that corporations pay - not be deductible by an FTE that is a trust, and will be taxed in the hands of an FTE that is a partnership. The investors in the FTE will be taxed as though the distributions were dividends.
It is expected that the new rules will apply to any publicly-traded “income trust” (or publicly-traded partnership), other than one that only holds passive real estate investments. These changes will generally take effect beginning with the 2007 taxation year for trusts that begin to be publicly-traded after October 2006, but will only apply beginning with the 2011 taxation year for those FTEs that are already publicly-traded.
What could this mean for US investors? John Walker, CFO of Evervest believes that cash flow will be dramatically hit and the trusts will become much less attractive to US investors. “For the big guys over 50% of investors are US. US investors over time are going to flee them,” he said.
Could the flipside be Canadian assets landing in the MLP structure? MLPs may offer some key benefits, perhaps allowing Canadian firms to sell stakes in low-maintenance, mature properties to investors without losing control over them.
Provident Energy Trust has already benefited. The company raised $111 million last year with its three-quarter ownership with Breitburn Energy Partners LP, an MLP that operates assets in California, Wyoming, and Texas.
In an effort to position itself for the impending tax law change, Canadian-based Enerplus Resources Fund said it will continue to support an active involvement in M&A market in the US, and perhaps look for US MLP opportunities.
The E&P MLP market in the US is small, but set to take off. While there are still plenty of unknowns surrounding Canadian companies and tax laws, the market may offer an opportunity for Canadian energy producers if the income trust withers. For now, it’s wait and see.