Beyond the pipeline

Kinder Morgan, the largest independent transporter of petroleum products in the US, transported approximately 1.9 MMb/d in 2009.All photos courtesy of Kinder Morgan.

Mikaila Adams, OGFJ Associate Editor

Beyond the financial crisis: it's the direction we're all looking. Beyond the pipeline: it's the direction many hydrocarbon producers were looking before the financial crisis reared its ugly head. During the years 2006 and 2007, many in the upstream sector began to take a second look at the master limited partnership structure for assets. Then befell the great economic crisis, and transactions of all types, both inside the energy industry and out, all but came to a halt. Fast forward to current day, and the idea seems to be in renaissance.

MLPs are limited partnerships whose interests (limited partner units) are traded on public exchanges like corporate stock. The traditional MLP approach is a limited partnership (LP) with a GP that is a wholly-owned subsidiary of the sponsor. Another option is the limited liability structure (LLC) where there is no GP. Because of the partnership structure, MLPs are flow-through vehicles that generally do not pay income taxes. Thus, unlike corporate investors, MLP investors are not subject to double taxation on dividends.

As of Dec. 31, there were 70 energy MLPs with a total market capitalization of $212 billion, according to FactSet and the National Association of Publicly Traded Partnerships. This number has grown from 18 MLPs with a market cap of $15 billion in 2000.

In truth, the majority of these are midstream MLPs. Midstream businesses are the first energy MLPs to come to mind, as they typically make the most sense to operate under the MLP structure. Midstream MLPs, for example, natural gas pipeline MLPs, typically operate stable cash flow businesses.

These type of MLPs "operate fee-based pipeline assets backed by long-term contracts," noted Tudor, Pickering, Holt & Co. Securities Inc. analyst George O'Leary. "Commodity prices don't tend to dictate the performance of these MLPs, certainly not to the same degree as they do for E&P stocks," he continued.

Barbara Spudis de Marigny of Gardere Wynne Sewell LLP reiterated these traditional challenges: "The industries using MLP form continue to be dictated by the reliability of revenue and its inelasticity relative to the price of oil and gas. E&P MLPs, by their nature, cannot be as confident of steady revenues as infrastructure or pipeline MLPs."

The MLP vehicle began with tax changes in the ‘80s. The sector began with Apache Petroleum Co. in 1981. APC, with Apache Corp. as its general partner, was born through a consolidation of interests in 33 of Apache's oil and gas programs. This MLP has evolved over time and is now Cimarex in a different form. Tax changes in the late ‘80s essentially prevented the disincorporation of corporate America. In short, problems with structure surfaced (distribution levels too high given the depleting nature of the business, over-leveraged companies, and general partner (GP) interests too often promoted at the expense of limited partner (LP) interests) and depleted assets without reinvestment caused the partnerships to self-liquidate. Investors and management teams alike were left burned by the entities.

Enter the pioneers. The beginning of the growth MLP really started to grab hold in the early ‘90s with Rich Kinder of Kinder Morgan and the late Dan Duncan of Enterprise Products Partners.

Despite its heavy association with pipelines, Kinder Morgan is, fundamentally, the largest upstream MLP. The company holds the title of second-largest oil producer in Texas, producing over 55,000 barrels of oil per day at the SACROC Unit and the Yates Field in the Permian Basin.

Today, however, it is LINN Energy that is known 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. When LINN Energy's MLP, led by the energy investment banking experience of Kolja Rockov (now LINN's executive vice president and CFO), went public in January 2006, the upstream MLP as we know it today was born.

In the August 2007 issue of Oil & Gas Financial Journal, before the effects of the economic turmoil took hold, some folks in the industry saw exploration and production (E&P) companies as the "next wave" of MLPs, and a select group announced intentions to ride the wave.

At the time, XTO Energy was reviewing its entire portfolio of producing properties for selective inclusion in an MLP with an initial capitalization of greater than $500 million. Then chairman and CEO Bob R. Simpson stated that, "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."

Shortly thereafter, the bottom fell out, the marketplace changed, and the MLP was not to be. XTO did, however, find its ‘opportunity' years later in December 2009. Its $40.4 billion buyout by ExxonMobil topped the list of North American energy deals in 2009.

In June 2007, Petrohawk announced its intent to throw its hat into the ring. The MLP, to be named HK Energy Partners LP, would be set up to acquire certain of Petrohawk's oil and natural gas properties located in West Texas, New Mexico, and Oklahoma. A Form S-1 was filed with the Securities and Exchange Commission (SEC) on Oct. 30, 2007, but then, on Jan. 25, 2008, citing market conditions, the company announced it would delay the proposed MLP public offering.

Other companies, namely Pioneer Natural Resources Co. and Encore Acquisition Co., were looking at the structure as well. The results were different.

Dallas-based Pioneer had approved a plan to form two new publicly-traded MLPs, one related to its long-lived proved developed reserves in the Spraberry field in West Texas, and the second related to its gas reserves in the Raton Basin field in southern Colorado.

Pioneer Southwest Energy (PSE) was offered up in April 2008 and now owns producing oil and gas properties in the Spraberry field in the Permian Basin and looks to acquire producing oil and gas properties onshore Texas and New Mexico.

At the time, Encore Acquisition Co. (EAC) was also working on its MLP spin-off. Encore Energy Partners (ENP) was formed to own and operate oil and gas properties in the Big Horn Basin, the Permian Basin, the Williston Basin, and the Arkoma Basin. It IPOed in September 2007 by selling 9 million units at $21 each.

After the wave-turned-ripple of upstream MLP IPOs from 2006-2008, the market for them went quiet. Was it the drastic change in the markets stopping the flow, or something more fundamental?

"Some companies that had considered an MLP as a way to "arbitrage" perceived valuation differences versus corporate form pulled back as they realized that you have to have an ongoing commitment and strategy to grow the MLP and that the IPO is just the first step in the process," said John Walker, chairman and CEO of EVEP and president and CEO of EnerVest.

So who's in?

Currently, the upstream MLP sector is made up of LINN Energy LLC (LINE), Legacy Reserves LP (LGCY), EV Energy Partners LP (EVEP), Encore Energy Partners (ENP), BreitBurn Energy Partners LP (BBEP), Pioneer Southwest Energy Partners LP (PSE), Vanguard Natural Resources LLC (VNR), and Constellation Energy Partners LP (CEP).

As previously mentioned, LINN Energy LLC IPOed in January 2006.

Midland, Tex.-based Legacy Reserves LP is focused on oil and natural gas properties primarily in the Permian Basin, Mid-Continent, and Rocky Mountains regions.

Houston-based EVEP went public in September 2006. The company "has enjoyed significant growth over the past four years, expanding its proved reserves base from 51 bcfe to approximately 800 bcfe and its enterprise value from $150 million to more than $1.7 billion," said Walker.

On Oct. 31, 2009, Denbury Natural Resources (DNR) acquired Encore Acquisition Co., which held the general partner of Encore Energy Partners (ENP). Because the ENP strategy did not fit with DNR's strategy, the GP and the units held by EAC were considered to be on the market beginning in April 2010.

On Nov. 16, 2010, Vanguard Natural Resources LLC (VNR) announced its intent to buy the general partner and 20,924,055 common units of ENP from Denbury.

Scott W. Smith, president, CEO, and director of Vanguard commented, "It was our thought that Denbury, as a leading CO2 development company, would have little interest in maintaining a public MLP in addition to managing a successful C-Corp. As the assets in ENP were already in an MLP structure, we were very comfortable with the production profile. The geographic diversity and oil weighted focus made this opportunity even more appealing."

He added that the company will run the two MLPs separately under one management team, but with two independent boards of directors.

California-based BreitBurn Energy Partners LP's assets consist primarily of producing and non-producing crude oil and natural gas reserves in the Los Angeles Basin in California, the Wind River and Big Horn Basins in central Wyoming, the Sunniland Trend in Florida, the Antrim Shale in Michigan, and the New Albany Shale in Indiana and Kentucky. The company was distressed to a degree and had litigation issues with Quicksilver Resources, but the companies have settled and BreitBurn reinstated distributions beginning with the first quarter of 2010.

As mentioned previously, Pioneer Southwest Energy (PSE) was offered up in April 2008 and now owns producing properties in the Permian Basin and looks to acquire properties onshore Texas and New Mexico.

Constellation Energy Partners is another associated with the upstream MLP group, although its tangled weave of utility-minded management and natural gas production from high cost coalbed methane has left the company with the smallest market cap and enterprise value. The company lists proved reserves located in the Black Warrior Basin in Alabama, the Cherokee Basin in Oklahoma and Kansas, and the Woodford Shale in the Arkoma Basin in Oklahoma.

The newest out of the gate is QR Energy. The Houston-based limited partnership – currently operating onshore, mature fields in the Mid Continent region, Northern Louisiana, the Permian Basin in Texas, and along the Gulf Coast – was formed in September by Quantum Resources Funds. The partnership raised $300 million in its December 16 IPO, offering 15 million shares at a price of $20 per share with the underwriting help of Wells Fargo, JP Morgan Chase, and Raymond James Financial.

One attractive piece of the puzzle is the opportunity to make up for the hit many investors took during the recession. Many are looking for vehicles to help recoup losses. Treasuries are sitting near 3%, utilities are hovering around 4%, midstream MLPs are averaging a yield of 5% to 6%, while upstream MLPs are coming in closer to 7% to 9%. From a macroeconomic standpoint, those yield numbers, coupled with concerns regarding the direction of the US dollar and speculation of a coming inflationary phase, are enticing.

Encore's current yield is 9.4% versus the group mean of 7.9% (not including Constellation which suspended its distribution on June 26, 2009 and has yet to reinstate). ENP's premium yield to the group can be attributed to its variable distribution policy. The policy produces a more volatile cash flow stream, which investors discount at a higher rate.

"EVEP has generated production and proved reserves growth for its unitholders on a per unit basis, resulting in quarterly per unit cash distribution growth of 90% and, for those who have held units since the IPO, a compound annual rate of return of 27% based on quarterly cash distributions plus unit price appreciation," noted EVEP's Walker.

But there is a flipside.

"The riskier nature of the E&P business is reflected in E&P MLP yields, an indication of the risk associated with an MLP. The riskier the business, the higher the yield demanded by its unitholders, typically," noted Tudor Pickering analyst O'Leary.

Take for example, O'Leary said, E&P MLPs currently trading at ~8% average yield versus natural gas pipeline MLPs at ~6%. In late 2008/early 2009 (the stock market had tanked and capital markets had closed up), the yield spread between natural gas pipeline MLP (least risky) and E&P MLP yields expanded significantly with the pipeline guys reaching average yield of approximately 10% while the E&P MLPs had an average yield above 30% during the same time period – an indication of which type of business is riskier under the MLP structure."

The elimination of double taxation effectively lowers the partnership's cost of capital, thus enhancing the partnership's competitive position when in pursuit of expansion projects and acquisitions. Like any project, risks must be considered carefully.

The most obvious risk is commodity price volatility. "E&P companies don't really fit the typical MLP mold because their operations/cash flows are very commodity sensitive – you can only hedge your production so far out into the future. Fluctuations in oil and/or gas price can significantly affect distributable cash flow. An MLP not being to cover its distribution is no good," warned O'Leary.

Alan Smith, CEO of QR Energy said: "For an upstream MLP to be successful, it must have long-lived, lower decline assets and be able to provide stable cash flows through an ongoing, long term hedging program," noting that QR Energy's assets are "well-suited for an MLP and include low-risk development opportunities."

That strategy is echoed by EVEP's Walker. "Today's upstream MLP's hold primarily mature, long-lived producing assets with low production decline rates. They also have commodity price hedges for a significant amount of their production for three to five years into the future, which helps to reduce commodity price risk and volatility in expected future distributable cash flow."

Other factors to consider, as noted by Vanguard's Smith, are the company's ability to grow and access capital markets.

"In a market where property transactions are plentiful and the capital markets are accessible, growth can be achieved quickly," he said.

For Vanguard, growth has been steady. According to Smith, over the last 18 months, the company has acquired over $200 million in assets and conducted three successful equity offerings.

Companies can grow through the drillbit or through acquisitions. The M&A market is heating up, opening up opportunities for growth – even shale comes into play.

LINN Energy has grown through the drillbit. In early December, the company announced a $480 million capex budget for 2011 consisting of two components: high rate-of-return liquids-focused drilling in the Granite Wash and Permian Basin Wolfberry trend and low-risk, low-cost projects. The capital program calls for drilling 45 horizontal Granite Wash wells (35 operated) and more than 130 Wolfberry wells in the Permian Basin. The company expects to drill more than 220 wells and complete more than 380 workover, recompletion, and optimization projects during the year.

"LINN's exceptional performance in 2010 enabled us to increase our distribution by 5% and deliver a year-to-date return to unitholders of more than 40%," said Mark E. Ellis, LINN's president and CEO in a company press release. "We estimate production to grow more than 35% in 2011."

In early September, LINN Energy signed three agreements to acquire properties in the Wolfberry trend of the Permian Basin for a combined price of $352.2 million.

Legacy Reserves LP also snapped up additional Permian Basin assets in 2010. On December 22, the limited partnership closed on its $103.3 million acquisition of Permian properties from Concho Resources Inc. The properties produce an estimated 1,419 boe/d, of which 47% is oil. Proved reserves are estimated to be 5.8 MMboe, 88% of which are considered proved developed producing.

The Concho acquisition was on the heels of another Permian Basin addition that also closed December 22 for $1.4 million in cash. The Lea County, NM oil well produces roughly 17 boe/d, 86% of which is oil. Proved developed producing reserves are estimated to be 54,000 boe.

Prior to that, in November, Legacy closed a $6.6 million acquisition of Powder River Basin oil assets with net production of 82 b/d with proved developed producing reserves of 300,000 barrels of oil. The acquisition was funded with its existing credit facility.

In a company press release, Steven H. Pruett, Legacy president and CFO, noted that the company continues to be active in the acquisition arena, allowing the company to increase production volumes and cash flow, all the while drilling its Wolfberry locations near Midland.

Drilling in an MLP, said EVEP's Walker, should be used primarily to maintain or slightly increase production. The majority of growth in such vehicles comes from accretive acquisitions of MLP-appropriate producing oil and gas assets.

EVEP and EnerVest Ltd., the controlling entity of EVEP's general partner, have large teams devoted to acquisitions. "The experience of these teams, and EnerVest's 18-year track record of success in the acquisition market, are key in having an aggressive but disciplined effort in acquiring oil and gas assets at attractive rates of return," noted Walker.

In late September, the company closed on the acquisition of properties in the Mid-Continent region from Petrohawk Energy Corp. for $119.9 million.

In August, EVEP completed a public offering of 3.45 million common units, raising net proceeds of $114 million in anticipation of closing the acquisition.

Just before year-end 2010, the company closed on the acquisition of Barnett Shale assets from Talon Oil & Gas LLC. EVEP acquired a 31.02% interest in the assets for $295.9 million. EVEP's outstanding debt after funding the acquisition stood at roughly $619 million on a revised borrowing base of $700 million.

As these transactions show, there appears to be no shortage of assets up for grabs. A December 21 research note from Robert W. Baird & Co. put M&A opportunities at roughly $250 billion.

MLPs stand to benefit as traditional independents shed conventional proved reserves – unsexy from a growth standpoint to the traditional independents – to finance shale growth. MLPs, as owners of low-decline, proved assets, are natural buyers of those conventional assets.

"There are a lot of factors to consider, but I think that rising oil prices and independents needing money to finance shale growth set you up for more M&A possibilities for the MLPs, and for the potential creation of more MLPs on an outright basis," noted Robert W. Baird analyst Ethan Bellamy.

And, over time, as shale plays begin to mature, another realm of M&A opportunities come into play.

In as little as five years after a well is drilled, shale assets may be deemed MLP-suitable. The earliest Barnett wells may already be MLP-suitable from a year-over-year decline standpoint. With the amount of money being poured into creating shale assets now, the potential for expansion of MLP-suitable assets looms large in the coming years.

So, while acquisitions are key to the growth of upstream MLPs, one must exercise caution. Overextending financial resources by growing too aggressively can leave companies with liquidity problems or difficulty obtaining additional financing.

MLPs are reliant on access to capital markets because the companies essentially pay out all cash flow after expenses. To grow, the upstream MLPs need continual access to the capital markets.

"If the capital markets aren't available and MLP-suitable assets aren't available at reasonable valuations, it could cause long term cash flow issues if production can't be maintained," warned Vanguard's Smith.

As it stands now, conditions seem favorable.

When asked about the feasibility of getting upstream MLPs financed in the current climate, Kyle Hranicky, head of the Wells Fargo Energy Group, commented: "The debt markets, including both bank and public high yield, for upstream MLPs have rebounded nicely over the last year."

Hranicky cited examples of recent financings including:

• BreitBurn Energy Partners, which closed an amended and extended $735 million borrowing base bank credit facility in May 2010 as well as issued $305 million in senior notes (as a first time issuer) in October 2010, and
• LINN Energy, which closed an amended and extended $1.375 billion borrowing base bank credit facility in April 2010 as well as issued $1.3 billion in senior notes in April 2010.

Are we poised to see the next phase of upstream MLP activity – activity that was stalled with the onslaught of the economic crisis, or will upstream companies find reliability of revenue and commodity price volatility issues too big a burden to bear? Time will tell.

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