MONETIZING MIDSTREAM ASSETS WHILE ENABLING OPERATORS TO MAINTAIN CONTROL
JEFF FULMER, CORENERGY INFRASTRUCTURE TRUST INC., KANSAS CITY, MO
IN THE CURRENT COMMODITY environment, necessity is driving innovation in financing for oil and gas companies that have solid long-term assets but near-term stresses in their capital structures.
One of the new alternatives in energy financing is partnering with a Real Estate Investment Trust (REIT). So far, two NYSE-traded REITs are active: CorEnergy Infrastructure Trust, Inc., which owns assets across the energy value chain, especially in the oil and gas sector; and InfraREIT, Inc., which owns power transmission and distribution assets as a spin-off from the Hunt family interests.
REITs are an investment vehicle better known for shopping malls and office buildings than for pipelines and storage terminals. But in the current phase of the pricing cycle, with its shock waves in lending and capital markets, some companies are increasing their available cash by thinking creatively.
Transactions with a REIT are an alternative to traditional financing - and there are advantages in this vehicle, especially in a time when capital markets are unwelcoming for oil and gas companies.
INFRASTRUCTURE AS REAL ESTATE
The core business of energy producers is finding, developing and selling resources to fuel the economy. But the process demands all kinds of "non-core" support infrastructure: offshore platforms, gathering systems, field tank farms, water supply and disposal systems, treatment facilities, electrical distribution systems, midstream and downstream pipelines, and storage, rail and marine terminals.
The REIT approach is based on the insight that much of infrastructure can be viewed as real estate. These assets occupy land in right-of-way corridors or at central points in the network. Infrastructure is the long-duration, capital-intensive asset class that is essential for moving energy to market.
The economics of infrastructure tend to be steady but unexciting. For operators, whether upstream or midstream, these fixed assets have predictable cost structures over the life cycle of energy reserves they support. If treated as a separate business, energy infrastructure typically yields low-double digit returns on invested capital.
In more typical times, exploration and production would deliver much higher returns than pipelines and other support infrastructures. Even now, many operators have higher-return opportunities that could benefit from monetizing midstream assets and redeploying the cash.
OPTIONS TO MONETIZE ASSETS
Under pressure from the down-cycle in commodities, many players in the energy industry are looking at alternatives to monetize assets.
The usual go-to sources for capital, issuing equity or taking on more debt, are difficult in a down market, when lenders are leery and borrowing bases are eroded. Private equity investment may be available - but with a high cost of capital, potential imposition of active involvement, and the need to exit the investment in typically three to seven years.
Selling assets outright is an option, as many companies are pruning their portfolios. But a straight asset sale means the operator must let it go, losing control of the very assets that allow for the production and transport of their reserves. The buyer assumes commercial control and, usually, 100% of the upside. An outright divestiture may also be coupled with layoffs of people associated with those assets.
Partnering with a REIT for an infrastructure sale-leaseback, on the other hand, enables an operator to monetize an asset with no disruption to its business. Title to the real estate shifts to the REIT, but the E&P or midstream operator maintains full operational and commercial control of the asset. REITs are long-term investors and are not looking to exit the asset or the relationship with the seller.
Strategically, the asset serves the same needs it always has. The operator's employees still run it. Commodities continue to flow from the field, get stored in the tanks and move downstream to market. The REIT does not take ownership of commodities, nor can it be actively involved in the operations of the asset.
BENEFITS OF AN OPERATING LEASE
Partnering with a REIT is balance sheet friendly. The operator's financial position improves because a physical asset is converted to cash, which can be redeployed to reduce debt or fund higher returning activities. The operating lease does not result in a liability on the balance sheet. Instead, a predictable operating expense is incorporated into the operator's income statement in the form of rent - similar to a utility bill. In CorEnergy's partnerships, we deal with long-duration assets and typically set up 10 to 15-year leases, so operators know what those costs will be going forward.
We can customize the rent to meet specific needs of each operating partner - for example, structuring rent levels to approximate an upstream company's internally allocated fees to access a gathering system, or developing a decreasing rent schedule that accounts for projected declining production volumes. While there is flexibility, lower rents over the lease term do imply lower transactional proceeds.
CorEnergy structures leases to include base rent, set as an annual rate adjusted by an inflationary index, and variable or participating rent, an add-on achieved only if the operator's volumes or revenues related to the asset exceed a threshold. This sharing of upside potential helps keep base rent lower and aligns interests.
The biggest benefit of an operating lease is that the operator maintains full control of the asset, while redeploying cash to other opportunities, which improve its return on invested capital.
VALUATION AND RENTAL COSTS
In partnering with an infrastructure REIT, an asset owner will find the valuation methodology and the lease rental structure straightforward and transparent. Prices paid in REIT transactions have proved competitive with other third-party evaluations, reflecting fair market value.
Valuation and rental structure are typically based upon EBITDA generation of the asset. The lease provides the operating company with long-term use of the asset in return for access fees in line with its internal allocation or the market for accessing similar assets. The base rent is thus substantiated by fair market determination. Our experience is that operating partners' rental payments are commensurate with fees in conventional contracts, such as gathering and transportation agreements.
A REIT can be more flexible in structuring a deal than a bank, and pricing can differ from other buyers because valuation is dependent upon the buyer's cost of capital and the asset's terminal value. In our experience as a publicly traded REIT, CorEnergy's ability to access the capital markets ensures that the risk/reward profile of the asset and the counterparty are transparently and competitively priced into valuation of that asset.
RISK SHARING THROUGH A LEASE
For an agreement to qualify as an operating lease, the REIT, which holds title to the asset, accepts terminal value risk. The energy company partnering with a REIT through an operating lease retains options at the end of the lease term to (1) extend the lease with updated rents to be determined at fair market value at that time; (2) buy back the asset at then-fair market value; or (3) walk away.
The REIT essentially shares in the long-term risk of the oil and gas reserves that are dependent on the asset, whether it is a gathering system or transportation facility. The asset abandonment liability is also shouldered by the REIT. If the economics of the business change over the term of the lease, the REIT could be left holding an asset with reduced demand and diminished value.
At CorEnergy we mitigate these risks by having industry-seasoned engineers on our management team. Our long-duration ownership strategy requires conviction on an asset's long-term cash flow potential and its terminal value at the end of the primary lease term. In the case of assets reliant on a depleting resource base, such as field-level gathering systems, our practice is to evaluate upstream reserve longevity to assess future anticipated utilization levels. For assets supported by market-based dynamics, such as terminalling facilities and long-haul transportation pipelines, supply and demand dynamics are analyzed to substantiate long-term demand and utilization.
In a real sense, then, an infrastructure REIT serves as a partner to an energy firm's core enterprise.
ACCESS TO CAPITAL
Retrenchment in the capital markets since mid-2014 has created major challenges for upstream and midstream companies. Due to energy infrastructure REITs being in their infancy, few companies are aware of their existence and the differentiated investors that they bring to the table.
For the last couple of decades, the main players focusing on midstream assets - apart from integrated oil and gas majors - have been Master Limited Partnerships (MLPs). MLPs have been instrumental in funding the US energy transformation of the past decade. Based on MLP portfolio management experience, our team launched CorEnergy as a REIT because the real estate structure offers simplicity, flexibility and access to a different sector of the capital markets as a source of financing for energy operators.
The audience for public capital is larger for REITs than for MLPs. REITs can be owned by institutions, individual retirement accounts, and foreign investors - which generally avoid owning limited partnership units. REITs pay out their income in dividends to shareholders and issue a simple Form 1099 for tax reporting, vs. the more complicated Form K-1 that MLPs use to report income and expenses.
Since MLPs operate the assets they own, energy companies that sell assets to an MLP also would turn over control to the buyers. In partnering with a REIT, the operator continues to manage and operate those infrastructure systems.
INNOVATION TAKING HOLD
As the energy industry struggles to contend with capital shortfalls in the current commodity cycle, some companies have creatively accessed capital from energy infrastructure REITs. Seeking to avoid dilution on the equity side - or more leverage on the debt side - companies are beginning to monetize assets and strengthen their balance sheets.
In addition to maintaining full operational and commercial control of their assets, these operators are monetizing at fair market value and leasing the assets back under a predictable cost structure, which preserves for them the majority of the upside.
Looking into the future, our sense is that the infrastructure REIT as a vehicle for financing energy enterprises is here to stay - and will continue to grow as the industry's fortunes revive.
ABOUT THE AUTHOR
Jeff Fulmer is senior vice president of CorEnergy Infrastructure Trust Inc., the first publicly traded real estate investment trust (REIT) focused on energy infrastructure. CorEnergy provides owners/operators in the energy sector with alternative financing through monetization of REIT-qualifying assets while allowing them to maintain full operational control. Prior to joining CorEnergy, Fulmer was a senior advisor for Tortoise Capital Advisors, where he provided industry insight and led the company's retail marketing efforts. As a petroleum engineer and professional geologist, Fulmer has more than 30 years of energy industry experience. He worked for the US Department of Defense in the post-9/11 threat environment, where he headed a group of infrastructure analysts engaged globally in critical infrastructure analysis, assessment and protection. Prior to the DoD, he served in executive management and technical positions for both oil and gas majors and independent exploration and production companies.
