Encouraged by investor interest and the abundance of maturing oil and gas basins in the U.S., upstream trusts-some in the form of the master limited partnership (MLP)-are making a comeback. With an asset model and operating strategy similar to that of the Canadian energy trusts, these companies are active acquirers that spend a lot of time developing-but not wildcatting for-sources of oil and gas reserves.

What might this mean for traditional independent E&P in the U.S.? The vehicle is not new to the upstream. Houston-based Apache Corp. pioneered the E&P MLP in the 1980s, a decade shadowed by memories of crashing oil prices.

Several oil and gas companies tried to follow in Apache's footsteps, but many used the wrong kind of assets and too much debt. Significant commodity-price fluctuations, poor reserve-to-production ratios and dwindling capital from public markets made keeping up with investor-distribution promises a struggle. Failure was imminent, and most upstream MLPs in the 1980s were either taken private, acquired, liquidated or converted into traditional E&P companies.

"They were including assets in places such as the Gulf of Mexico-declining at over 30% a year," says John Kang, an analyst with RBC Capital Markets. "This didn't make sense because it put them on this treadmill of having to buy new assets or make new discoveries, spending a ton of capital along the way. Also, they were including risky exploration prospects instead of the less-risky development and exploitation plays."

John Walker agrees that most of the earlier upstream MLPs didn't have a sound operating strategy. Walker is chairman and chief executive officer of a newly public trust, Houston-based EV Energy Partners LP, and CEO of traditional E&P company EnerVest Management Partners Ltd.

"There was no futures market then," he says. "While some companies used the right assets, they were overleveraged. In a downturn, there was no opportunity to hedge and they couldn't make distributions. And, there was no A&D market. There wasn't an infrastructure of financing sources or firms that marketed deals."

Walker wanted to launch EV Energy Partners five years ago but none of the brokerage firms he talked to was interested. "We thought it was a great vehicle and expected it to take over a large part of the marketplace, but the brokerage firms still remembered the 1980s and the problems. They didn't think upstream MLPs made sense.

"Only within the past several years have these firms started to believe these [MLPs] are great upstream vehicles if established properly. We couldn't have put it into place if we hadn't been persistent."

EV operates assets in the Appalachian Basin, primarily in Ohio and West Virginia, and in the Monroe Field in northern Louisiana. As of year-end 2005, its properties had estimated net proved reserves of 44.8 billion cubic feet of gas and 1.1 million barrels of oil. Its general partner is comprised of EnerVest (71.25%); Houston- and Dallas-based EnCap Investments LLC (23.75%); and management (5%). In September, it priced 3.9 million units at $20 each. At press time, the units were $21.84.

The MLP was launched to complement EnerVest's institutionally funded, traditional E&P business, Walker says. For EnerVest, the ideal institutionally funded E&P portfolio is approximately 50% proved developed producing and 50% upside potential. As these properties become more developed, they need to be sold.

"The MLP is a great buyer for those assets, with its focus on longer-life, low-risk reserves and production, a more predictable cash-flow stream and a lower cost of capital," Walker says.

John Freeman, vice president, energy-equity research, with Raymond James & Associates Inc., says the close relationship between EV and EnerVest is a plus. "No company will have a more intimate knowledge of EnerVest's properties when it comes to market. Therefore, competitors are at a distinct disadvantage in a bidding process. This is not to say EV will get all the properties EnerVest divests over time...but we like EV's position and anticipate that it will grow significantly over the next several years from third-party acquisitions and EnerVest properties."

The market is "missing" the fact that EV has no debt to speak of, Freeman adds, while some of its peers have an average 75% debt-to-capital ratio.

Walker adds, "I suspect we will see some of the bigger independents spinning out the appropriate assets into MLPs. It would give shareholders a high rate of return."



Revised strategy

This time around, a handful of savvy management teams are pairing long-lived U.S. assets with lessons from the past to launch publicly traded MLP-, LLC- or LP-structured companies-generally falling into the "trusts" category-that have distinct benefits for individual investors.

In 2006, Houston-based Linn Energy LLC led the IPO charge with funding from Quantum Energy Resources. Linn focuses on properties in the Appalachian Basin, primarily in Pennsylvania, West Virginia, New York, and Virginia. As of year-end 2005, it had proved reserves of 193.2 billion cubic feet of gas equivalent and about 1,600 net productive gas wells. It priced 11.8 million units on Nasdaq at $21 each in January 2006; by last month, units were trading at $27.68 each.

Also in 2006, Los Angeles-based BreitBurn Energy Partners LP was formed by BreitBurn Energy Co., a subsidiary of Provident Energy Trust, to acquire and develop properties in the Los Angeles Basin in California and the Wind River and Big Horn basins in central Wyoming. It was started with assets from BreitBurn Energy Co., a traditional E&P. At year-end 2005, the LP's estimated proved reserves were 29.7 million barrels of oil equivalent (98% oil, 91% proved developed). In October, it priced 6 million units at $18.50 each on Nasdaq; at press time, units were trading at $21.97.

In November, Baltimore-based Constellation Energy Resources LLC, a subsidiary of Constellation Energy Commodities Group Inc., priced an IPO of 4.5 million units at $21 each. The LLC was formed to operate the parent's working interest in 436 gas-producing wells in Robinson's Bend Field in Alabama's Black Warrior Basin. It had year-end 2005 reserves of 112 billion cubic feet. At press time, units were $23.25 each.

Also in November, Midland, Texas-based Legacy Reserves LP filed for an IPO of 6 million units. The LP was formed in October 2005 to focus on oil and gas properties in the Permian Basin of West Texas and southeast New Mexico.

What's changed for these trusts since the 1980s? Hedging makes it easier to have a stabilized revenue stream. Smart management teams understand debt needs to be a low percentage of capitalization, and that having long-lived assets is essential.

Richard Roy, an analyst with Citigroup Global Markets, says the change in the upstream trusts' asset mix dramatically improves the group's chances of success.

"The newer MLP structures have properties that have stable production profiles and low decline rates. Management is simply extracting hydrocarbons from the ground and paying out the cash flows generated from the sale of oil and gas. While the cash-flow stream is still subject to commodity prices and production declines over time, it's not as risky as the assets that led to destruction back in the 1980s."

Walker adds, "Today, your assets' reserve life doesn't have to be 20 years, but it probably should be at least 12 to 15 years. That way, even if you get (price) fluctuations, you'll still be around. I expect MLPs will capture a significant portion of the upstream market, but they will not be a significant generator of new reserves. People have become myopic in the way our industry is viewed. We have all kinds of assets, and having the right vehicle matched up with those assets is important."



Value-chain evolution

Some of the older basins in the U.S. have been producing since the early 1900s. As production declines, traditional E&P companies are less inclined to work in these fields. But MLPs are well suited for the task.

"Traditional E&P companies try to grow their reserve base by going into fields they can explore, and attempt to double the size of the field through new discoveries," Roy says. "With the newer (trust) structures, the idea is to take a mature field with oil and gas in place and extract as much out of it as possible through development and by using enhanced recovery methods. The risk is lower, as these structures often have success rates upward of 90%."

Though their effort may only extract up to an additional 2% from a field, depending on the field this amount could be huge.

An increased number of E&P trusts in the U.S. would create a value-chain pattern similar to the one that has developed in Canada with the advent of royalty trusts. These exploitation companies are producing from fields that were previously owned by traditional exploration companies, Roy says.

"In the end, the royalty trusts use their technical expertise to get more hydrocarbons out of the fields. Many of the fields are marginal, and wouldn't even be in production if it weren't for the royalty-trust structure's low cost of capital. In Canada, royalty trusts now account for a relatively large portion (30%) of Canadian production of oil and gas."

The movement of assets down the U.S. value chain would be fairly straightforward. Majors and independents wanting to sell these lower-profile assets can drop them down to an upstream MLP, which may then bid more competitively because it is better suited to profitably extract the remaining potential.

RBC's Kang says, "You'll have the majors with all the exploration engineers, geophysicists, capital and other resources to go after the big exploration plays. The midsize companies will consolidate some of the smaller players and do (exploration) and exploitation, leaving the MLPs to work on the tail-end of production, focusing on properties that have been online for over 20 years and are declining at 4% to 7%.

"Through consolidation, the MLPs should bring more efficiency to the maturing oil and gas system."

Roy expects the different types of U.S. producers to coexist without the frenzied acquisition trends that have gripped the Canadian landscape. "The stable-production, low-decline assets will go to the MLP and the riskier ones can go into a subsidiary or the development corporation, with a plan to drop them down to the MLP over time.

"This approach lets a company buy larger packages of assets, carve them up and make them suitable to pay out the cash flows, but also keep them for further growth."

Most of the large independents will get bigger, Walker predicts, and while the MLPs slowly take over the middle, the smaller E&P shops will still exist to generate prospects and drill one-off wells. "But in the future, there will be fewer (traditional) $100-million to $5-billion E&P C-Corps."



Attractive investment

A number of factors make the upstream trust an attractive investment vehicle. The No.1 draw is the lower cost of capital, Kang says: a royalty trust is not a tax-paying entity.

"It can give a company a much more competitive bidding posture when they pursue assets. Their primary competitors are going to be smaller E&P companies and private funds. A traditional E&P company will not typically chase mature assets that won't ultimately give it reserve and production growth in the long term. MLPs can often outbid the private and smaller guys, who may not have as low a cost of capital."

There is a formula that must be followed in the upstream MLP arena to come out on top, Walker says. "If you're not experienced at acquisitions and your focus has been primarily drilling, then it may not be a good idea to put your assets into an MLP. These vehicles should have a measured pace of drilling-enough to maintain or slightly increase production.

"This vehicle does not fall in line with the 'drilling more, exploring more to find additional hydrocarbons' business model; it does fall in line with the profile of many of the existing assets in the U.S."

Not adhering to the "prudent drilling" rule can put an MLP on a treadmill of disaster. Significantly increasing drilling over time increases the decline rate each year, which increases the risk of not being able to maintain distribution levels. "The MLP is ideally suited to distributing cash flow, not using most of it for drilling. If folks set up MLPs that are based on a lot of drilling and debt, they're going to be in trouble," Walker says.

Through trusts, Kang says, investors get to play the E&P game with slightly less risk than if they invested in a typical E&P company. "You know you're getting production from mature long-lived assets. It's just a matter of whether these guys make accretive acquisitions. The assets are there. It's just a matter of getting the deals done and consolidating."

Walker adds, "When almost 75% of U.S. wells are stripper wells, why not put investors into vehicles that offer tax advantages and return a significant portion of their free cash flow?"

Though the capital markets weren't scrambling to invest in the MLPs in 2006, they're definitely warming up to the idea of high yields and exposure to a strong growth vehicle, Kang says. "There are so many assets available for these guys to consolidate to grow distributions. It's slowly gathering more interest.

"With the surge of commodity prices, a lot of E&P companies don't necessarily need money to fund their capital-intensive programs because cash flow from operations is plentiful. These E&P hybrids that went public in 2006 and the one about to go this year will determine whether this structure will work in E&P this time around."

Roy says these first new E&P MLPs have set a precedent. "Investors are interested in propositions that have a high yield and give them exposure to commodity prices. This is a bit different than owning a large integrated, since you're basically getting paid a relatively attractive cash yield to wait on the next uptick in energy prices."

The MLPs are aggressively hedged to protect the downside. "They also keep a fairly large cushion. For example, if they generate one dollar in cash flow, they pay out $0.60 and keep $0.40 to reinvest in the business and to help them through a commodity-price decline."

Walker says, "We can continue to be accretive and make our price-distribution hurdles even if gas prices go down. If gas dropped to $2, everyone would be hurting. But I'd rather be on our side than theirs."

In the end, one of the biggest hurdles in having a successful MLP is discipline. The drilling program must find a balance in production rate versus decline rate; do only accretive acquisitions; and focus on maintaining, and over time growing, distributions, Walker says. "You only do well if your investors do well."

To make it work, an MLP has to have the right assets, $3- to $4 million to set up the vehicle, 12 months to get it up and running, and be experienced in making acquisitions. "But right now, my concern is that other entities may try to set up an MLP to take the money and run. This is not a flashy, get-rich-quick vehicle. And when they fail, it will only hurt the rest of us." M