In today’s environment, earnings volatility and cash-flow pressures are leading to capital shortages, placing increased pressure on the higher cost elements of many oil and gas companies’ portfolios. Upstream companies, in particular, face complex capital requirements and expenditure planning challenges due to long lead times and potential inflexible capital projects. Many also experience complications raising capital due to difficult market conditions (and the related impact on financial performance). With exploration and production budgets under pressure and capital expenditure programs under increased scrutiny, it is imperative for upstream companies to effectively communicate strategic response plans with boards and other key stakeholders.

As upstream companies continue to trim capital spending in response to the drop in oil prices, global spending growth of independents, according to certain commentators, could be down 15% to 20% this year, with North America being the most significantly impacted (with a material expected year-over-year decline in growth). As a result, certain operators are delaying completions and many are embracing a renewed focus on lowering the relative cost base through actions such as restructuring supply chain and supplier arrangements.

Amid this new environment, many executives wonder if going public as a master limited partnership (MLP) is still worthwhile. Alternatively, for those upstream companies already operating as an MLP, executives are grappling with what the right strategic next steps are (or ought to be). While sophisticated hedging strategies and other methods to manage risk garner increased attention, properly evaluating the pros and cons of going public (and operating as a public company) is critical.

Ultimately, the use of MLPs continues to be a viable option for alternatively raising capital. Following are some factors to consider in whether to take the MLP path.

MLP flavors

First, what are the “flavors” of MLPs for upstream companies? Is now the time for an upstream company to form an MLP? For companies already in the MLP structure, how are oil prices impacting operations and forward looking prospects? Is it an appropriate time to evaluate an exit?

Traditional MLPs. In a traditional MLP, the MLP discloses an intention to make minimum quarterly distributions of cash (MQDs) to unitholders. The amount of the MQDs factors into a broader distribution arrangement, which ultimately impacts the dollar-per-unit threshold at which (and in what amount) the MLP sponsors receive incentive distribution rights (IDRs). In a traditional MLP, different types of ownership interests generally exist—namely, the general partner interest, common units and subordinated units (which are retained by the sponsor and convertible according to certain events and/or the passage of time). The sponsor “controls” the MLP through its ownership of the MLP’s general partner.

Variable pay MLP. Under a “variable pay” MLP structure, the public owners are not promised any MQD, and, conversely, the MLP sponsor does not receive IDRs. Consequently, both the sponsor and the public owners typically share pro rata in the upside (and downside) of operations. Variable pay MLPs often take the form of a limited liability company (as opposed to a limited partnership).

Forming an upstream MLP

Upstream (and other) companies may consider an MLP for a variety of reasons, such as access to a different class of investors; partial liquidity (or complete monetization through a phased approach); potential ability to unlock the value of assets within the structure (and potentially set a value for certain sponsor-retained assets); creation of an alternative form of acquisition capital; and/or potentially lowering the cost of capital.

Ultimately, however, forming an upstream MLP is a complex decision that requires thoughtful consideration and long-term strategic analysis. Especially in today’s pricing environment, management of upstream companies should carefully consider cash flow stability and the ability to grow distributions over a long period of time.

In either the traditional MLP structure or the variable pay MLP structure, the market generally places a strong emphasis on growth of underlying available cash for distributions. Consequently, investments in mature reserves with long remaining lives are ideal (as opposed to looming significant, capital-intensive drilling programs). Upstream MLPs often focus on properties with low decline rates and/or significant sponsor-retained assets (with a high ratio of proved developed producing reserves) to both maintain distributions and to message a growth story to the market.

So is now the right time to form an upstream MLP? It depends.

For an upstream company evaluating an MLP in the current volatile pricing environment, evaluating cash flow stability and growth potential is critical. Does the company already have a critical mass of mature properties that would support the MLP structure? Where in the drilling and completion process are the assets, and what capital is required to make the reserves economic? What is the health of the company’s current capital structure (e.g., leverage, constricting covenants, debt/equity ratio, current financing terms, current hedging terms and hedge periods, etc.)? These are all questions that are essential in evaluating whether the MLP structure is preferable.

Given the uncertainty in pricing, the MLP structure can still be beneficial for both sponsors and the public; however, now, more than ever, careful planning (for both injecting assets into the structure, achieving growth in varying economic environments and unwinding or exiting the structure if needed) is absolutely vital in ensuring that the structure is right for the company, as the structure is not a “one size fits all.”

For companies with aggressive and complex future drilling programs and/or management teams that would prefer to reinvest cash flow as opposed to distributing such cash flow on a current basis, other public vehicles (as opposed to an MLP) may be preferable. For those companies, a corporate IPO may be preferable. Corporate IPOs may be desirable where the asset base is not as mature, significant capital expenditures and/or exploration are needed, or where the management thesis is not focused on long-term, continuous, aggressive growth.

Pricing impacts

For companies already in the MLP structure, the recent volatility in pricing has presented a number of challenges—challenges that many upstream companies face, regardless of investor base.

For MLPs with a strong asset base, mature producing properties with long productive lives and plentiful sponsor-retained assets to fuel future growth, today’s environment presents an opportunity to not only maintain the status quo, but to grow. MLPs with strong financial health might be able to capitalize on current pricing to make accretive additions to their portfolios.

For MLPs facing cost of capital challenges, a potential mitigation strategy is to reduce or eliminate general partner obligations (i.e., for those in a “traditional” MLP structure). Potential methods could include (a) the MLP acquiring its general partner (and associated IDRs) to facilitate a lower cost of capital, (b) capping IDR splits below 50%, (c) resetting IDR splits at lower levels (which could retain a certain level of management incentive), or (d) other methods.

Outside of structural changes that might result in a lower cost of capital, consolidation (through a merger or otherwise) may be a potential option for long-term stability; however, pricing and agreement on valuation might be challenging given where commodity pricing was and where it is now (and the relative short duration of the decline in pricing).

Overall, the outlook for existing MLPs mirrors, to a certain extent, the outlook for companies in the broader sector—those that are financially and structurally sound can thrive in this environment, and a variety of methods and strategies may exist (either through structural changes, consolidation, or otherwise) to provide for long-term success.

Depending on a company’s view of what “recovery” means (i.e., a $50-$60 per barrel world, a $60-$75 per barrel world, or something north of that), careful planning for long-term stability (or short- to long-term monetization) is imperative. If the current environment persists, forcing a sell-off of some companies’ attractive assets to generate cash, an opportunity may arise for an existing MLP, or one thinking about going public as an MLP, to capitalize on this low-price environment.

While the MLP structure has many benefits, it must be thoughtfully analyzed to ensure that the structure aligns with investor and management aspirations.

Greg Matlock is the MLP leader for Ernst & Young LLP in the U.S.