MLPs and The Shale Plays

Given the shale-play exploration and development successes of independent oil and gas operators, many wonder if upstream master limited partnerships (MLPs) will play a meaningful role in developing America’s unconventional hydrocarbon resources.

In short, yes. However, the more difficult question is, when?

Generally, MLPs are indifferent with respect to hydrocarbon-production mix and basin location. To highlight the geographic point, Memorial Production Partners LP recently closed the acquisition of long-lived offshore California oil producing assets, a first for the MLP sector.

Given MLPs distribute a substantial majority of available cash flow to unitholders, managers are most focused on acquiring assets with predictable production (shallow decline) and low-risk drilling opportunities (maintenance capital) in conjunction with undertaking multiyear hedges for a significant percentage of their future production.

Historically, these asset attributes are most commonly associated with conventional production from long-established oil and gas fields. However, Barnett shale development history shows, as unconventional production approaches its terminal decline phase, MLPs are able to justify acquiring at a purchase multiple interesting to sellers.

Barnett model. Initially developed in the 1990s, it was not until 2004 to 2007 that operators meaningfully improved Barnett play economics via enhanced horizontal drilling and completion techniques. Only in 2010 did an MLP strategically enter the play. EnerVest Ltd., in tandem with its MLP subsidiary EV Energy Partners, first entered the Barnett with its $1-billion acquisition of Talon Oil & Gas and followed with a $1.2-billion acquisition of Barnett properties from Encana Corp. and Braden Exploration in November 2011. One might argue these acquisitions endorsed the appropriateness of shale-based assets for the upstream MLP model—for EVEP, anyway.

Type curves from the Barnett suggest approximately five to seven years of production precede these resource-play wells reaching maturity (defined as a 10% or lower decline curve), an indication that several more years remain before the newest shale plays (Marcellus, Eagle Ford, Bakken, etc.) attract significant MLP interest.

Next generation. Looking forward, expect MLPs to become active in those resource plays with the most attractive well economics and returns. It stands to reason that current operators will drill their most profitable prospects first, thus first advancing these plays to maturity.

We expect the earliest MLP-ready production from the Marcellus to come from operators unable to achieve significant scale or from assets where further development opportunities are more limited. Owners of large acreage positions will likely hold those assets in the near to medium term unless compelled to sell due to liquidity issues or for other strategic purposes.

Gas shales. What about the “gap” resource plays, such as the Fayetteville, Woodford and Haynesville? Low gas prices have essentially put these plays on hold, as companies with positions are holding on to the significant remaining upside as options for future development and delaying when these assets might become MLP ready. The Woodford shale is smaller in areal extent, thus limiting the opportunity to build scale through acquisitions, and the Fayetteville is substantially held by a limited number of operators.

While the Haynesville shale may have MLP-ready assets, most is held by production. The allure of the large resource base has thus far compelled owners to sit on the option, awaiting higher gas prices.

Hoard of plenty. Currently, U.S. Lower 48 onshore production approximates 16 million barrels of oil equivalent (BOE) per day. MLPs currently produce approximately 400,000 BOE per day. Similarly, Lower 48 onshore proved reserves are approximately 78 billion BOE with upstream MLPs similarly comprising less than 3% of total onshore reserves. These statistics suggest a potential opportunity for MLPs to own and operate significantly greater hydrocarbon reserves and future production.

We have less visibility into when the holders of these unconventional assets will feel compelled to sell and, if they do choose to monetize, whether liquidity will come in the form of an outright sale, or via formation of a subsidiary MLP (drop-down vehicle).

To the extent the current owner can deliver a long-term, stable growth story, expect to see formation of new MLPs. Quicksilver Resources Inc., for example, has filed a registration statement with the SEC and is exploring the MLP structure for its Barnett assets. Other independents are considering a similar strategy for their MLP-ready assets.