Timing, they say, is everything. For master limited partnerships focused on the production of oil and natural gas—upstream MLPs—this statement could not be more appropriate. This niche subsector of the energy market is poised for dramatic growth, driven by an exponential expansion of available assets and sustained market demand for yield-based products.
The business structure of MLPs is unique and descends from decades of oil and gas partnerships. As the name suggests, MLPs are partnerships, not corporations. The distinction is important, because the income from a partnership is taxed only at the individual level. In contrast, income from a corporation is taxed at the corporate level and then again at the individual level. The caveat to an MLP’s legal privilege of avoiding double taxation is that all profits, less small amounts required for working capital and maintenance, must be distributed to partners.
The viability of an MLP is, therefore, significantly influenced by the nature of the assets within its portfolio. Assets requiring large or unpredictable capex present a host of management problems for an entity precluded from retaining earnings. For upstream MLPs, suitable assets include the following:
- Mature production with an aggregate well vintage exceeding five years since initial production.
- Largely developed acreage with appreciable reserve life and linear decline type curves.
- Predictable development profiles with limited drilling risk and visibility for growth.
Potential For Growth
The market share of MLP-eligible assets exceeds 70%, while market share of the 12 upstream MLPs currently listed on the NYSE and Nasdaq exchanges approximates 3%. Recognizing that a portion of the MLP-eligible assets will not be MLP-appropriate, we haircut the asset pool by 80% to arrive at what we view as a conservative estimate. Our supply-side analysis suggests the asset base of upstream MLPs has the potential to grow by a factor of five.
If upstream MLPs are interested buyers of these assets, the key question then becomes, Can the current holders be compelled to sell? We believe the answer is yes.
Motivated C-Corp Sellers
Integrated oil companies have a strong track record of financial discipline and a history of operating their businesses based on the long-term strategic management of their assets. These companies believe their primary responsibility to shareholders is to deliver high returns on capital (return on capital employed, or ROCE). When the market presents investment opportunities below a certain ROCE threshold, integrated oils respond by returning capital to shareholders rather than lowering their return standards.
For decades, integrated oils and large-cap E&Ps looked for their most prospective investments abroad. Domestic prospects simply could not compete with the resource-laden profiles of acreage in West Africa, Asia, South America and the Middle East. Despite challenging operating conditions, civil unrest and the ever-present risk of resource nationalism, international investments regularly delivered returns on capital in excess of 25%.
As a result of rising geopolitical risk, taxes and operating costs, the margins of international and offshore operations are contracting. While international returns may still exceed the hurdle rate required for investment, they are no longer the crown jewel of shareholder value creation they once were.
Evidence of this strategic shift in investment opportunities has been reflected in the capital allocations of upstream producers. Over the past few years, the capex budgets of these companies have increasingly favored domestic investments. It is important to note that although the returns of domestic investment opportunities are on the rise, declining returns abroad are the main catalyst for this strategic shift in capital allocation.
Given the lack of international exploration-fueled returns of times past, it is our contention that economically disciplined producers will increasingly recognize they cannot justify holding the relatively pedestrian returns of mature, long-lived fields in their portfolios.
Divestment of lower-returning assets is not a new strategy for integrated oil companies. During the past decade, integrateds have jettisoned a sizable amount of retail, midstream and refining assets. We believe mature, long-lived production assets—MLP-appropriate wells—are next.
Should these factors materialize as envisioned, we believe upstream MLPs will be the primary benefactors of this secular trend toward market segmentation of asset returns at the field level. As return-seeking producers—namely C-Corp integrateds and large-cap E&Ps—reassess the strategic merit of MLP-appropriate assets within their portfolios, we anticipate a portion of these assets will become available to upstream MLPs.
Presented with the opportunity to increase assets under management by a factor of five, upstream MLPs are well-positioned to pair this growth potential with a market hungry for additional yield-based investment vehicles.
Michael Peterson is an energy analyst at MLV & Co. in New York and has more than 15 years of experience in the energy and commodities markets.