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