Many investors clamoring for a stake in unconventional oil and gas may get their foot in the door through a new twist on Master Limited Partnerships (MLPs), said KPMG LLC’s Mike McGoldrick.

Meet the variable-rate MLP, which could supply much-needed capital to upstream and downstream operators and make investors happy with potential windfalls.

“Variable-rate MLPs are under consideration by E&P companies, refiners, chemical manufacturers, drillers, fracing-sand producers, fertilizer companies and companies involved in the handling and supply of water to the energy sector,” McGoldrick, KPMG’s federal tax director, said in an Oct. 31 conference call.

McGoldrick says stay tuned: “They look like they’re really going to really grow in the MLP space with people you wouldn’t normally associate with being MLPs.”

An MLP is a publicly traded partnership that is treated by the IRS as a corporation. Income must be derived from business operations in real estate, natural resources or minerals sectors.
Despite their high returns and rapid growth in the past 10 years, MLPs are a relatively unknown segment of global capital markets, according to a September report by investment consulting firm NEPC LLC. MLPs distribute most free cash flows to holders of units, which are akin to shares.

Their new cousin, the variable MLP, offers the potential for even loftier yields, tax shields and the hope that they will follow in the footsteps of traditional MLPs. However, cash flow distributions could be sporadic, and analysts caution that variable MLPs might struggle in tough economic times.

“The recent trend has seen variable distribution MLPs enter the market,” said Andrew Brett, NEPC senior research analyst, private markets. “These businesses have less stable cash flows but have attracted the attention of investors due to their often initial high initial yields. These businesses may seem attractive in the short-term but could struggle in poor economic conditions.”

Distributions of disposable cash flow are made but not mandated by variable MLP agreements, McGoldrick said. So in down years, no distributions may be made. Because of that risk, distribution percentages will “generally be higher” than more traditional publicly traded partnerships, he said.

McGoldrick told Hart Energy that most sponsors of MLPs say that if interest rates were to increase materially, they would expect the demand for MLP units to decline.
Another risk cited by MLP sponsors is that their continued increase could overcrowd the market. They also face other risks associated with other ventures, such as environmental regulations and economic recession.

“The variable rate MLPs that have been issued -- gone public -- indicate that unlike traditional MLPs investors should carefully take into account that the projected future cash flow and cash distributions are uncertain and that the variable MLPs are in business sectors where margin volatility has historically been a problem,” he said.

Though in their infancy -- four have made offerings and others are in the formation stage -- the new MLPs initial yields range from 13% to 19%, McGoldrick said.

One variable-distribution MLP, CVR Partners LP (NYSE: UAN), has issued guidance this year for a 6.4 % yield, said Wes Harris, vice president of investor relations. The fertilizer company manufactures ammonia and urea ammonium nitrate.

Traditional MLPs are dominated by midstream companies operating pipelines, terminals and natural gas plants. Their bread and butter are transportation, storage and distribution because of predictable, steady cash flows.

Left out in the cold are unhedged oil and gas production, refining and petrochemical manufacturing that do not fit the traditional model, McGoldrick said. But executives hungry for capital are exploring them.

“In certain segments they look at what competitors are doing, or the small independents, and they’re asking the question, ‘Shouldn’t we be in the MLP space?’ ” he said.

Companies can see several benefits to the partnerships, including recovering some equity investment and paying down debt of acquisition costs. They also obtain liquidity without being bound to minimum distributions that have “killed other MLPs” in the upstream and downstream energy segments, McGoldrick said.

On the other side of the equation, investors are drawn to potentially high yields, tax shields between 60% to 80% for the first five years and the fact that “MLPs have dramatically outperformed the other sectors,” McGoldrick said.

From 2002 to 2011, traditional MLPs annual returns -- distributions and appreciation in unit value -- are 18.4%. By comparison, the Dow returned 4.6% and the S&P 500 2.9% during that time, McGoldrick said.

In the past two years, MLPs market cap has grown from $230 billion to more than $400 billion.

Since MLPs pay distributions, not dividends, they don’t face “the threat of being taxed at over 40%,” McGoldrick said.

Variable MLPs have additional tax advantages because of more favorable depreciation allowances, McGoldrick said.

The tax life for petrochemical plants, oil and gas producing assets, sand-mining equipment and refineries ranges from five to 10 years. Midstream assets, such as petroleum product pipelines, have 15-year tax lives, he said.

So far two fertilizer companies, an independent refiner and petrochemical manufacturer have formed variable MLPs. They offer no minimum distribution target, no subordination rights and no incentive distribution rights, McGoldrick said.

Northern Tier Energy LP, (NYSE: NTI) a downstream company with refining, retail and pipeline operations, is a prototype.

It consist of a “group of private equity fellows who bought a Minnesota refinery and some convenience stores from Marathon for $880 million” McGoldrick said. “Between cash receipts and value for units still outstanding, it prices out at $1.2 billion.”

Northern Tier, based in Ridgefield, Conn., purchased the 74,000 barrel per day (Mb/d) refinery in 2010. The company said it will announce a distribution on Nov. 12, the first it’s paid since closing its initial public offering on July 31.

Other refiners are attempting to copy Northern Tier’s model.

Harris said CVR’s parent company recently announced it would take all refinery assets and “drop them down into MLPs.”