As commodity prices remain high, acquisition activity is clearly slowing.


Current volatility in commodity markets and uncertainty in equity and credit markets have created some speed bumps for master limited partnerships (MLPs) to overcome. Today’s market conditions and fierce competition for assets are testing the MLPs’ ability to fuel their growth without their customary silver bullet of regular accretive or single, transforming acquisitions.


Growth is the lifeblood of MLPs, and demonstrating dynamic growth is necessary to attract new capital. Recently, energy MLPs appear unable to find an available supply of accretive or single, large acquisitions, especially as companies become ever larger. While existing MLPs are raising capital, completing small to midsize acquisitions and managing organic-growth projects, especially in the midstream sector, we now see a broader portfolio of new growth strategies.


Even in a bear market, the MLP sector remains strong; cash distributions continue to grow. MLPs retain robust fundamentals, despite recent financial results that show upstream and midstream MLPs have been significantly affected by unrealized derivative losses due to rapidly increasing commodity prices.


Nonetheless, MLPs continue to outperform the broader equity market. MLPs outperformed Standard & Poor’s (S&P) 500 Index during seven out of 10 years and delivered an average hefty return of 17.3% versus S&P’s 5.9% from 1998 to 2007, according to Wachovia Bank. Now, however, the Wachovia MLP Index has generated a negative 7% return for the group, versus 15% for the S&P 500, during the first six months of 2008.


With regard to MLP initial public offerings (IPOs), the market is sluggish, showing only three deals completed in the first six months of 2008, compared with 30 IPOs during the past three years. The IPOs in 2008 were by Western Gas Partners LP, Pioneer Southwest Energy Partners LP and Williams Pipeline Partners LP. Together, these three deals generated about $800 million, compared with $3.2 billion generated in 2007 and $3.8 billion in 2006—providing further evidence of a slowing IPO market.

Raising capital
While management teams cannot influence the broader economic conditions in the U.S., which are discouraging MLP IPO activity and depressing equity markets, the future growth and performance of existing MLPs still rely on execution of growth strategies and oversight ability. The message to management teams is that they need to remain focused on executing their business strategies, albeit showing flexibility to adjust to new ways of hitting their short- and long-term growth targets, and dissect the operating and financial effectiveness of raising capital, acquisitions, risk management and organic capital activities.


Today, raising the right mix of debt and equity capital to feed the MLP’s growth is one of the sticking points challenging management teams. While MLPs are on their way to raising more capital dollars than in 2007, they are left grappling with equity overhang because of management reluctance to go to the market to raise equity until unit prices rise.


Raising equity capital right now means MLPs will get less per unit in today’s market compared with that of the 2007 high. Conversely, most investment-grade MLPs appear to have steady lines of credit that allow them to raise the debt capital they need, whenever they need it.
Due to low unit prices, MLPs have raised only $5.7 billion from equity offerings in the first six months of 2008, yet $9.2 billion from debt offerings. This is in contrast to $14.7 billion in equity raises and $4 billion in debt raises during full-year 2007. Proceeds from secondary equity offerings have decreased from $8.6 billion in 2007 to $2.8 billion in first-half 2008.


Meanwhile, analysts are publishing price targets significantly above MLPs’ current unit prices. As a result, many management teams claim their units are undervalued due to the depressed equity markets. Price targets are 50% higher than current prices for midstream MLPs and 42% higher for upstream MLPs, based on an RBC Capital Markets’ equity-research report in August 2008.


While lower unit prices do not provide an attractive market for MLPs to raise equity capital, credit-rating agencies and MLPs’ general thirst for capital will likely require them to do just that in the near future.

Acquisitions and hedging
Market seers have been chattering about the acquisitions market over the past year as intense competition, high commodity prices and earnings before interest, taxes, depreciation and amortization (EBITDA) multiples continue to make it harder for MLPs to identify accretive acquisitions.


Due to their dependence on acquisitions for growth, this is, by far, a higher hurdle for upstream MLPs to overcome than midstream MLPs, although both rely heavily on this growth strategy. Other than having sound financial fundamentals, upstream MLPs must replace reserves and grow production to ensure distribution growth, especially in an environment of escalating costs.


To stay ahead, management must scrutinize their financial parameters for acquisition targets and focus their due-diligence efforts to avoid overpaying for assets and businesses. This will require management to perform quality financial and tax due diligence on potential acquisition targets to determine the earnings run-rate of the target business or assets, and identify key expiring contracts, customer relationships and other significant exposures and contingent liabilities.


As commodity prices remain high, acquisition activity is clearly slowing. Energy MLPs completed $4 billion of acquisitions in first-half 2008, compared with $17 billion in full-year 2007, and $10 billion in full-year 2006.


Paired with acquisitions, MLPs place significant emphasis on hedging strategies to manage their exposure to changes in commodity prices and to limit surprises that can affect a company’s ability to meet its distribution targets. In general, MLPs tend to hedge 70% to 80% of their near-term exposure with percentage decreases in later years.


While hedging manages commodity-price risk, it is vital that appropriate policies and procedures, internal controls and risk-management programs be placed in operation, along with appropriate oversight from senior management.


Inherent exposure to commodity prices differs between upstream and midstream MLPs, while actual exposures vary for each MLP depending on the nature of its operations and derivative strategies. Overall, MLP management teams seek to reduce any commodity-price risk by hedging most of their price exposures. Often, upstream MLPs directly benefit from higher commodity prices.


Hedge strategies can protect the downside from lower prices but also limit the upside from higher prices, as was evident in recent quarters as commodity prices strengthened.


While commodity prices and hedging programs are the main drivers for upstream MLPs, midstream MLPs do not necessarily benefit directly from higher commodity prices. Those with significant marketing operations generally prefer volatile markets and those with gas-processing operations benefit when there is a significant differential between natural gas and liquids prices, such as was seen in 2008.


Despite the strong fundamentals, trends in earnings have been volatile in 2007 and 2008, primarily due to gains and losses from commodity derivatives. In the second quarter, some 15% of midstream MLPs and 60% of upstream MLPs reported net losses almost entirely due to unrealized commodity derivative losses.


For example, Linn Energy LLC reported second-quarter adjusted EBITDA of $162 million but a net loss of $712 million, primarily due to $773 million of unrealized commodity derivative losses. “Second-quarter 2008 proved to be another record-setting quarter for Linn Energy. The company posted the highest production rates, adjusted EBITDA and distributable cash flow in its history,” says Michael C. Linn, chairman and chief executive.


That same quarter, BreitBurn Energy Partners LP reported adjusted EBITDA of $62.3 million, but a net loss of $286 million primarily due to $320 million of unrealized commodity-derivative losses. The company reported that its losses were due to the impact that higher oil and gas futures had on changes in fair value of commodity-derivative instruments related to expected sales through 2012.


As oil prices continued to weaken in the third quarter, one would expect companies to report unrealized gains from commodity derivatives in the quarter. However, these are non-cash items, which is why MLPs generally focus investors on their adjusted EBITDA results.
Investors’ increasing uncertainty about the effect of significant price swings on liquidity, income volatility and distributions has escalated the importance of companies and their investor groups understanding the true impact of this huge volatility in commodity prices on MLP performance. Companies are recognizing the importance of being totally transparent about their derivatives strategies and related risk-management activities, ensuring they have adequate policies, procedures and controls.


Perception of commodity-price risk can influence unit prices over the short term, so most MLPs are providing more information and transparency around their derivatives activities in earnings releases and conference calls.

Organic capital projects
On the midstream front, as growth through acquisitions becomes more challenging, the number of new organic capital projects has spiked. Midstream MLPs are positioned to play an increasingly larger role in the growth of energy infrastructure as significant expansion projects are planned. MLPs spent $11 billion in 2007 on organic projects, compared with $6 billion in 2006 and $3 billion in 2005. Such projects include new interstate and intrastate pipelines, storage, gathering systems and processing plants.


Strategies for organic growth vary depending on the geographic and functional nature of an MLP’s existing asset base. On one extreme, the strategy is to integrate and obtain synergies from existing assets. For example, a midstream MLP in the oil sector with core storage hubs and a broad geographic spread of transportation assets might have a large portfolio of small to medium capital projects ranging in the tens of millions of dollars.


On the other extreme, the strategy is to focus on a small number of large projects. An example of an MLP following this strategy is Boardwalk Pipeline Partners LP, which has a Gulf Crossing Expansion project consisting of a 42-inch, 357-mile line with a $1.8-billion price tag, part of a $2.9-billion capex program for 2008.


Midstream companies in the oil sector will have to closely monitor the projected volume growth from oil-sands activity in Canada. Pipeline projects depend on volumes from upstream projects and delays in new volumes can significantly affect the economics of midstream capital projects unless they have locked-in commitments from shippers. Because the success of these projects relies on new supplies of oil or gas, this strategy could ultimately affect the ability of midstream companies to raise cash distributions.


One of the largest challenges for midstream companies is to manage all of these capital programs. Successful management includes achieving project returns, meeting the budgets and the timelines for completion, and identifying and managing risks.


Delays in the completion of capital projects and cost overruns can quickly deteriorate the economics on these projects and adversely affect future distributions and growth targets. In contrast to corporations, MLPs have limited shock-absorption capability for cost overruns because of the focus on available cash.


Cost is crucial, especially in the current environment where the U.S. energy sector is experiencing rapid cost inflation, according to cost indices prepared by Cambridge Energy Research Associates (CERA). Although CERA does not publish a midstream cost index, its upstream and downstream project-cost inflation increased 11% and 8%, respectively, in the second half of 2007. CERA chalks up this trend to increases in steel and oil prices, supplier capacity shortages and a shortage of skilled labor and raw materials.


To further exacerbate the complexity of these projects, during the past decade the midstream sector has lost the in-house expertise to manage such complex capital-investment projects because of its intense focus on acquisitions, operations and regulatory compliance. Now, management is often driven to hire multiple outside contractors, requiring it to then orchestrate multi-party involvement and compressed project timelines.


Using contractors presents challenges in terms of risk management, environment, safety and quality. Companies may not recoup costs if their contractors fail to maintain a strong control environment and document costs that comply with regulations. Midstream companies must strike the right balance between maintaining project control and relying on contractors and subcontractors.


Additionally, many midstream MLPs struggle to secure the qualified labor, because they lack the project size, the buying power or the long-term relationships to attract the larger top-tier engineering firms. This leaves many midstream companies to rely on smaller contractors that often struggle to attract and retain qualified resources.


In response, some companies are experimenting with outsourcing some engineering to overseas service providers in an attempt to identify qualified resources at much lower costs.


Knowing relevant cost risks upfront can not only save a midstream company money but also its reputation. Investors want growth but also want predictable cash flow. Late warnings of cost overruns or project delays can cause them to lose confidence in management and question success in hitting future growth targets.


To better manage costs, schedules and true project processes, management must apply heftier controls to these major construction efforts and capital programs, including contractor audits and earned-value management systems. Management should consider these steps to ensure unit-holders enjoy the full benefits of these investments: analyze and plan for each project’s regulatory climate and risk; establish a capital-investment management framework; and develop focused management reporting.

MLPs’ future
Amidst all these challenges and market uncertainty, investors need some evidence of energy MLPs’ ability to maintain growth and generate superior returns. Upstream MLPs are probably under a bigger spotlight, because they have a shorter track record and depend more on accretive acquisitions and commodity prices, and, for certain MLPs, on drop-down assets from their parents. On the positive side, they are growing in number and continue to build a good track record of earnings, while increasing reserve life and production. From that perspective, times are good.


However, upstream MLPs make up a relatively small sector with some 10 upstream MLPs compared with between 45 and 50 midstream MLPs in the U.S. When one or two start to have bad times, it may affect the others.


On the midstream front, things look positive, but each MLP has its own challenges. As stated, energy infrastructure is in an impressive phase of expansion, and midstream MLPs remain the structure of choice. As a critical part of the energy sector, they have the burden of building out pipeline and storage infrastructure, which provides opportunities for growth and good returns. Assuming that the next president and Congress will leave all the tax benefits in place, midstream MLPs have significant opportunities to maintain growth and their attractiveness to investors.


While they cannot change the market, the future growth and performance of MLPs relies on each management’s ability to execute operational strategies, raise capital, properly manage capital projects, and achieve the desired synergies from acquisitions.


Going forward, investors will be paying close attention to see which MLPs are able to meet their distributions and other financial targets. For midstream MLPs without transforming acquisitions, this will depend on the success of capital projects, with many expected to be completed in the next couple of years.


For upstream MLPs, this will depend on the ability to increase reserve life and manage the effects of volatile commodity markets. Ultimately, for the leading MLPs and management teams, the next phase of growth may need to come from consolidation within the energy MLP sector. Those that grow and generate superior returns will survive.

Author's Update: Market events in the second half of October have lead to a significant drop in crude oil prices, low and volatile unit prices, and a larger focus on the cost and availability of raising capital to fund future growth. While liquidity from operating cash flows will likely remain strong, especially with appropriate hedging strategies, MLPs must now make some very strategic decisions as to how, when, and at what cost, to raise capital in order to fund the future growth and whether to slow down their cash distribution growth targets. There is no doubt that such a capital intensive sector is under pressure but the fundamentals remain strong if growth strategies can be appropriately managed. We may still see consolidation within the sector, especially with non-cash stock transactions.

Simon Tait is leader of Pricewaterhouse­Coopers’ U.S. energy MLP practice. He may be reached at 713-356-4332.