Where To For E&P MLPs?

?Able once again to see upside in the MLP model as oil prices rebounded and the debt and equity markets showed signs of life, Legacy Reserves LP committed to remaining an independent public partnership, according to Steve Pruett, president.

In first-quarter 2009, in the heart of the economic downturn, Legacy Reserves LP, an E&P master limited partnership based in Midland, Texas, faced a difficult operating environment. Its spring bank borrowing-base redetermination had shrunk by $70 million to $340 million, reflecting current market prices in which West Texas Intermediate crude had hit a low of $32.60 per barrel during the quarter. Legacy was drawn to $300 million, a marginally comfortable spread, but the prospect for the fall redetermination was uncertain. Together with the lack of access to the debt and equity markets, which had seized up since year-end 2008, company management foresaw a real and present danger to its liquidity.

“Things looked pretty bleak,” says Legacy president Steve Pruett. “Our model of acquiring assets funded 50% with equity and 50% with debt was coming to an end, so we were faced with looking more like a royalty trust than a live, growing MLP. While the MLP model wasn’t broken, it appeared that it was on extended vacation and we didn’t know when it was going to return.”

Thus, when private-equity fund Apollo Management VII LO made an offer of $14 per unit in cash, minus cas distributions made prior limited partnership in early April, it appeared to be a lifeline when no others might appear. The offer represented a 50% premium compared with the trailing 30-day average.

“It looked like an opportunity management shouldn’t keep from our unit holders,” says Pruett. If deemed fair by Legacy’s conflicts committee compared with other alternatives, “then it should be something the unit holders had a shot at voting on. That was the bottom line.”

While the deal was under review, however, oil prices rebounded to around $70 per barrel, and the debt and equity markets showed signs of life. Able once again to see upside in the MLP model, Legacy’s independent directors comprising the conflicts committee rejected the Apollo offer and committed to remaining an independent public partnership.

Legacy’s journey is one all upstream MLPs have had to navigate recently. While facing the same headwind as other incorporated E&Ps, the small subsector of 10 public limited partnerships battles unique challenges related to its model of buying accretive long-lived assets with the goal of paying out stable distributions to investors. Results have varied within the group, but news of the demise of upstream MLPs seems premature.

Suspended distributions

“They’re feeling the pinch,” says Michael Hall, vice president of oil and gas equity research with Stifel, Nicolaus & Co. Inc. “This particular environment we’re in is highlighting the potential problems with the upstream MLP model.”

Making distributions while working with a depleting asset base is one particular challenge upstream MLPs face in a tightened economic environment. Most MLPs pay out the large majority of profits via distributions to unit-holders in a tax-free pass through. Fearing cuts in distributions, many investors abandoned the beleaguered subsector this past fall. In a few cases, that fear has been realized.

“This particular environment we’re in is highlighting the potential problems with the upstream MLP model,” says Michael Hall, vice president of oil and gas equity research with Stifel, Nicolaus & Co. Inc.

“A lot of these companies are carrying assets on their books that were put on via acquisitions during pretty heady times,” Hall says. “There was a lot of capital floating around in the market, and the sector got a little aggressive in its bidding.” As those acquired reserves continue to get written down, and lacking new acquisitions, the pressure mounts on borrowing bases, which in turn pressures distributions.

“The proposition of maintaining a flat asset base despite a declining profile, while at the same time distributing cash flows, becomes pretty difficult,” he says.

BreitBurn Energy Partners LP provides an example. The Los Angeles-based MLP bought a $1.45-billion Antrim shale package from Quicksilver Resources Inc. in late 2007 in a company-transforming half-equity, half-cash deal. It followed up in June 2008 by buying out its sponsor company, Calgary-based Provident Energy Trust, for $345 million, further tapping its credit facility to a total of $717 million. Then this past April, its borrowing base was reset from $900 million to $760 million and, while exceeding borrowings, the reduction triggered covenants in the company’s borrowing facility. It was forced to suspend distributions and direct all cash flow to debt reduction.

With 75% of its portfolio gas-weighted, many investors fear this fall’s redetermination could take a further bite out of BreitBurn’s credit base. Randy Breitenbach, co-chief executive, said the company will consider “all reasonable alternatives to further debt reduction” in the meantime. Add to these uncertainties a lawsuit by Quicksilver, its disgruntled majority interest owner, and the verdict is still out on BreitBurn’s future.

Likewise, Constellation Energy Partners LLC suspended distributions when its borrowing-base reduction put it at 98% drawn. Also adapting to a reduction, the hybrid upstream and midstream partnership Eagle Rock Energy Partners LP, Houston, voluntarily cut distributions by some 94% in an aggressive effort to enhance liquidity.

To the average MLP investor, cutting or suspending distributions is “a big deal,” suggesting that the promise of a consistently growing dividend may be a pitch that is an unjustifiable expectation, says Hall. A “floating” dividend might be more prudent to the model. He believes the industry is in for another round of borrowing-base reductions in the fall, “particularly for companies with gassier reserves.”

Capital is critical

“Accretive acquisitions are the main theme in the MLP sector, and access to capital is a key component of continued growth through acquisitions,” says Curtis Newstrom, vice president of business development at Linn Energy LLC.

Following its $2-billion acquisition of assets from Dominion Resources in 2007, Linn deleveraged through strategic divestitures of properties noncore to its asset portfolio even before the economic downturn made landfall, putting the company on a heading to be able to weather the coming storm. It raised some $900 million in three divestitures in 2008.

Hedging is a key component of Linn Energy LLC’s business model that helps protect unit-holder distributions, according to Curtis Newstrom, vice president of business development.

When the bond and equity markets opened in May, Linn took advantage, issuing approximately $350 million in bonds and equity. The company has more than $580 million in liquidity pro forma the offerings.

“Access to capital is key for the MLP model,” Newstrom says. “Linn’s ability to close both of these transactions, along with our new $1.69-billion credit facility, in the current economic environment is a testament to Linn’s low-risk business model.”

Newstrom credits hedging as a key component of Linn’s business model that helps to protect unit-holder distributions. The company has approximately 100% of production hedged through 2011, with average prices of $8.25 for gas and $93 for oil.

“We’re fortunate to be hedged several years out at attractive prices,” adds Newstrom. “If you’re not hedged in today’s environment, generating sufficient cash flow to cover distributions could become difficult.”

Cutting distributions is the last resort for an MLP. “You want to avoid it if possible.”

In good times and bad, MLPs hold an advantage in acquisitions by not having to pay corporate taxes, but it is still only those MLPs with access to capital that have the necessary firepower. “If you don’t have a lot of existing available liquidity, it’s tough to do a deal even if you are tax-advantaged.”

Linn has made the turn from preserving liquidity to building additional liquidity to take advantage of opportunities, he says. “There are going to be companies struggling and forced to sell assets, and when those assets come on the market, we want to be on the front line.”

Going and coming

Three public MLPs are exiting the space, all for unique reasons and largely unrelated to the downturn.

Philadelphia-based Atlas Energy Resources LLC discovered its legacy Appalachian assets were sitting on top of a gold mine of Marcellus shale potential. The intensive capital needed to drill out the resource play and resulting negative cash flow would not be conducive in an MLP model. The company determined it was no longer an MLP and has chosen to merge with its C-Corp parent, Atlas America Inc., to attack its upside potential, possibly one of the best positions in the Marcellus.

Quest Energy Partners LP, Oklahoma City, last year charged its former chief executive Jerry Cash with embezzling up to $10 million. The lawsuit was ultimately settled, but having been severely damaged in the markets and facing delistment and going-concern questions, the limited partnership will be rolled up into its parent, Quest Resources Corp.

Constellation Energy has been quietly on the market for more than a year. Owned 38% by Baltimore utility Constellation Energy Group Inc., the parent had been fighting its own liquidity issues before partnering with French utility Eléctricité de France on its nuclear- generation business this past fall. Sources say the utility wants out of managing oil and gas properties, but has found little interest in the MLP’s Cherokee Basin assets in the weakened marketplace.

Abraxas Energy Partners LP never made it to IPO, as the private MLP subsidiary of Abraxas Petroleum Corp. got caught between waiting for SEC approval and the closing of the equity markets. Under pressure from a bridge lender that was supposed to be paid out at the time it went public, Abraxas has chosen to abandon the MLP model and merge its assets with its parent corporation.

Conversely, three MLPs have found new life with the opening of the capital markets and expect to emerge leaner and stronger from the downturn. In addition to Linn Energy, Fort Worth-based Encore Energy Partners LP and Houston-based EV Energy Partners LP have recently reloaded with debt and equity transactions, using the raises to fund acquisitions and pay debt.

Taking advantage of the reaffirmation of its borrowing base and the open window in the capital markets, in the second quarter Encore announced two acquisitions, the majority as drop-down assets from parent Encore Acquisition Co., for some $143 million. Encore president and chief executive Jon S. Brumley boasted, “While other upstream MLPs are struggling to find their footing in this marketplace, Encore Energy Partners has been able to make two significant acquisitions in 2009.” The company raised some $154 million in two equity offerings to fund the deals.

EV Energy seized the opportunity to reload with an $80-million equity raise to pay down debt and fund a small bolt-on acquisition.

Moving ahead cautiously

EV Energy chief executive John Walker emphasizes that E&P MLPs are in much better shape than their counterpart C-Corp companies. The reason, he reiterates, is “because we’re so fully hedged.” With distributions being the reason for an MLP’s existence, he says, his company is heavily hedged into 2013. The hedges generate $7 million a month in excess cash flow, which EV is applying toward debt reduction and maintaining the distribution.

The company acquired a modest $200 million of assets in 2008, sticking to its philosophy of steady growth through smaller acquisitions. “We want to maintain the ability to make acquisitions regardless of the cycles of oil and gas prices,” Walker says. “By being disciplined at the high end of the cycle last year, we are in a good position to take advantage of acquisition opportunities this year and beyond.”

EV Energy earmarks about one-third of cash flow to distributions, one-third to debt reduction and one-third to maintenance, which includes replacing reserves.

One of the reasons MLPs got into trouble is because some did acquisitions at very low discount rates to quickly transform their companies, and essentially overpaid. “You can’t do that,” he says. Have patience and discipline to buy at discounts rates in the range of PV-10 to PV-15. “You’re not going to buy a big pile of assets at those discount rates, but you can never overcome a bad acquisition.”

Walker says the sector as a whole will move cautiously going forward. “We are going to acquire, but anything we do won’t lever us up. It will be neutral or delevering in nature.”

Legacy’s revival

Legacy’s Pruett says the consideration to take the partnership private was unrelated to cash flow and specifically about the risk of a reduced borrowing-base redetermination in the fall if prices stayed low.

“Cash flow was good because of our hedge position,” he says, which protected distributions in the short term. “But should we have ended up fully drawn or close to fully drawn, we would have needed to substantially reduce or potentially suspend our distribution to pay down debt to a more manageable level.”

Pruett says the company would have significantly reduced distributions preemptively to get ahead of the banks. With $65 million a year in distributions, using some of that money to pay down debt “would quickly get us back into a comfortable position.”

Weighted at 72% oil and gas liquids, “we feel much better now” about the fall redetermination, he adds.

Not only was the company concerned about lower price decks, but hedges were due to roll off in the fall. “We couldn’t replace those high-value hedges we had put in place in 2008 with the same value.” Another factor: equity issuances came at a yield of 20% or higher. “That’s not a cost of capital that will provide for a successful business plan of acquiring assets—that yield was not sustainable.”

Legacy has not shelved acquisitions, he says. If an acquisition were “tremendously accretive” and he had confidence in accessing some form of equity, “that would give us confidence in getting back to the business of acquiring.” Presently, Legacy is making small acquisitions out of cash flow.

Taking advantage

Will there still be a place for upstream MLPs when the markets settle? “For the right mature asset and for the right investor base, it makes sense,” says Hall. He suggests the sector should stick with smaller transactions that don’t make headlines.

“By being disciplined at the high end of the cycle last year, we are in a good position to take advantage of acquisition opportunities this year and beyond,” says EV Energy Partners LP chief executive John Walker.

“They ought to not get ahead of themselves in terms of size of acquisitions. The bigger you get as an upstream MLP, the harder and harder it is to replace that declining production base. It will be more singles and doubles as opposed to all the home runs that we saw before.”

One advantage MLPs have over a C-Corp E&P, Newstrom points out, is the financial stability provided by their hedge book, which helps them ride out challenging times like these. “MLPs are generally going to hedge longer than E&Ps,” he says, which may only hedge for a year to 18 months, at the most, or not hedge at all.

Walker thinks the current environment is one of the best periods for acquisitions in a lifetime and thus one that favors MLPs. “If you buy a PDP property you know exactly what you’re getting and have eliminated a lot of risk. If you can buy at a PV-15 or better in a depressed market, then you’ve done something highly accretive with very little risk relative to drilling.”

Over time the space will attract more MLPs, he believes, as about 75% of all wells in the U.S. are mature stripper wells that fit better in an MLP structure than a C-Corp structure.

“There are still a lot of good things to say about the MLPs,” Walker says.