Energy investment manager Tortoise Capital Advisors in 2012 set apart its Tortoise Capital Resources Corp. unit as a new firm, CorEnergy Infrastructure Trust Inc. It charged CorEnergy with an unusual mission: Acquire midstream assets and hold them in a real estate investment trust (REIT)—an unusual corporate structure in a sector where most public firms are either MLPs or conventional corporations, and where private-equity-backed operations are common. A REIT owns but cannot operate assets, and CorEnergy’s assets are leased to upstream producers or midstream operators. CorEnergy’s CEO took a few moments to visit with Midstream Business to discuss why its concept has worked and why he feels midstream REITs have a bright future.
MIDSTREAM Your background before CorEnergy was working with more conventional MLP structures. What led you to organize a midstream REIT?
SCHULTE There were two things. First, I had a front row seat to witness the growth of the market, starting in 2001 as a board member of two MLPs, and then developing and overseeing several MLP funds. As an investment committee member at Tortoise Capital Advisors, I had direct experience providing capital to stable, contracted, low-risk energy midstream business models.
Second, my partners at CorEnergy and I recognized that there are limitations on the types of investors that are willing to put money into MLPs because of the partnership structure. We appreciated the attractive risk/return profile of midstream assets, but saw what we believed to be a more tax-efficient approach to ownership that would enable a broader investor universe to have access to energy infrastructure.
These two observations led to the formation of our [REIT] in 2012.
The Pinedale Liquids Gathering System in Wyoming was CorEnergy's first asset and serves Ultra Petroleum Corp.
MIDSTREAM Let’s cover the basics: CorEnergy is a REIT that owns midstream energy assets. Why do this in a REIT rather than an MLP or private-equity structure?
SCHULTE Both MLPs and private-equity-sponsored companies operate distribution and processing businesses, providing critical producer services and transportation across the energy value chain. MLPs generally prefer to operate networks of assets that can be optimized by management teams, who are rewarded for increasing distribution performance. Private equity provides entrepreneurial teams with long-term, patient—but not permanent—sources of funds to build or acquire scale. These companies intend to eventually conduct an IPO or sale to an MLP.
This MLP and private-equity ecosystem has generally worked well for two decades and there is significant investor appetite for it, but what these midstream businesses do not emphasize is steadfast infrastructure without a good strategic growth story. These “dedicated infrastructure” assets—mostly pipelines and storage assets—were built-to-suit to address the specific needs of a small number of users and have no real opportunity for enhancement.
MLPs place these assets lowest on their list of projects since they cannot augment performance. Private-equity funds could buy these assets, but they need to resell them in a few years. For upstream companies desiring to retain control over their dedicated infrastructure, our REIT provides a way to monetize the assets and use proceeds to fuel higher-value activity, essentially improving returns on invested capital. As a publicly traded company, our REIT never has to resell the asset to provide investor liquidity. Our investors have access to liquidity every day on the New York Stock Exchange.
MIDSTREAM For investors, what differences are there between owning shares in CorEnergy’s REIT approach vs. units of an MLP or even a private-equity venture?
SCHULTE The stable, high-cash-generating business models in the midstream provide very desirable investment characteristics, but have historically been difficult for most investors to access. MLPs carry tax compliance burdens, and private equity is aimed at larger investors with a high tolerance for illiquidity.
REITs, which traditionally own retail, industrial and residential real estate, do not conduct active businesses in those facilities. If all they do is rent them out, then that REIT is not a taxpayer.
The dividends from the REIT are ordinary income dividends and they tend to be owned in retirement and/or tax-exempt accounts. Similarly, utilities are largely owned by institutional investors, many of which are tax-exempt retirement plans or mutual funds.
On the other hand, operating businesses, like those conducted by MLPs, have all the characteristics of an active trade or business. That means that the investor needs to pay tax in an operating manner on the income that they get on their [IRS] Form K-1. This is true even for retirement accounts, making them far less tax-efficient to many potential investors.
A closed-end fund structure can own MLPs, allowing tax-exempt investors the ability to own certain energy assets by receiving “dividend” income. That’s one approach to owning MLPs. If you don't like pass-through income, you could buy a closed-end fund such as those pioneered by Tortoise.
Closed-end funds, however, are also investment companies regulated under the Investment Company Act of 1940. As such, the ability of other investment companies to own them is severely limited. Whereas, a REIT is not an investment company under the 1940 act, so mutual funds have no restrictions on ownership.
The liquid investment universe for REITs and utilities is $2.5 trillion of equity investment globally. This demonstrates a very large market of capital that would rather have dividend income than the “active trade or business” income generated by an MLP. CorEnergy provides those investors with diversification to their portfolios’ traditional REIT investments through energy infrastructure.
MIDSTREAM How about producers? What is the advantage for an upstream company to partner with CorEnergy vs. owning its own midstream assets or working with a midstream MLP firm?
SCHULTE All of these structures have opportunities and limitations, and one of the limitations of the REIT is that it cannot conduct an active trade or business. Unlike an MLP that wants to have an active role in optimizing a network of related assets, CorEnergy targets energy infrastructure assets that are not easily integrated into someone else’s network. Therefore, we appeal to energy companies that want to maintain control of their assets because they are critical to that particular company’s operations. We still provide a funding mechanism, as an MLP would, but when we buy an asset, the upstream company will stay in complete operational and commercial control of it under the terms of a lease.
The lease is analogous to a gathering and processing agreement from an MLP.
MIDSTREAM The past five years have seen dramatic swings in the commodity cycle for oil and gas. How did CorEnergy fare through the hard times when many operators were distressed?
SCHULTE Well for us, it was the best of times and the worst of times. It was the worst of times because, as a brand-new business model, our investors were unsure how we would fare during a period of significant distress in the energy sector, so our stock price correlated very highly with oil prices. As prices, both of oil and our shares, bottomed out in February 2016, there was significant concern about the viability of our revenue stream.
But it also proved the best of times, as our contracts were durable and honored throughout the period of distress in the upstream sector. We never missed a monthly lease payment.
There are two reasons for that: First, we own assets that are critical to our upstream counterparties, in desirable fields that are integral to their overall operations. That is why they didn't want to reject the lease of our assets or sell the underlying reserves, which our tenants own, to a third party. And second, the lease contract is a real estate contract with a higher level of priority at bankruptcy than a financing or service contract.
So now, we have proven that our revenue stream is reliable even in periods of distress as long as our assets are critical to our upstream operators.
MIDSTREAM Describe your property in Wyoming, the Pinedale Liquid Gathering System. Why did you recently buy out Prudential Capital as a minority owner of this asset?
SCHULTE The Pinedale asset was the first REIT-qualifying asset that we purchased at the end of 2012. It has 150 miles of pipeline with over 100 different receipt points and four distinct aboveground storage terminals. The Pinedale Anticline itself is one of the most prolific and low-cost natural gas production fields in the U.S., with good physical connectivity to the West Coast demand markets.
We had a view, and still do, that the longevity of that field would be significant because of the low decline rates and the large number of additional drilling locations that have already been delineated in the field. This field will be active for a very, very long time.
In this lower-price environment, Ultra Petroleum Corp., which leases the system from CorEnergy, has continued to reduce field drilling and operating costs such that they are economically drilling new locations at natural gas prices below $3 per million British thermal units. They have recently announced the testing of horizontal drilling, and these results have proven to produce above expectations.
Although we don’t yet know the extent of the opportunity that they will create, we believe that the horizontal drilling potential has the ability to increase the life and productivity of the field. This will benefit our system as it handles liquids coming out of those natural gas wells.
Prudential Capital was a co-investor with us in the equity of the project at the time of purchase. They were a terrific partner for us, in part because of the depth of knowledge of their team across the upstream and midstream markets, and also their validation of our strategy and structure when they made their first investment. At some point during our ownership, we expected that Prudential would wish to liquidate their position. We recently agreed to purchase their interest and for them to help finance the purchase with a loan on the asset. We really have appreciated Prudential Capital’s relationship over the years. And importantly, they are still involved in the asset as a senior lender.
MIDSTREAM CorEnergy is still pretty small compared with many midstream energy companies. What is your growth strategy?
SCHULTE We find that the $50 million-$250 million size range is suitable for our capacity to transact by ourselves. If it’s much smaller, the documentation and process may not be worth it. For larger transactions, we have developed many promising relationships with well-known infrastructure investors who have expressed interest in co-investing with CorEnergy.
We have a backlog of opportunities, but the vast majority do not pass the scrutiny of our due diligence. We do, however, expect to transact on one or two acquisitions per year. Although we didn’t acquire a new third-party asset in 2017, we feel we have gotten back on stable footing after the recent energy crisis. We had five significant investigations of assets, one of which is still ongoing. The others were at various stages of due diligence or documentation, but we decided to not proceed due to our strict underwriting criteria.
We have now come out of the energy crisis with our strategy validated and believe once we complete one or two more transactions, our scale will become more enticing for counterparties and lenders.
MIDSTREAM Do you think the current economic climate, both generally and in the energy sector specifically, is favorable for CorEnergy to make additional acquisitions?
SCHULTE Yes, we do. The energy sector downturn has caused everyone in the upstream environment, including major global integrated oil companies, to reassess their balance sheets and drilling plans. Traditional external sources of capital are limited and equity investors are pressuring companies to control their costs, limiting their drilling activity to what they can fund internally from operating margin. When energy prices declined, that margin had been reduced for potential drilling activity.
With commodity prices seeming to have firmed up, energy companies want to get back to production stability and growth, making them hungry for lower cost capital. CorEnergy can provide a source of funds from something that already exists on their balance sheet. They can sell us relatively low-returning, critical assets and then redeploy those dollars into higher-return opportunities, thereby enhancing the value of their enterprise.
MIDSTREAM How about interest rates? What does the potential for a rising interest rate environment say about your growth prospects in terms of income statements and future acquisitions?
SCHULTE Rising interest rates are always a concern for investors in income-oriented equity securities. Over time, MLPs and REITs have been able to raise dividends at a rate that mitigates the challenge of inflation, and we think we are in the same position. We don’t have a significant amount of floating-rate debt outstanding, so we don’t expect to face higher borrowing cost to any material degree. Additionally, we can price our cost of capital into an acquisition and earn a positive spread. If we were unable to adjust our pricing appropriately, we wouldn’t go forward with an acquisition.
We have hedges in our current contracts against inflationary pressure. Our leases have CPI [Consumer Price Index] adjustments in them to offset rising inflation over the long term. So to us, whatever the environment is for our cost of funds, it’s translated into pricing of our lease with our counterparty.
MIDSTREAM Do you see CorEnergy as a player in the midstream sector over the long haul? Would it make sense for others to look into adopting the REIT structure for midstream assets?
SCHULTE You know, 2015 through 2017 were tough years for all midstream investors, and our stock reacted negatively during a portion of that period. Now, it appears investors recognize CorEnergy’s differentiation. Nonetheless, exposure to energy generally is cyclical and has an impact, positive and negative, on companies like ours that serve that industry.
After proving our business strategy through the downturn, we believe that our vehicle will be a long-term investor and owner of energy infrastructure assets. We have broad access to capital and appeal to investors that have low-risk, long-term horizons for their investment capital. Investors that buy utilities and REITs generally want to sleep at night. They don’t need high growth, but they want limited risk. We acquire critical assets that have long-duration, contracted cash flows that will enable our investors to have peace of mind, while we selectively provide much-needed capital to energy companies as they return to growth.
MIDSTREAM How do you broaden your investor base?
SCHULTE We have developed our initial investor base with energy-focused funds that own CorEnergy in their non-MLP accounts. Our mission is to broaden the awareness of CorEnergy with non-MLP investors, particularly other investors who generally want low-risk income, such as investors approaching retirement.
We have started to do that with our perpetual preferred securities, which are owned by REIT funds, and our convertible bonds which are owned by investors in financial securities. We expect that increasing exposure to continue as we build our business with our common equity being more broadly owned by both U.S. and non-U.S. investors.
Paul Hart can be reached at firstname.lastname@example.org or 713-260-6427.
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