Last year, crude oil production from U.S. shale plays accounted for 10% of the globe’s oil, elevating the nation’s ranking among the top producers worldwide and setting in motion a need for new pathways to turn that black gold into cold cash. And for companies in the midstream sector, most of them structured as MLPs, it’s putting a sweet spot right on their bottom line.
Driven by the abundant new supplies of crude and NGLs, MLPs completed a record 21 IPOs in 2013 in the midstream space of pipeline, transmission and storage businesses. As companies have grown to meet demand for infrastructure, the phrase “midstream majors” has become part of the vernacular to describe the super-size partnerships formed to move product.
The rise of the midstream sector in recent years was serendipitously predicated on the shale boom. Less than a decade ago, seven midstream companies together had an enterprise value of more than $5 billion; today, two dozen of those midstream firms have each attained that rarified dollar figure, and most of them are structured as MLPs.
What is it about an MLP model that lends itself to growing a midstream company?
It’s the pass-through tax feature that means unitholders pay taxes on their distributions, instead of the partnership paying taxes and having little left over for quarterly dividend payouts. What’s more, with multiyear contracts and a tolling system of sorts, a midstream MLP’s lifespan can go on indefinitely provided there are hydrocarbons to move.
“I really think we’re to the point that every single company is thinking about [forming an MLP], as long as they have qualified assets,” Jed Shreve, a principal at Deloitte LLP in Houston, told Midstream Business.
An MLP is a very capital-efficient structure, John England, vice chairman and oil and gas leader at Deloitte, told Midstream Business. “We think most of the big players—probably all of the big players—in the midstream space will be MLPs,” he said.
Indeed, when the firm coined the term midstream majors, it was likely thinking of players such as Enterprise Products Partners with its $82 billion enterprise value, or Kinder Morgan, which among all its business lines has an enterprise value of $110 billion.
“We realized the size of some of the midstream companies was starting to approach the size of some of the large upstream players, of some of the formerly integrated upstream players,” England explained. “If you look at the market cap of all the Kinder Morgan companies, it exceeds that of a number of the large oil companies. So part of being in that classification is cutting across multiple commodities, not just being a gas midstream player, but also in oil and natural gas liquids.”
Major league
MLPs have evolved significantly in their near-30-year history. The first one, Apache Corp., wasn’t even a midstream company. In fact, most of them were fairly standard oil and gas exploration and production companies, Mary Lyman, executive director of the National Association of Publicly Traded Partnerships, told Midstream Business.
Lyman was one of the original hires by Apache’s lobbying effort in the 1980s that coalesced into the national organization as it stands today.
The MLPs of the 1980s didn’t have the hedging programs that oil and gas partnerships can explore today, she said, which made them significantly riskier than modern partnerships. Lyman said that by the late 1980s when the first midstream MLP—Buckeye Partners LP— formed, partnerships operating under the MLP umbrella were split into thirds of oil and gas, real estate and others. In the subsequent decades, the integrated companies found they could make more money investing elsewhere and they spun off their midstream assets into MLPs, which had become a more suitable structure for hard, high-capital assets, Lyman said.
Examples of that are all over the energy space, with ConocoPhillips splitting off its midstream and downstream assets into Phillips 66; Plains Resources Inc. forming its Plains All American Pipeline LP; and Spectra Energy following suit with its Spectra Energy Partners.
It’s what makes an MLP special that has enabled the amount of capital spending to meet the challenges of the new shale plays, Lyman said. That’s especially true for the energy sources that are being found in areas that were not producing areas before.
“If the MLP structure went away, it’s not as if all pipeline building would halt, but I think it would be a lot slower and probably more expensive, with the result that the pipeline owners would have to charge higher rates and energy overall would cost more,” she said. “We had an economist look at that and found it would slow down the pace of pipeline building by almost 30% in the first couple of years and would raise energy prices in the long run.”
Given the record-setting numbers of 2013, and the revved-up 2014 start, there doesn’t appear to be a slowdown in companies looking to take their midstream assets public. On April 1, six-month-old Enable Midstream Partners in Oklahoma City launched its IPO with a $500 million offering of 25 million common units.
Midstream’s midgame
Researchers at Deloitte noted in the 2013 report, “The Rise of the Midstream: Shale Reinvigorates Midstream Growth,” that the surge comes at a time when the industry was expected to have entered an age of maturity. With little growth expected in the production of domestic hydrocarbons, forecasters had predicted U.S. pipelines would be built-out by now.
But the millions of barrels of newly recoverable oil and gas have generated billions of dollars’ worth of infrastructure needs in the U.S.
A December 2013 report from the American Petroleum Institute (API) estimated as much as $90 billion of direct capital will be allocated for oil and gas infrastructure this year. Through 2020, API expects an average $80 billion to be invested annually in U.S. midstream and downstream infrastructure. A gradual decline of direct capital investment for infrastructure will reach almost $60 billion each year by 2035, API said.
Still, it’s tricky to pinpoint precisely where the midstream sector is in its cycle, Hinds Howard, vice president and senior financial analyst at CBRE Clarion Securities in Pennsylvania, told Midstream Business.
“It can mean different things to different people,” he said. “Is the question about where we are in the life cycle of MLP investment returns, MLP participation in infrastructure build-out or the MLP investor base?”
The opportunity set for MLPs seems to have some legs to it, he said. “If the U.S. energy infrastructure sector, including MLPs and natural gas pipeline corporations, is roughly $650 billion of enterprise value, then one way to look at it is that MLPs have more than 100% to go in the next 12 years. That line of thinking would argue for the middle innings answer.”
Jason Stevens, director of midstream research at Morningstar Inc., told Midstream Business the investment cycle does appear to be in its midgame.
“As shale gas and tight oil get developed, midstream is chasing the drillbit,” he said. “Nothing gets built unless there are producer commitments on attractive terms, so by its very nature, midstream will trail development of new resource plays.”
The name brand plays, Stevens said, pointing to the Bakken, Eagle Ford, Marcellus and Permian are effectively the “sweet spots” in the country. Consequently, he said, it’s unlikely that under the current price regimes investors will see any of the other so-called emerging shales really become dominant producers of hydrocarbons.
“So if you’ve found the sweet spots, we’re putting in the plumbing right now for those big sweet spots, then you get to a point where within several years’ time, the opportunity set to put in new, big-diameter pipe really begins to shrink considerably,” he said. “We look at this and say the early innings are passed us. We’re not yet to consolidation and decelerating growth. Where we are then in the cycle are the middle innings, the midgame.”
But the 2012-2013 levels of capital spending could bear out to be the cyclical peak, Stevens said.
“You’ve got an industry that’s already seen what happens with a boom in shale production—one that’s committed to lots and lots of takeaway capacity in the Haynesville—and then you’ve got all these Haynesville pipes running at about half-utilization,” he said. “So you’re not going to find producers willing to make long-term commitments if they don’t see the production being there.”
Capital is still needed in the ground to plumb out West Texas to the Gulf Coast, as well as other markets. What’s more, the prodigious production in the Marcellus has just about every player in the region evaluating how to adapt systems to move gas in the Marcellus to the north, west and south, Stevens said. But by 2017, the Marcellus could have the plumbing in place to move up to 18 billion cubic feet per day (Bcf/d), although production is expected to be lower, close to 17 Bcf/d.
Howard explained the MLP investor base, however, may be closer to maturity.
“Funds alone don’t seem to be enough to make the entire MLP tide rise these days. MLPs with distribution security and growth are seeing investment flows, but it seems to be at the expense of other, less well-positioned MLPs,” he said.
As the sector reaches the size of real estate investment trusts and utilities, it’s possible that the expansion of the investor base is “entering a twilight period,” he said.
Super cycles
As the saying goes, every new beginning comes from some other beginning’s end. And so there is talk of an emergence of the next “super cycle” of MLP investment: the need for infrastructure to connect the U.S. with the rest of the world with LNG liquefaction, LPG export and perhaps crude and ethane export facilities.
“The way I like to think about it is that current game is in the middle innings, but another game is already beginning,” Howard said.
England agreed, and said the growth of exports in LNG and refined products means more need for pipelines, storage and terminals.
“As we become more of an energy exporting country, I think that also provides more opportunity for the midstream players,” he said.
Houston glut
Much of the infrastructure thus far has been designed to relieve the glut of light, sweet crude that has bottlenecked in the Cushing, Okla., trading hub. But some analysts warn that diverting it to the Gulf Coast, where refineries are better-equipped for the heavy crude from Canada’s oil sands, means another glut is in the making.
Such a scenario leaves the industry with two options, Morningstar’s Stevens said. The federal government will have to acquiesce to the increasingly loud chorus of economists calling for a lifting of the ban on exporting crude, or figure out a way to move light crude to the east and west coasts from Houston.
As Stevens explained, that could be accomplished by diverting crude at the field level, away from the Gulf Coast. Such a plan could bring renewed interest to Kinder Morgan’s Freedom Pipeline, the $2 billion project scrapped last year that would have moved crude from the Permian Basin to California, or it could present another opportunity for Enbridge’s Sandpiper project, which is slated to take Bakken crude to Ontario. Other options include the reversal of the Ho-Ho pipeline, but that simply moves the glut from one port in Texas to another in Louisiana.
“You still need to move it. You’ll see barge, you’ll see some rail. Is there room to put a crude pipe from Louisiana to the East Coast? Or, to convert a refined products pipe? I think there’s potential there, and I would imagine midstreamers are looking at maps and trying to figure out if the economics bear out. But the obvious answer—the clearest answer—is to allow crude exports,” he said. “I think reality has a way of exerting influence over politics, given enough time.”
Throwing in a little variety
During its 30 years, the MLP structure has unquestionably evolved. Inside the last three years, eight new MLPs have gone public with a variable rate structure: two fertilizer producers, three refineries, one oilfield services group and two others. All told, it’s about 3% of the overall MLP market cap, representing about $18 billion.
At CBRE, Howard said investors may see one or two of the variable rate MLPs on the IPO circuit going forward, but they are geared more toward assets such as oilfield services and refining.
Maierson explained that because interest rates have been suppressed for several years, more investors look for equity vehicles that can provide a yield. Investors may be less concerned about the stability of a distribution, but they will expect more yield because it’s a variable they are willing to take.
CVR Partners kicked off the emergence of the variable rate MLP in April 2011, and the others quickly followed. “Eight in three years is enough to call it a trend,” Maierson said.
At the time of the IPO, the yields have been higher than a traditional MLP that must offer, or strives to offer, a minimum quarterly distribution, but over time, these yields have gone way down, he said. Consider Emerge Energy, for example, which went public last year.
Maierson said the idea was there should be more demand in one month or one quarter and less demand in another month or another quarter. At IPO, the yield was about 16.5%, which is much higher than one would expect from a traditional MLP. Today, the yield is in the 7% range.
“Investors demand a lot of yield because the distribution can fluctuate wildly, and I think after a year of performance, investors say, ‘I understand this business and I believe in the relative stability of the business and as demand rises,’” Maeierson said. “It pushes the price up, which pushes the yield down.”
When Emerge went public, it was trading at $17 per unit. That price is now closer to $62 per unit, making it the best-performing MLP of 2013, he said.
‘Pipelines of the water’
Another key growth area for MLPs is in the shipping industry, the so-called “pipelines of the water.”
Currently, there are seven shipping MLPs and one offshore drilling MLP, mostly formed within the space of just a few years. And there’s likely more to come, Matthew Phillips, vice president of maritime equity research at Clarkson Capital Markets in New York, told Midstream Business.
As Phillips explained, there is a growing view that the industry is in the early stages of a cyclical upswing in several shipping sectors, making it significantly more interesting to investors during the last 12 months. Transocean Ltd., GasLog Ltd. and Tsakos Energy Navigation Ltd. have openly discussed forming MLPs.
Transocean, which is the world’s largest offshore drilling contractor, said in November it would drop down a number of offshore rigs into an MLP and take it public in 2014. Seadrill Partners LLC, a smaller competitor to Transocean, made a similar move in 2012, and its shares saw a subsequent bump of more than 30%. GasLog said in January it would offer units in an MLP to own certain LNG carriers with multiyear charters. Tsakos’ management has been monitoring the MLP possibilities for its LNG carriers for at least a year, analysts said.
What lures a shipowner or other offshore-focused organization into an MLP is the same set of factors that make it appealing to an integrated energy company, Phillips said. There is a valuation uplift caused by dropping stable assets backed by long-term contracts into an MLP structure.
“That said, shipping is a volatile business, and the contract structure and counter-party is very important in evaluating marine MLPs,” he said. “This is the main reason LNG tankers were the first to show up in MLPs—they were backed by 25-year contracts with major energy companies.”
The appeal is increasing among both issuers and investors, Phillips said. Issuers like the valuation and investors like the yield.
The home stretch
Industry experts forecast that midstream MLPs will continue to grow organically through the rest of this decade.
“To me, it’s the beauty of the private ownership of mineral rights,” Deloitte’s Shreve said.
“When the free market can steer the development and you don’t have the government imposing restrictions … for the most part, you’ve got the free market driving all of this infrastructure growth because of this renaissance we’re having with all the hydrocarbons we now have.”
Much of that domestic build-out will continue through 2019 when organic growth will drop off before it is replaced by more acquisitive expansion of companies, analysts said.
“And then we could see there being a lot of consolidation from where these bigger players start to be even more acquisitive,” said England.
Shreve likened the transition to an American phenomenon of the previous century—the automobile.
“Like any industry over time, consolidation occurs,” Shreve explained. “In the early 1900s, we had 100 different companies making cars. Today you only have a few through consolidation. I think that’s just a natural progression of any industry.”
Stevens noted that some consolidation has already started. Last year, Kinder Morgan bought Copano, and Regency is buying Penn Virginia’s and Eagle Rock’s midstream units.
“Bigger companies will opportunistically consolidate the smaller guys that fill out their portfolio, and I’d expect the second tier, third-tier players in midstream to look to bulk up,” Stevens said. “In this business, if you’re not getting to size and scale, you’re going to get left behind. You won’t have many opportunities for in-fill investment. So when the math works out, expect combinations to be the rule, not the exception.”
Experts and industry observers have been expecting a wave of midstream consolidations for years, Maierson said, but so far, it’s been a slower phenomenon than initially expected.
“I think it will happen, but one of the problems of midstream companies trying to acquire each other is, it’s only economic to the buyer if the difference in the yield between the buyer and the target is significant enough. Up until pretty recently, the gathering and processing and transportation MLPs have traded within such a tight band of each other that it never really made sense for one to buy another,” he said. “So it remains to be seen whether there will be this big wave that we’ve been predicting for the last seven or eight years now.”
Another scenario Maierson said could emerge into a trend is companies forming MLP joint ventures (JVs) to make the most of their midstream assets. Enable Midstream Partners LP, a JV formed last year by affiliates of Center- Point Energy Inc. and OGE Energy Corp., announced recently a plan to raise $500 million through an IPO. What makes the plan extraordinary is that it accounts for only 6% of the company, which would give it a market value of $8.4 billion from the start, he said. Such an auspicious beginning would make it the largest MLP IPO to date.
“With that deal, I think others are going to say, ‘maybe I get to critical mass and maybe I get to a more attractive valuation and pricing if I combine my assets with somebody else’s,’” Maierson said. “And, a joint venture allows you to maintain some elements of control.”
Plains Throws A Curve Ball
By Deon Daugherty
The largest MLP IPO in 2013 was the massive move made in October when investors saw Plains GP Holdings LP (PAGP), the general partner of Plains All American Pipeline LP, raise the largest IPO for the year with a $2.8 billion offering. Interestingly, although it’s structured as an MLP, management of the general partner gave up the pass-through status, and it will be taxed as a corporation.
As Plains’ Chief Executive Greg Armstrong explained during a fourth-quarter conference call with analysts in February, the primary objective of the move was to give the owners of the general partner—Plains All American (PAA)—a targeted level of liquidity. “Additionally, because PAGP has elected to be taxed as a corporation, we now have an acquisition tool that could enable the PAA organization to structure a tax-free transaction with the C-corp under the right circumstances,” he said. “Although PAGP is a taxable entity, the step-up in tax basis of the initial transaction and expected step-up in future transactions suggest the PAGP will not incur current income taxes for a number of years.”
The company’s goal for its MLP in 2014, Armstrong said, “is simply to achieve an increase in PAGP’s November 2014 quarterly distribution rate of approximately 25% relative to the initial quarterly distribution. ... We are already off to a good start with respect to our distribution goals.”
The Plains’ IPO had a yield of 2.7%, the lowest ever for a GP’s initial offering, said Hinds Howard, MLP chief at CBRE Securities, adding it would be “hard to argue the lowest-ever yield IPO that raises $2.8 billion is anything but a success.”
An MLP that chooses to be taxed as a corporation has a broader investor base, in part, because it eliminates the administrative hassle of filing a complicated Internal Revenue Service Schedule K-1, Kenny Feng, CEO of the Alerian MLP Index, told Midstream Business. But the main benefit of being structured as a partnership that is taxed as a corporation is that it gives the sponsor, or GP, the ability to retain more control, he said.
As explained by Ryan Maierson, a partner in the Houston office of Latham & Watkins LLP, who specializes in MLPs, more of the partnerships are choosing to be taxed as a corporation for a couple of reasons.
Targa Resources Partners LP filed the first GP IPO in several years in 2010, and since then, four others have made the move, including last year’s Plains offering in October, which was followed by Cheniere Energy Partners LP in December.
“The idea was investors aren’t going to get the flow-through tax advantages of investing in a partnership, but there are institutions out there that are prohibited from investing in a flow-through entity, but they can invest in C-corps,” he told Midstream Business. “Targa made the decision to take it public as a C-corp and maybe attract a broader audience. That was extremely successful.”
2014 Tax Reform Efforts Not Expected To Impact MLPs
By Deon Daugherty
Worried that your investment in an MLP may lose its luster if Congress gets its act together this year?
Don’t break out the calculator just yet.
“The first thing you have to know about this proposal is it’s not going anywhere,” Mary Lyman, executive director at the National Association of Publicly Traded Partnerships told a group of MLP investors recently.
“There is absolutely zero chance that any kind of tax reform will be passed this year, and probably not next year, unless there is a miracle of bipartisanship or one party [gains] control,” said Lyman, who has spent the last 30 years enmeshed in the Washington, D.C., mechanizations of MLPs.
Lyman explained that any real movement would require that 2016 election returns lean heavily toward one or the other party to create an environment in which there could be an opportunity for tax reform.
“But as long as this intense partisanship and unwillingness to move ahead with things that could benefit the other party continues, we will remain in gridlock,” Lyman explained. The proposal offered by U.S. Rep. David Camp, R-Mich., eliminated capital gains treatment of carried interest and made overtures to eliminate financially oriented MLPs, Lyman said, such as private equity firms Blackstone and Fortress Investment Group LLC.
“This was kind of a surprise from Chairman Camp because Republicans have not looked favorably on the effort to tax carried interest as ordinary income and to shut down these financial MLPs,” Lyman said, adding, “but the proposal has been out there for several years, so in that sense, it’s not something new.”
Camp’s bill, almost 1,000 pages of reform proposed by the House Ways and Means Committee, made a variety of cuts to MLP qualifying income rules in Section 7704 of the Internal Revenue Code, including the elimination of income derived from real property rent and gains, fertilizer, timber and the transportation and storage or alternative fuels.
Alas, House leadership has said the bill won’t pass this year, and Camp won’t be around to push the tome through Congress. He’s announced that he will retire at the end of this term. What’s more, Camp’s partner on the bill, Montana Democrat Sen. Max Baucus, in February accepted an appointment from President Obama to be the ambassador to China.
Even if tax reform were crafted in a way that mitigated an MLP’s advantages, the midstream sector would still thrive, said John England, vice chairman and U.S. oil and gas leader at Deloitte LLP.