Unable to effectively hedge commodity prices or secure adequate equity for capital expenditures, few exploration and production (E&P) companies in the early 1980s found success with the then-emerging master limited partnership (MLP) sector. Today, however, E&Ps are rediscovering the MLP market in a big way, and a significant pool of assets appears to be trending toward the sector, a group of energy experts said Thursday.
After no activity in 2005, five publicly traded E&Ps spun off MLPs in 2006, one has debuted this year, and a “fairly firm backlog of incremental IPOs [initial public offerings] is coming in 2007,” said Lehman Brothers’ Rick Gross, managing director of equity research. Lehman this week cosponsored the Sixth Annual Master Limited Partnership Conference with the National Association of Publicly Traded Partnerships.
The six publicly traded E&P MLPs formed in just the past year include:
Quantum Energy Partners’ Scott Soler, managing director, said his firm is convinced E&P MLPs will become an ever-growing portion of the MLP space.
“The running room for the vehicle’s use and growth for E&P assets is substantial, in our opinion,” Soler said. “In the 1980s, 1981 to 1987, over 100 MLPs were formed, of which 31 were upstream MLPs. The E&Ps could again represent at least 30% of MLPs in this era…possibly a higher percentage this go-round, given the more prudent management of the types of assets being placed into them and the hedging ability in these MLPs.”
The difference between now and a generation ago is that E&Ps today may effectively hedge production for five years or longer, Soler noted. Also, MLPs today typically budget 15-20% of their earnings into maintenance capital to replenish reserves and hold production flat.
“Hedging is much different today,” Soler said. “There are more tax incentives, there is much more capital available today, much better management is in place than in the past. All the risks are there; we know what the risks are. E&Ps are an inherently risky business, but the risks have been largely mitigated from what generally was there in the 1980s.”
Quantum, which helped to launch Linn Energy’s MLP, estimates that about $270 billion worth of North American assets are proved, developed, producing assets, “many which technically qualify for MLP treatment,” said Soler. Most of the assets owned by publicly traded E&Ps, he said, “are mature, lower decline rate assets, many which could be revalued on a distribution yield basis and resultant multiples that are much higher.”
Tortoise Capital Advisors’ Dave Shulte said that “properly managed, E&Ps can take a production philosophy and build around it protection that investors demand from the midstream. They can create cash flow that’s not much different in risk than the midstream companies. I do believe there is more discipline in place for modern MLPs, and we’re learning how a modern E&P can avoid a lot of the problems old MLPs had.”
Jerry Swank of Swank Capital LLC said he has talked with U.S. investment banks “that indicate another 10 are possible as trust IPOs in the near future. And the IPOs coming are just the tip of the iceberg.” Most of the asset spin-offs, he said, will come from larger E&Ps and integrated oil companies.
“We believe that the potential size for the U.S. E&P MLP market could easily surpass $50 billion in the next five years,” said Swank. “The ultimate potential size is difficult to grasp, but it could exceed $200 billion given the number of small- to mid-cap operators. It’s a very big, very liquid market. A lot of money is coming into the business, and there’s very little room for disappointment.”
However, E&P face several obstacles as they enter the MLP market, and they have to have a compelling story, said Soler.
When Linn Energy decided to become an MLP, Soler said the challenge was to make it a growth-oriented, distribution-yielding vehicle that would capture premiums for Linn and Quantum’s investors. U.S. investment banks had to be convinced to get behind the idea, and Linn Energy had to demonstrate how it could mitigate commodity price exposure and overcome embedded cash flow decline associated with production run-off.
“What finally compelled us to try this was to claim U.S. first-mover competitive advantage,” said Soler. Another MLP, Copano Energy LLC, provided a “roadmap to ideal E&P yield/growth structure,” and Linn Energy itself had “nameplate management and an optimal asset base.” Quantum then factored in the “baby boomer ‘yield plus growth’ megatrend,” and the IPO was formed. In the end, Linn Energy’s gross IPO proceeds totaled $246.8 million; $95.3 million went to Quantum. The IPO was priced at $21/share, representing a 7.6% yield. Institutional ownership was about 30%, and “all of this was done with only $16.3 million of equity.”
Swank said to successfully launch an MLP, E&Ps have to demonstrate “management, management, management.” The quality of the assets has to be shown, and capital expenditures should be less than cash flow from operations, he said. Even with a good story, though Swank said the “biggest hurdle will be institutional acceptance, and possibly more important, energy industry acceptance. The change in the management mindset is crucial.”
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