Master limited partnerships (MLPs) in the energy sector have been growing at a rate of about 30% a year, and some might expect the pace to soon begin to flatten out or even decline. But don’t count on it. If anything, MLPs are poised to not only continue to multiply and expand within the energy sector, but they are also developing in what once was an unlikely arena: the exploration and production (E&P) sector.

Merrill Lynch energy analyst Gabriel Moreen, vice president of natural gas pipelines, utilities and MLP sectors, led a conference call on Wednesday to talk about the outlook for energy MLPs. With nearly 50 public energy MLPs operating across North America, Merrill is forecasting the energy sector’s growth rate to hit the $100 billion mark in market capitalization by the end of 2007.

“MLPs have made an impressive run in the last few years relative to the S&P [Standard & Poor’s 500 Index],” said Moreen. “The aggregate energy MLP market cap has more than doubled in the past five years. Since 2000, the number of energy MLPs has grown to 51 from 23.” What’s driving the impressive growth are the “MLP-able assets” that could be moved into a partnership structure, which is not expected to abate. “A lot of assets are expected to make their way into MLPs, and they are being moved or spun into partnership structures.”

MLPs often trade on the public exchanges or in over-the-counter markets, and they consist of a general partner and limited partners. The general partner manages the partnership, usually holds a small ownership interest (typically 2%) and is eligible for incentive distributions. The limited partners provide capital and receive cash distributions, but they have no role in the partnership’s operations and management. MLPs are considered to be “pass-through entities” by the Internal Revenue Service since their operating results are passed through to the limited partners. To qualify as an MLP, a partnership must receive at least 90% of its income from qualifying sources that include mineral or natural resource activities, interest, dividends, real estate rents, gain from the sale or disposition of real property, and income or gain from commodities or commodity futures.

Energy industry veterans are well aware of the success of some of the biggest energy MLPs in North America: Boardwalk Pipeline Partners LP, Enbridge Energy Partners LP, Enterprise Products Partners LP, Kinder Morgan Energy Partners, Oneok Partners LP, Plains All American Pipeline LP, TC Pipelines LP and Williams Partners LP.

“Most of the partnerships are for the natural gas midstream markets, which are predominantly pipeline and storage…regulated assets,” said Moreen. However, he said E&Ps now are taking a closer look at MLP structures to see if they may benefit their shareholders. MLPs generally are used to hold assets not directly affected by commodity prices, which would not seem to be a likely avenue for E&Ps, which live and die by the price commodity market. However, Moreen said MLP structures are expanding their scope and may offer a lot of tax benefits for producers.

Following the royalty trust success achieved by many smaller Canadian-based producers (i.e., Provident Energy Trust, Paramount Energy Trust), Moreen said U.S.-based E&Ps are considering MLPs in the same way — to reduce taxes. The first E&P MLP “hit the market” earlier this year, and “we see quite a strong potential trend,” said Moreen. As an example, in July, a subsidiary of Dallas-based independent EXCO Resources Inc., which went public in February, signed a deal to buy Winchester Energy Co. and affiliates from Progress Energy Inc. for $1.2 billion in cash (see NGI, July 31). In conjunction with the purchase, EXCO announced plans for an initial public offering (IPO)of units in a new MLP to hold the Progress Energy assets and some of EXCO’s existing assets.

Merrill expects to see more IPOs for E&P MLPs. Five, Moreen said, are expected this year alone. Four coal MLP IPOs also are slated to debut, as well as three energy shipping IPOs.

“We are entering a new growth capital expenditure phase for needed midstream energy infrastructure,” said Moreen. “For natural gas, this relates to the Rockies and deepwater Gulf of Mexico production. There also is continued outsourcing of energy infrastructure needs by E&Ps and refineries…E&Ps aren’t usually considered for an MLP structure because of the commodity sensitivity mitigation…This is not the place to bet on $100 oil or lower gas prices. But higher oil prices correlate to more development, lower gas correlates to more E&P activity, and that’s part of what we may be seeing…

“We are intrigued by the potential for E&P MLPs, and we’ll put an ‘asterisk’ there to proceed with caution” on E&P MLP growth going forward, said Moreen. “Certain types of E&Ps are appropriate for MLPs, and it may be very competitive for the acquisition market because an MLP could acquire a whole slew of acquisitions at a lower tax cost.”

In any case, “we continue to see powerful organic growth drivers,” said the analyst. “Organic growth is positive in our view, there’s less competition for organic growth relative to acquisitions. The growth prospects in this sector still are very solid despite the spectacular growth. We expect robust cash distribution growth to continue for MLPs. Several major expansion projects are coming on line in 2007, which bodes well for 2008.”

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