Michael Peterson, Energy Research at MLV & Co.
Luck, as they say, is when preparation meets opportunity. For master limited partnerships engaged in the production of oil and natural gas—Upstream MLPs—good fortune may be just around the corner. Driven by an exponential expansion of available assets in the years ahead, combined with sustained market demand for yield, Upstream MLPs are poised for dramatic growth.
MLPs are structurally advantaged
For reference, MLPs are tax advantaged business structures authorized by Congress. These partnerships—the product of many years of oil and natural gas enterprises—sidestep corporate taxation and are taxed only at the individual level. By avoiding double taxation, MLPs unlock substantive value for their partners. The primary caveats to MLPs' favorable tax treatment are the requirements that a large majority of profits be distributed to partners, and that assets be domestically domiciled.
Absent the ability to retain earnings, the success of an MLP is largely dependent upon the stability of the underlying asset base. Assets requiring large or unpredictable capital expenditures present a host of management problems for an entity prevented from maintaining a rainy day fund. If MLPs under-invest, future earnings may suffer; if they over-invest, current earnings may provide less than 100% distribution coverage. For Upstream MLPs, the characteristics of suitable assets include the following:
* Mature production with an average well vintage exceeding five years,
* Developed acreage with meaningful reserve life and linear decline curves,
* Predictable development profiles with limited drilling risk and visibility of growth.
MLP-appropriate assets are plentiful
Currently, MLPs comprise 3% of domestic oil and natural gas producing assets. Of the remainder, roughly 24% have been drilled during the past five years and are therefore, not MLP appropriate. This leaves 73% of all domestic oil and natural gas producing assets—assets which are MLP eligible but not yet held by MLPs. Recognizing that a portion of MLP eligible assets may not be MLP appropriate, we haircut the asset pool by 80% to arrive at what we believe is a very conservative estimate. This assessment suggests the asset base of Upstream MLPs is well-positioned to grow by a factor of more than five.
If Upstream MLPs are interested buyers of these assets, can the current holders be compelled to sell? We think the answer is yes.
Financially motivated C-Corp sellers
Integrated oil companies have a strong track record of financial discipline and a history of operating their businesses based on the long-term strategic management of their assets. These companies believe their primary deliverable to shareholders is high returns. When the market presents investment opportunities below a certain threshold, management responds by returning capital to shareholders.
For decades, integrated oils and large-cap E&Ps looked for their most prospective investments abroad. Domestic prospects simply could not compete with the resource-laden profiles of acreage in West Africa, Asia, South America and the Middle East. Despite challenging operating conditions, civil unrest and the ever-present risk of resource nationalism, international investments regularly delivered returns exceeding 25%.
Risk adjusted international returns in decline
As a result of rising geopolitical risk, taxes and operating costs, the margins of international and offshore operations are contracting. While international returns may still exceed the hurdle rate required for investment, they are no longer the crown jewel of shareholder value creation they once were.
Evidence of this strategic shift in investment opportunities has been reflected in the capital allocations of upstream producers. Over the past few years, the capital spending budgets of these companies have increasingly favored domestic investments. It is important to note that although the returns of domestic investment opportunities are on the rise, declining risk adjusted returns abroad are the main catalyst for this strategic shift in capital allocation.
Divestment trend well underway
Given the lack of international exploration-fueled returns of times past, it is our contention that economically disciplined producers will increasingly recognize they cannot justify holding the relatively pedestrian returns of mature, long-lived fields in their portfolios.
Divestment of lower-returning assets is not a new strategy for integrated oil companies. During the past decade, integrateds have jettisoned a sizable amount of retail, midstream and refining assets. We believe mature, long-lived production assets—MLP appropriate assets—are next.
Upstream MLPs to benefit
Should these factors materialized as envisioned, we believe Upstream MLPs will be the primary benefactors of this secular trend toward market segmentation of asset returns at the field level. As return-seeking producers—namely C-Corp integrateds and large-cap E&Ps—reassess the strategic merit of MLP appropriate assets within their portfolios, we anticipate a portion of these assets will become available to Upstream MLPs.
Presented with the opportunity to increase assets under management by a factor of five, we believe Upstream MLPs are well-positioned to pair this growth potential to a market hungry for additional yield-based investment vehicles.
About the author
Michael Peterson is a managing director & senior equity analyst in MLV & Co.'s Energy Research team and has over 15 years of experience in the energy and commodities markets. Specializing in the macroeconomic relationships of energy commodities, his valuation work encompasses both aggregate market mechanics and firm level fundamental analysis. Prior to joining MLV & Co., Peterson covered integrated oil, refining, and exploration and production equities for International Strategy & Investment Group, Morgan Stanley and SunTrust Robinson Humphrey. He also traded energy commodities for Duke Energy and equity index products at the Chicago Mercantile Exchange for Prudential Securities. Peterson holds an MBA from the University of Chicago in International Finance, an MS from the Illinois Institute of Technology in Financial Markets & Trading, and a BA from the University of Denver in Political Science and Economics.