Business-development professionals in the oil and gas sector know the upstream master limited partnership (MLP) is a popular vehicle for holding producing oil and gas assets, and for good reason: This form of a public partnership offers tremendous pre-tax cash flow for investors.

So why are some oilfield acquisition specialists-including existing MLP execs-throwing up caution signals just when the concept for upstream MLPs is gaining momentum?

"Irrational exuberance," according to Wil VanLoh, co-founder and managing partner of Houston-based private-equity provider Quantum Energy Partners. Simply, the popularity of the asset class is beckoning many to jump onboard without making sound judgments as to the appropriateness of the entity choice.

VanLoh recently spoke at the sixth annual A&D Strategies and Opportunities conference in Dallas, presented by Oil and Gas Investor and A&D Watch, along with several other industry leaders regarding the pros and cons of upstream MLPs.

All of them believe the frenzy over MLPs is motivating some to jump in for wrong reasons. Said VanLoh: "It's a vehicle that has some incredible applications, but it also has the potential to be a massive train wreck if it's abused."



Distributions matter

John Walker sees abuses in the MLP class and is quick to sound the alarm. Walker is chairman and chief executive of EV Energy Partners LP (Nasdaq: EVEP) in Houston, one of the seven current publicly held upstream MLPs in existence and formed in September 2006.

"Half of the MLPs in existence today, and half of those yet to be created, won't be in existence three to five years from now," he predicted. If they do survive, he said, they will merely be "limping along."

EV Energy Partners has 301 billion cubic feet equivalent of proved reserves with net production of 49 million cubic feet equivalent per day. Its parent, EnerVest Management Partners Ltd., of which Walker is president and chief executive, currently operates more than 11,000 wells in 11 states, with reserves of approximately 1.2 trillion cubic feet equivalent producing 251 million cubic feet per day.

Why does Walker-the engineer of one of the first new upstream MLPs, and one with a growth rate exceeding 500% since formation-forebode such a dire future? Wrong objectives driven by "MLP mania." Buying inappropriate assets and executing wrong strategies, he believes, will lead to the eventual demise of a significant number of present and future MLPs.

"There's only one objective in an MLP: to increase distributions every quarter," he said. "You can only serve one master-and that's the one master."

Too many players are rushing to MLP for bad reasons, including quick returns and justifying overpaying for assets-or even prestige. "The MLP is a long-term yield vehicle that many are managing or thinking about creating for short-term gratification or results.

"People are completely missing the mark in terms of why they are creating it. We should be asking whether the existing or proposed MLPs are employing current or proposed strategies that will be strong vehicles in five, 10 or 15 years."

Walker believes MLPs should target shallow-decline assets with a decline rate between 5% and 10%, with an overall portfolio objective of 7% to 8% decline. U.S. basins are mature and are perfect for MLP acquisitions, as 74% of all wells in the States are stripper wells.

What's an inappropriate asset? Any requiring too much drilling. "A portfolio should be 80% to 90% PDP (proved developed producing reserves) because we only have one master, and that's giving that quarterly distribution."

Accretive acquisitions are the way to go. Any drilling beyond keeping the production curve flat will change the overall decline curve of the MLP and create long-term problems of sustaining quarterly distributions.

"If you start trying to drill beyond keeping your production curve flat, you're going to accelerate the decline curve and end up in a cycle that's going to create a problem. I'm absolutely convinced of it."

Also inappropriate: early-stage resource plays, "because there's too much capital going out the door. You simply can't have negative cash flow and meet your quarterly distribution expectations."

There are many more risks, but the real risk at this moment is execution risk. "Undisciplined acquisitions will never be a basis for a sustainable company."

Lack of A&D experience by some existing MLPs adds to the false impression of what assets are right for an MLP. Buyers must know how much they can pay for an asset and be willing to live with failure when making bids. "A successful company in the A&D business fails (at winning an asset package) nine times out of 10. That thus creates success."

If size were strictly the basis for success, according to Walker, then someone might pay a present value (PV) of 5.0 to 7.0. But Walker said that deal is too tight. All the upside has to work out, and a bump in the road will cause cash-flow problems.

Investment bankers also play a role in fanning the frenzy, he said. Often, they don't have a clear understanding of what makes a successful MLP and sell "a field day of bad advice" by creating a false impression.

"That's the perception of the market. That's a problem being exacerbated by investment bankers talking to C-Corps about spin-outs. I do not think they are correctly talking about cost of capital. The mistakes of some companies in this business are made because of a lack of experience."

As an example, Walker recounted a call in which a company wanted him to join in a bid on a property. The company suggested Walker bid the PV at 5.0 or 6.0, and the company would bid "the upside" at PV 10 or 12, and that would make a great partnership. That, said Walker, is "pretty stupid," but illustrative of today's acquisition climate.



Paying too much

VanLoh sees the danger for MLPs in heated competition driving up purchase prices, resulting in buyers simply paying too much for assets to make the MLP model sustainable.

"No one can dispute there's greater competition today," he said. MLPs have "paid a significantly greater premium than a C-Corp would have paid for those assets."

VanLoh sees a shift in how assets are valued, which he describes as increasingly shaky. "In order to get a deal, a lot of MLPs are tempted to make aggressive assumptions about production decline profiles, production and capital costs, and about the quality and magnitude of the exploitation potential that remains on the assets they are buying."

Many of these start-ups won't survive, he said. "The projections they are making in order to be the high bidder are way too aggressive and they are going to fail."

MLPs can also create a false sense of distribution growth to unit-holders by purchasing higher-decline, lower reserve-life-index (RLI) properties. RLI estimates longevity of the reserves, based on dividing the reserve base by the current annual production.

That false sense of success happened in Canada as royalty trusts-Canada's equivalent vehicle to an MLP-experienced tremendous growth for years as commodity prices doubled and tripled and RLIs dropped by almost half.

"Then we know what happened," VanLoh said. "We had a train wreck in Canada last October, initiated by a tax law change and exacerbated by the market finally realizing the false sense of growth that had been caused by rising commodity prices and falling RLIs. When you start seeing U.S. MLPs buying six- or eight-year RLI properties, that's when I would start heading for the door."

Investors buying into an MLP are like investors who buy bonds. "You're getting paid to never miss a minimum targeted distribution to your investors," he said.

Hundreds of billions of dollars of "old, tired" producing wells without a lot of growth potential are still held by traditional E&P companies, trying to eek the last few drops of oil and gas from the ground. The publicly traded E&P companies, rewarded for growth and production, will benefit from the MLPs by spinning out or divesting these assets to them.



Misperceived capital costs

The present perception is that MLPs can pay more for PDP assets than can a C-Corp because their cost of capital to acquire is lower, according to Steve Pruett, president and chief financial officer of Legacy Reserves LP in Midland, Texas (Nasdaq: LGCY). But is this true?

"The access to private equity has been unparalleled-astounding," he said. "For a company to be able to raise $1.5 billion of equity within three days without a road show-just making phone calls-is a mindbender."

Yet, "we've been led to believe by the appetite for our securities that the cost of capital is very low, when in fact it's probably not as low as what we perceived, because yield is not the whole story."

Legacy is one of the earlier players in the upstream MLP class, forming in 2005 and going public in January of this year. Legacy has purchased more than $170 million in assets since, primarily in the Permian Basin. Most recently, Legacy closed two deals worth $74 million combined in early October.

Pruett emphasized that the cost of capital is not the yield or dividend rate, nor the interest rate on debt, the price-to-earnings ratio (PE) or the unit-price return, as many believe.

Rather, the true cost of capital is determined by: the hurdle rate, or the required rate to induce investment for project approval; in addition to the opportunity cost of capital (the return one can earn from alternate investments of similar risk); and the weighted average cost of capital, or WACC.

A truer cost of capital for purchasing assets using a WACC formula takes into account factors such as capital structure. Higher debt levels, for instance, tend to reduce the cost of capital, as do paying dividends and trading off yields, as MLPs do.

However, he said, the perceived lower cost of capital compared with an E&P C-Corp may be reduced when growth expectations and option value is factored in for MLPs. Lower cost of capital will be the factor fueling MLP acquisitions "until the increased cost of equity outpaces the lower cost of debt, or interest on debt rises to junk or distress levels."

The WACC for an MLP has three components. The first is the cost of equity to the limited partner-the forward yield plus the growth expectation. Next is the cost of equity to the general partner-the implied general-partner yield plus interest growth. Then the cost of debt must be factored in.

On average, upstream MLPs are buying packages with about 81% PDP reserves, while traditional C-Corp companies are buying 59% PDPs in theirs, he said. "From our perspective, a PDP barrel is worth more than a PUD (proved undeveloped) barrel. Our peer group is pursuing PDPs that generate cash flow to fund our distributions."

But, he added, "MLPs should have a low beta like a utility."

Are MLPs wise to pay more for PDP assets than do C-Corps? It's unclear, according to Pruett. "It remains to be seen where we'll really settle out in terms of WACC."



Beware market changes

Shannon Nome believes MLPs could ultimately be forced out of acquisitions primarily by unexpected changes in the market. Nome is managing director and a senior research analyst covering E&P stocks for Deutsche Bank in its Houston office.

"It seems we've just barely started to enjoy this," she said, and "now we're having to worry about what can derail the whole thing."

The growth of the MLPs as an asset class is due to tax-law barriers coming down to institutional ownership. "The institutional interest is critical for the asset and the explosive growth, and yet it is tenuous."

What could go wrong? More tax-law changes, for one. The Canadian royalty trusts have experienced a storm of tax-law changes, with many trusts exploring converting to traditional E&P companies or just selling their assets outright.

"Tax-law change is the one I hear most about from institutional investors," Nome said. "I would probably rank this as a less serious threat in the near term, but certainly something that is on the table if this asset class grows as we suspect it could."

Helpful to U.S. upstream MLPs is that, unlike in Canada, the U.S. limited the scope of MLP eligibility to natural resources, which should eliminate "having the rug pulled out," she said. In Canada, royalty trusts were being formed from retail and other non-industrial industries.

"We've watched during the past year as Canadian rig counts have dropped 40% to 50%, following the announcement of a planned removal of royalty-trust tax breaks. Removing that ruined an entire exit strategy for a generation of Canadian (investors)."

She sees withdrawing tax incentives from U.S. energy MLPs as contradictory to U.S. aims to be more energy independent. "Removing the tax incentives to invest seems counterproductive," she says.

Still, should tax laws change for the worse, Nome does not see that as lethal to MLPs. "Paying out taxes may not undermine MLP strategies. U.S. E&P companies don't generate that much in tax cash receipts anyhow. Most of my (coverage) companies pay 20% to 30% of their taxes in the form of cash receipt taxes."

The drive by MLPs to expand over-aggressively will lead to execution failures, she added. "Quality is going to matter."

In the early stages of upstream MLP formation, "you kind of throw a dart" as to the right acquisition metrics. But over time the structure is evolving. (For more on this, see "Upstream MLP 101," Oil and Gas Investor, June 2007.)

For investors, Nome likes to see a geographic focus of assets, as that cuts down on execution risks, but restricting the MLP strategy to one area "gets tougher and tougher as the base of assets grows."

Nome likes a strategy of modest growth of about 3% to 5% annually, which she believes is sustainable over the long term. "If you do the math, 25% annual growth means you're doubling in size every (few) years. That is simply not a sustainable strategy.

"That's the kind of model that could derail interest in the MLPs-that proverbial train wreck."







CALCULATING THE COST OF CAPITAL

Legacy Reserve LP's Steve Pruett believes too many MLP start-ups are basing acceptable acquisition costs on wrong assumptions. Primarily, yield is not the whole story, he emphasizes. Rather, the cost of capital to fund acquisitions should include factors such as the risk of higher levels of debt and the cost of that debt.

To calculate a truer cost of capital, he suggests, use the following weighted average cost of capital (WACC) formula:

r* = rD (D / V) (1 - TC) + rE (E / V)

r* = adjusted cost of capital

rD = firm's current borrowing rate

TC = marginal corporate income tax rate (0% for MLP)

rE = expected rate of return on the firm's stock

D, E = market value of the firm's debt and equity

V = D + E = total market value of firm



RE = rf + b(rm - rf)

rE = expected rate of return on units

rf = risk-free rate, U.S. T-bills (4.5%) or 10-year T-notes (4.6%)**

b = volatility of a given unit's or asset's return relative to the return of a market portfolio (b = 1 is market risk for S&P 500)

rm - rf = market risk premium (6%-9%)

Note: Hurdle rate = riskless rate + risk premium. ** As of late August 2007. Source: Legacy Reserves LP

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