Exploration and production-oriented master limited partnerships (MLPs) have come full circle. E&Ps initiated and grew MLPs in the 1980s, but during the latter part of the decade and into the 1990s, they fell into disfavor. As commodity prices tumbled, many of the original oil and gas MLPs were unable to maintain distributions and left the market. Midstream MLPs filled the breach, with some E&Ps spinning off midstream assets. Not until 2006 did E&P MLPs return to some favor with investors.

Michael Blum, managing director and analyst at Wells Fargo Securities, notes that unlike today’s model, the E&P MLP of the past “was a flawed business model.” Those partnerships were weakened by volatile commodity prices and a depleting reserve base, which relied on exploratory drilling to sustain cash flow.

“Without reinvestment, the predecessor upstream MLPs were essentially self-liquidating partnerships and were unable to sustain their distributions. Current upstream MLPs own longer-life reserves and employ a lower-risk, more factory-like exploitation and production operation,” Blum says. Further, “Today’s upstream MLPs have the ability to hedge their commodity-price exposure, reducing cash-flow volatility.”

Ethan Bellamy, director and senior equity analyst with Robert W. Baird & Co. Inc., agrees. “Upstream MLPs took longer to make a comeback because the original oil and gas assets that had been structured as partnerships in the 1980s had such abysmal performance. Indeed, many of today’s asset managers and investment bankers still talk frequently about having spent the formative days of their careers cleaning up the detritus from over-levered, high-decline upstream assets that collapsed, along with oil prices.

Says Ethan Bellamy, director and senior equity analyst with Robert W. Baird & Co. Inc., “Simply put, yield-valued publicly traded entities garner premium-implied cash-flow multiples well ahead of what those same assets in a corporate or private structure would receive.”

“Upstream MLPs have grown substantially, and more are coming to the market. The assets, financing and returns are all there,” he says.

Success attracts capital. At year-end 2011, the average E&P MLP traded at 7.5 times EV/2012 EBITDA (earnings before interest, taxes, depreciation and amortization), with a dividend yield of 7.8%, according to Baird estimates.

The initial public offering of Linn Energy LLC in January 2006 marked the return of oil and gas producing assets to the MLP structure. Since then, the number and popularity of E&P MLPs have rebounded. At year-end 2011, there were 12 E&P MLPs, sometimes referred to as upstream MLPs, or publicly traded partnerships (PTPs). They include BreitBurn Energy Partners LP, Constellation Energy Partners LLC, Dorchester Minerals LP, EV Energy Partners LP, Legacy Reserves LP, and recent newcomers LRR Energy LP, Memorial Production Partners LP, Mid-Con Energy Partners LP, Pioneer Southwest Energy Partners LP, QR Energy LP, and Vanguard Natural Resources LLC.

The growth rate of these upstream entities, which had picked up steam in 2006 and 2007, was slowed by the national recession. In 2006, there were four IPOs, in 2007, just three. By 2008 only one went public, and by 2009, IPOs had disappeared.

QR Energy was the only upstream MLP IPO in 2010. Priced in December 2010, it was sponsored by Quantum Energy Partners, a private-equity firm, and offered 15 million units at $20 per unit.

Activity rebounds

As 2011 drew to a close, activity picked up. LRR Energy closed its IPO in November. Sponsored by private-equity provider Lime Rock Resources, it was priced at $19 per unit, with 9.4 million units offered. In December, an additional 1.2 units were priced at $19. Houston-based LRR Energy, headed by co-chief executive officers Eric Mullins and Charles Adcock, has 30 million barrels of oil equivalent of proved reserves in the Permian Basin, Mid-continent and Gulf Coast.

Memorial Production Partners LP, sponsored by private-equity firm Natural Gas Partners, sold 9 million units at $19 each. Houston-based Memorial, led by John Weinzierl, operates oil and gas properties in South Texas and East Texas.

Mid-Con Energy Partners LP sold 5.4 million units at $18 each. The Tulsa-based company focuses on E&P in the Midcontinent. The offering represents about 30% of its value.

Its chief executive and founder is veteran oilman Randy Olmstead. He says the company calls itself the “waterflooding guys,” because the bulk of its operations involve waterflooding to coax secondary production out of mature fields. The MLP structure makes sense for Mid-Con because waterfloods are long-lived assets, he notes. Yorktown Partners provided the initial start-up equity to Mid-Con in 2004.

Another MLP, sponsored by Quicksilver Resources Inc., was expected to do an IPO early in 2012 for its Barnett shale assets.

Atlas Energy LP previously had an upstream MLP, but its assets were sold to Chevron Corp. Atlas is now carving out assets from Atlas Energy Inc. for a new IPO, to be named Atlas Resource Partners LP. Ed Cohen, chief executive of Atlas Energy, told analysts in a recent conference call, “As a result of the present heated, cash-consuming and costly competition to develop unconventional oil and gas plays, an effort to be sure in which we have been an early pioneer, companies struggling to pursue these costly projects are often amenable to selling production from acreage in conventional plays on terms extremely attractive to buyers.

“But, with everyone fixated on developing unconventional gas, there are relatively few purchasers for these undervalued conventional assets. Atlas Energy to the rescue.”

Cohen said the new MLP would create a “separate currency, which will better enable us to significantly expand cash flows from our upstream E&P natural gas and oil production assets through strategic acquisitions and organic development, but without diluting Atlas Energy’s ownership in its other interests.”

Premium multiples

Baird’s Bellamy was conditioned as a pipeline analyst to be risk averse, and initially he was highly skeptical of E&P MLPs. Over time, however, he has come to believe in a higher long-term oil-price environment and a viable model that requires reinvestment of cash flows and aggressive risk management.

“Now, we see the same dominant factor driving upstream MLP success and expansion that drove the midstream sector: multiple arbitrage. Simply put, yield-valued publicly traded entities garner premium implied cash-flow multiples well ahead of what those same assets in a corporate or private structure would receive,” he notes.

Royalty trusts, upstream MLPs, midstream MLPs, midstream corporations, and E&P C- Corps all have different risk and return attributes and, accordingly, different investor bases.

It is likely that the next big wave of M&A will be set up to take advantage of the substantial valuation spread between E&P MLPs and E&P C-Corps.

“Most investors who think ‘MLP’ are thinking about a pipeline partnership with stable cash flows rather than a hydrocarbon producer, but I don’t think it is fair to say that one of these asset classes is more in favor than another. Commodity-price sensitivity isn’t the dirty phrase you think it is to some investors, who think conflict with Iran is likely or who are looking for a hedge against competitive global-currency devaluation.

“E&P is a lot bigger than midstream in terms of total domestic asset value, and upstream MLP suitable assets with low decline rates continue to expand as the original shale wells start to mature, offering truly enormous expansion opportunities for the upstream MLP sector. This has already occurred in the Barnett shale, and we will increasingly see this in other areas where wells are five or more years old,” Bellamy says.

L inn Energy is a dominant upstream aggregator and developer and one of the more impressive PTP success stories of the past five years, he notes. Further, companies like Linn Energy have the scale to move into unconventional resource plays now. “So, with both mature and resource-driven assets available to the upstream, we would not be surprised in 10 years if the upstream sector eclipsed midstream MLPs in market value.

Linn Energy itself has said it is neither an MLP nor a corporation, although it is a publicly traded limited liability company with partnership tax status. Unlike a typical MLP, it does not have a general partner, nor does it pay an IDR (incentive distribution right).

The midstream sector accounted for 45% of all MLPs, while the E&P sector accounted for 12%, says Mary Lyman, executive director of the National Association of Publicly Traded Partnerships. That’s a reversal from 1990, when E&Ps accounted for 21% and midstream, 10%.

At year-end 2011 there were 100 MLPs or PTPs traded on public exchanges, with 76 of them being energy related. While the terms MLP and PTP are often used interchangeably, MLPs typically refer to those partnerships that operate under the natural resources exemption for publicly traded partnerships in the Internal Revenue Code. PTP, a broader term, encompasses MLPs as well as real estate and financial partnerships that operate outside of energy.

The exact statistics vary with daily stock fluctuations, but total market capitalization of the MLPs/PTPs, at year-end 2011, was estimated at $301.2 billion, with the energy and natural resources sector accounting for about 93%. The midstream sector accounted for about 69% of total MLP capitalization, compared to E&P MLPs, which—even with a rebound since 2006—accounted for 5.3%. Midstream MLPs totaled an estimated market capitalization of about $207 billion. Total market capitalization for E&P MLPs was over $16 billion.

The comeback of E&P MLPs was the topic of a research note released in late October 2011 by Raymond James & Associates Inc. Analyst Kevin Smith noted, “Over the past decade, midstream MLPs have experienced an incredible growth spurt as retail investors have sought tax-shielded yield returns. As the midstream MLP cycle has proven out, it seems obvious to us that the next step in the game is a similar shift of capital to E&P MLPs.”

A number of E&P MLPs emerged in the past year as investor interest picked up.

Valuation disparities

Valuations are driving interest, according to Smith. “With the substantial valuation spread between E&P MLPs and E&P C-Corps, it would make sense that the next big wave of M&A will be set up to take advantage of this valuation disparity. In fact, most upstream MLPs are currently worth almost double their C-Corp counterparts.

“We are not saying that you should expect a rash of upstream MLP acquisitions of C-Corps tomorrow, but we are saying we think that it is coming over the next few years. This valuation arbitrage will likely be just too tempting for E&P partnerships to pass up. As upstream MLPs grow in size and feel the pressure to do larger acquisitions, the natural solution will be to start picking off undervalued C-Corps. We have found that since most institutional investors can’t (or don’t) play in the MLP space, they simply are not aware of the wave of E&P acquisitions that is likely about to envelop the C-Corp sector.”

Historically, MLPs were created to focus primarily on inorganic growth, with a minor organic growth component, as they consolidate assets that are producing tremendous amounts of free cash flow into a tax-advantaged entity, notes Smith. He predicts that C-Corps will become attractive prey for additional E&P MLPs yet to be formed.

“People sometimes forget that Apache was the first MLP, formed back in the early 1980s. The problem back then was inability to hedge commodity prices for long periods of time, wrong asset base, and high interest rates. All three of those factors came together to wipe out the upstream MLP business model,” says Smith.

“The comeback is because of the wide arbitrage between yield-oriented investments vs. E&P C-Corp valuations. In this low-interest-rate environment, investors are hungry for yield. So, if you can structure a product that has stable cash flow and pays a high dividend, you will likely get a much better valuation in the market place vs. a traditional C-Corp valuation.

“Keep in mind how much the E&P industry has matured over the last 20 years. Before the emergence of shale drilling, U.S. oil and gas production was in a steady state of decline. The U.S. is one of the most mature oil and gas areas in the world. It only makes sense to put some of these old wells that are generating a ton of cash flow in a tax-friendly structure.

“Upstream MLPs try to take a large part of the commodity price risk off the table by hedging between 65% and 85% of their production for the next four to five years. When you combine the hedges plus the stable production profile, this helps mitigate cash-flow volatility that is normally associated with E&P companies.”

The modern-day MLP got its start in 1986-87, when Congress passed the Tax Reform Act of 1986 and the Revenue Act of 1987. The law stated that to qualify as a MLP, an entity had to earn at least 90% of its income from “qualified sources.” These sources were generally limited to natural resources or mineral activities, including exploration, development, mining, processing, refining and transportation.

MLPs must pay out all available cash on hand each quarter to unit-holders, minus the incentive distribution right payment to the general partner (a range of 2% to 50%, based on meeting predetermined growth targets), and cash reserves needed for the proper conduct of the MLP’s business.

That requirement will keep MLPs coming back to the capital markets, for both debt and equity.

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