Master limited partnership (MLPs) units have evolved in the minds of many investors. Early on, many saw them as something resembling a bond. They have evolved in recent years into a better-yielding, equity-like alternative to corporate stocks.

But that bond-like slow, steady income has given MLPs a solid niche in the upstream, drilling-and-production side of the energy business. The number of upstream MLPs seems to be growing.

The partnership concept may still be the exception upstream to conventional corporations, rather than the rule. But it is nothing new, thanks to many years of partnerships of one form or another in the business, according to Michael Peterson, energy analyst for MLV & Co.

The success of an upstream MLP is “significantly influenced by the nature of the assets within its portfolio,” Peterson says. “Assets requiring large or unpredictable capex [capital expenditures] present a host of management problems for an entity precluded from retaining earnings. For upstream MLPs, suitable assets include the following:

• Mature production with an aggregate well vintage exceeding five years since initial production.

• Largely developed acreage with appreciable reserve life and linear decline type curves.

• Predictable-development profiles with limited drilling risk and visibility for growth.”

Several upstream-focused MLPs were among the 48 firms presenting at the Independent Petroleum Association of America’s recent Oil and Gas Investment Symposium (OGIS) in San Francisco. All of them exhibited those three attributes, Peterson tells Midstream Business.

Most of the companies added a couple of points to Peterson’s definition in their presentations. Extensive price hedging to reduce commodity price volatility and selective, well-priced acquisitions to create growth came up frequently as additional bullet points on strategy slides.

“An upstream MLP is not the place to develop [properties]. It’s intended for more of a harvest structure,” Mark Houser, president and chief executive of EV Energy Partners LP, said during his presentation.

QR Energy LP illustrated its strategy as stair steps: shallow decline/long-life assets provide a foundation upon which it adds low-maintenance capital requirements, significant commodity hedging, operational control of assets and accretive acquisitions. The top step: increasing distributable cash flow for QR unitholders.

That strategy has enabled QR to increase quarterly cash distributions per unit to 48.75 cents from 41.25 cents from first-quarter 2011 through second-quarter 2013—an 18.2% increase. Its current annual yield is 11.8%.

LRR Energy LP has a similar upstream MLP story to tell, Eric Mullins, LRR’s co-chief executive and chairman told the conference.

“Our focus is on consistency to avoid volatility. We manage for the long term,” Mullins said.

The firm has sought out low-risk, mature assets, giving it a reserve life of 13.4 years. It focuses its portfolio on mature assets in the Permian basin, Midcontinent and East Texas; it controls development as the operator of 84% of its properties, and it combines an extended developmental inventory with prudent acquisitions, Mullins added.

Growth can come via dropdowns or joint bids with sponsor Lime Rock Resources, acquisitions from Lime Rock or third-party acquisitions. Couple that with ample developmental inventory, including new drilling and workovers, and LRR expects to keep its quarterly distributions rising in the foreseeable future, Mullen said.

The partnership sported a 12% yield in September, which Mullins pointed out compares very favorably with an average 9.6% for upstream MLPs and 5.8% for the Alerian MLP index—all markedly above the 2.7% currently offered by 10-year Treasury bonds and 1.9% for the S&P 500 stock index. LRR’s total distribution coverage is 1.11.

Hedging production is a core strategy of slow-and-steady upstream MLPs—an important way to even out the yo-yo nature of commodities prices and assure the even cash flow investors seek.

“We’re in the manufacturing part of the business,” Cary Brown, chairman and chief executive of Midland, Texasbased Legacy Reserves LP, told conference attendees, adding hedging must be a fundamental for upstream MLPs, along with strict financial discipline. Legacy said it had a debt-to- EBITDA ratio of 3.2 for the second quarter, excluding pro form a effects from several recent acquisitions.

Success at hedging future prices can vary widely, depending on the commodity, LRR’s Mullins said. The crude oil and natural gas hedging markets are well developed with lots of buyers and sellers willing to offer agreements going out several years—perfect for upstream MLP strategies. “But NGL [natural gas liquids] hedging is not as well developed,” he added and what NGL hedging there is tends to be short term.

Acquisitions are important too, “they drive growth,” Legacy’s Brown added—but purchases must be prudent. Prudent use of debt represents a crucial strategy for all MLPs, Peterson tells Midstream Business, since cash must gain to unitholders.

“The transitory circus in Washington notwithstanding, CFOs [chief financial officers] are comfortable with their access to capital,” he says. “During the past few years, consensus expectations have been for rising interest rates. Accordingly, most partnerships have layered-on a comfortable amount of term debt. With common equity reflecting the weakness of the third-quarter sell-off in the sub-sector, CFOs are reticent to issue common equity at current levels.”

But prudence can be hard nowadays when the action gets hot, particularly in plays like the Permian where a lot of new players have entered the market. They may be new to the business and not understand what they’re paying or they have other reasons for beating out established players.

Bidding can become intense and sales prices can go well beyond initial estimates for the value of the assets in the block.

Edward Cohen, chairman and chief executive of Atlas Resource Partners LP, said there has been a “herd mentality” in some plays that has priced deals for otherwise attractive assets out of reach. “We buy a lot, and we sell a lot. We may not be the highest bidder but the best bidder,” he added. “But I sleep well because we are so cautious. We tend to do unexciting things.”

In The Middle Of Utica’s Upstream

By Paul Hart

Midstream assets can dovetail nicely with an upstream MLP’s plans. EV Energy Partners LP holds major producing interests in eastern Ohio’s Utica shale—and a share of two Utica midstream assets that provide key takeaway capacity.

Mark Houser, the partnership’s president and chief executive, outlined for attendees at the Independent Petroleum Association of America’s recent Oil and Gas Investment Symposium (OGIS) in San Francisco, how the midstream operations fit into its story—a region where EV has “long-term, great assets” as the unconventional play unfolds. The firm and earlier its parent, EnerVest Ltd., had conventional production in the region before the Utica unconventional play came alive in recent years.

EV owns 21% of the Utica East Ohio Midstream system that gathers, processes and fractionates wet gas for Chesapeake Energy Corp., Total SA and EnerVest. The system went online in the third quarter with 800 million cubic feet (MMcf) per day of processing capacity and 135,000 barrels (bbl.) per day of fractionation capacity and 870,000 bbl. of storage. EV points to Utica East’s “upside potential as development drilling expands” in the Utica. It serves roughly 1 million dedicated working interest acres. The system is a joint venture between M3 Midstream, Access Midstream Partners and EV.

The partnership holds a 9% interest in Cardinal Gas Services, a lowpressure, wet-gas gathering system serving Utica producers. The system has 200 wells connected with the prospect of 4,600 wells in its service area during the next 18 years. Partners are Access Midstream Partners and Total.

EV projects a stable, long-term cash flow from the assets from a net capital investment of $335 million to $395 million through 2017. The bulk of that investment has come this year. Financing has been with bank debt.

The partnership projects midstream EBITDAX of more than $60 million per year by 2016 and 2017. Utica East fees are set by contact. Cardinal Gas has cost-of-service arrangements with fixed internal rates of return.

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