Meet A Midstream REIT

Call it a midstream makeover. An affiliate of Tortoise Capital Advisors is breaking new ground by transforming an energy business development corporation (BDC) into a real estate investment trust (REIT) holding transmission, pipeline and gathering assets.

The new entity is believed to be among the first publicly traded energy infrastructure REITs formed. Among the initial steps was a change of name late last year to CorEnergy Infrastructure Trust Inc., replacing the prior Tortoise Capital Resources Corp. name and reflecting the title of its management company, Corridor InfraTrust Management LLC. (BDCs are similar to venture capital funds and some have been set up as publicly traded, closed-end investment funds.)

But key to the transition to REIT status was a major midstream acquisition, involving the pipelines and central gathering facilities built by Ultra Petroleum Corp. to serve the strategic assets of its Pinedale anticline natural gas field in Wyoming. Far and away the dominant assets of the new REIT to date, these midstream assets were acquired through a newly formed subsidiary, Pinedale Corridor LP.

The purchase, which was structured as a sale-leaseback, was announced by CorEnergy last December. This gave the firm not only the real property assets, but also the requisite 12-month timeframe to meet its expected goal of qualifying for REIT status by the end of 2013. Partnering in the transaction with an 18.9% stake was Prudential Capital Group, long known for its history of energy investing.

“We believe we’ve cracked the code on broad, investor-friendly access to U.S. energy infrastructure by utilizing a publicly listed REIT, much like Tortoise Capital did for retail investors with master limited partnerships (MLPs) in designing the first closed-end fund,” said CorEnergy Chief Executive David Schulte during the company’s first quarterly call since the major midstream acquisition.

“We’re like a non-operating MLP,” he continued, outlining the company’s objective of providing its shareholders with “an attractive, risk-adjusted return, with an emphasis on stable distributions and long-term distribution growth.”

Fitting for a REIT

For investors, the new REIT-structured vehicle represents “a low volatility, long duration, inflation-protected energy investment,” Schulte tells Midstream Business. Based on its “stable and modestly growing cash flows over a very, very long horizon,” the company anticipates being able to deliver returns on invested capital of 8% to10% per year, including annual distribution growth of 1% to 3%. This would compare favorably with stocks with similar risk characteristics, such as utilities and other REIT sectors.

How transformational was the move from BDC to REIT?

At $228.5 million, the purchase price of the Pinedale midstream assets compared to a portfolio of assets—made up primarily of public and private securities—that totaled just around $100 million in the BDC. To help fund the purchase, CorEnergy liquidated most of its position in MLP securities, raising $26 million. In addition, in what was clearly a skittish equity market late last year amid “fiscal cliff” concerns, the company raised roughly $74 million by issuing 13 million new shares.

With roughly $100 million from the two sets of security sales above, CorEnergy tapped two other sources for a further $100 million. It entered into a secured term credit facility for $70 million, and it received a $30 million co-investment from Prudential for its 18.9% stake. Rounding out the remaining $28 million were other equity securities accepted by Ultra, with a market value of $23.5 million, as well as roughly $5 million in cash.

Of its prior portfolio, essentially the only unchanged assets were certain private securities, valued at a little less than $20 million, and an investment in a transmission line operated by Public Service Co. of New Mexico, which CorEnergy expects will also qualify as a real property asset for REIT status. The latter, known as the Eastern Interconnect Project, is projected to have approaching a 7% cash-on-cash return during its life—lower than the targeted 8% to10%, but “appropriate given its lower risk level.”

Behind the transition to REIT status was CorEnergy’s belief that the BDC format offered “too limited a platform to execute its strategy,” a view shared by several other BDCs that have also since changed strategies, said Schulte. A REIT structure offers greater flexibility, especially in view of the growing capital needs of the energy industry. Affiliate Tortoise Capital puts the capital investment needs projected for pipelines alone at $78 billion over the next three years.

“As upstream companies focus on their highest-return opportunities, we expect them to continue to divest, monetize or partner on the ownership of infrastructure assets, so they can preserve capital to fund drilling and exploration opportunities,” says Schulte.

Further opportunities

Prudential Capital Group, which has some $13 billion in private debt and equity investments in the energy sector, similarly sees further opportunities for upstream players to recognize value in infrastructure assets that otherwise would lie “fallow” on company balance sheets. Often, however, exploration and production companies hesitate to unlock the value of assets they view as strategic if, in doing, so they risk having to give up control, Brian Thomas, managing director in the energy finance group of Prudential Capital Group, tells Midstream Business.

Thomas contrasts the approach of certain “control-oriented” investors—often under pressure to monetize assets within certain time frames—with the “buy and hold” strategy employed by Prudential and, now, CorEnergy. A “buy and hold” approach not only “resonates” better with E&Ps considering a strategic asset sale, but also has the advantage of complementing Prudential’s need to match long-lived assets with the similarly long-lived liabilities of its insurance business.

Owners “may not want to sell these assets to someone who theoretically will seek to sell them in five to seven years,” he explains. “As a life insurance company, we have very long liabilities consistent with our business model. Midstream assets are a very good fit for our balance sheet; they’re long term in nature, generally provide good distributable income and have very solid long-term intrinsic value.”

Even though Prudential, with its extensive history of energy investing, has ample opportunity to structure its own private transactions, there was good reason to join forces with CorEnergy on the purchase from Ultra of what was named its Liquids Gathering System (LGS) in the Pinedale Anticline.

Prudential knew members of the CorEnergy team from their work at Tortoise as having “like-minded investment interests.” In addition, Prudential had a “good active working relationship” with Ultra.

“For a maiden voyage, it was a good opportunity to work with parties with which we’ve already had long-term relationships. I think that helped a lot,” recalls Thomas. “You work through the challenges and tailor something that meets people’s priorities without compromising your own.”

The $228.5-million purchase of the LGS assets was in the form of a sale leaseback, under which Ultra will continue to operate the assets for an initial 15-year period. Options exist to extend the lease for 5-year periods. The triple net lease provides for a base rent of $20 million per annum, subject to adjustments for inflation based on the consumer price index. The lease also includes an additional “participating rent” based on the LGS assets’ volume growth. Total rent (minimum plus participating) is capped at $27.5 million per year.

‘A good fit’

While Thomas says Prudential would have considered structures other than a REIT, “we look at this as good fit. Having this type of arrangement, in which a REIT holds a gathering system, provides greater certainty of revenue stream visibility over a very long horizon.”

A major factor attracting both CorEnergy and Prudential to the transaction was not just the LGS asset itself, but also the quality of the reserves behind the system.

The LGS consists of more than 150 miles of underground gathering pipelines, while the latest available Energy Information Agency data, from 2009, put the Pinedale Anticline among the top five U.S. natural gas plays based on proved reserves. Ultra’s estimated proved reserves in the Pinedale and Jonah fields stood at 4.3 trillion cubic feet equivalent (Tcfe) as of December 31, 2011, while 3P reserves—proved, probable and possible—were estimated at 10.2 Tcfe, according to reservoir engineering firm Netherland, Sewell & Associates, which has identified an inventory of more than 5,000 future drilling locations.

CorEnergy Chairman Rick Green emphasizes the importance of having made “a thorough and deep examination” not just of the LGS assets, but also the reserves backing them. Noting the Pinedale is “one of the top five producing reservoirs in the country,” you have “a very high quality asset behind the LGS,” Green tells Midstream Business. And all the better, he notes, “because at the end of the lease, they turn operations of the LGS back to us; we own it. You take a very serious look at this as an owner, not a financer.”

Even in a low-gas price environment, the LGS assets “are supported by economically attractive, long-term reserves,” adds Thomas. Reserves are in a mature area that, without need for exploration, offers “plenty of room to run.” In addition, Ultra has a strong record of stewardship of its Wyoming acreage and a “good working relationship with the Bureau of Land Management (BLM).” The BLM mandated the use of a full-field liquids gathering system for any natural gas produced in the Pinedale area in 2008. Prior to then, water and condensate from producing wells were trucked out of the field.

With Pinedale primarily a dry-gas reservoir, the LGS assets mainly involve the gathering of gas and separating out of water and some condensate. The system, running at about 80% of capacity, can be expanded incrementally by adding separators at a relatively low cost, if necessary. “The LGS is really a utility system that manages water coming out of wells in an environmentally and economically smart way,” says Green. “This happens to be a new one in very good shape.”

No processing assets

Schulte is careful to note CorEnergy’s interest in REIT-qualified real property assets, such as pipeline, gathering, storage and transmission assets, does not encompass processing assets. IRS regulations, as they currently stand, are limited to what it considers “conduits and vessels,” separate from “conversion” assets. Since processing could be considered a “conversion” asset, it would be “too uncertain” to acquire and lease processing assets in the absence of a specific IRS ruling.

Schulte says CorEnergy has additional transactions under “preliminary review” that range in size from $50 million to $200 million. With an equity market capitalization under $200 million for CorEnergy, he acknowledges there may be an element of “boot strapping” its way up to some of the larger of these opportunities. With debt at the lower end of a 25% to 50% preferred range, plans to enter into a revolver agreement with a bank group may open the door to a first step of smaller, accretive acquisitions.

Over time, Schulte is confident of adequate investor appetite to grow the energy REIT. First, income needs of individual retirement accounts (IRAs) and other tax-exempt monies represent a huge pool of capital that can own REITs. By contrast, IRAs tend not to hold MLPs to avoid the unrelated business taxable income (UBTI) issue. In addition, both REITs and utilities have wide institutional ownership that CoreEnergy can look to tap into as its market capitalization grows.

“We’re small right now, but we believe that as we grow in size, there will be an institutional audience that will benchmark us appropriately against similar low volatility, long duration, inflation-protected equity investments,” says Schulte. “One of the things we’ve demonstrated to the market is the appetite of larger institutions, like Prudential, for the kinds of investments we are making. And that would enable us to do larger-size acquisitions than on our own.”

Having a major transaction behind it is obviously an important landmark for CorEnergy in light of the new framework of a sale-leaseback in an energy REIT.

“It was a complex negotiation that built a partnership as opposed to just executing a transaction,” says Green.

“The first deal is always the hardest,” adds Thomas. “Hopefully, it sets a template for future parties to consider. Once you have examples in the market, and a track record for getting them done, a larger universe of people will consider that as an option for assets they might like to monetize.”

The growing use of a REIT structure in energy infrastructure would not surprise Thomas, who says it may be viewed as another vehicle that can “expand” rather than simply “reallocate the pie of capital” needed to support energy industry growth. Relative to the MLP sector, “I don’t think this is something that steals opportunities from the plate of traditional MLPs. It’s supplemental as opposed to a substitute.”

Shulte elaborates that growth in the MLP sector tends to be driven by expansion opportunities or by opportunities to integrate assets into an existing MLP network. “But not all energy and midstream opportunities are that type,” and where divestitures are motivated mainly on monetization grounds, “a REIT provides a better fit for that type of asset.”

Whatever the next move is for CorEnergy, Schulte indicates that the combination of acquisition and financing used to grow the company would have as a priority to ensure accretion to the benefit of the existing shareholders. Taking up existing bank capacity, as well as tapping possible preferred or joint venture financing, may well be on the agenda. But Schulte declares himself “very circumspect” about possibly accessing the equity market—unless to do so would allow CorEnergy to raise distributions from its current level of 50¢ per-year rate.

Chris Sheehan can be reached at csheehan@hartenergy.com or 303-800-4702.