With the protracted downturn in energy, master limited partnerships (MLPs) serving the midstream sector have taken their fair share of knocks. But MLPs and similar vehicles for the upstream sector—historically numbering far fewer than their midstream counterparts—have fared much worse and are a mere fraction of the force they once were. Is there a future for upstream MLPs?

Just over three years ago, Linn Energy affiliate LinnCo LLC acquired Berry Petroleum Co. in what was heralded as the first-ever acquisition of a public C-Corp by an upstream LLC or MLP. The acquisition carried a price tag of about $4.3 billion. In May of this year, the three affiliates--Linn Energy, LinnCo and Berry—entered a restructuring agreement with noteholders and filed for Chapter 11 bankruptcy.

Other upstream MLPs have suffered a similar fate. Just days later, Breitburn Energy Partners LP said it was filing for Chapter 11. Breitburn said it expected to “continue its operations without interruption,” relying on cash from operations, cash on hand and a $75 million debtor-in-possession financing facility. These would provide “more than adequate liquidity to fund its operations during the restructuring process.”

How did such circumstances arise in a sector that for the most part claimed a conservative strategy? And, in the rubble now populated mainly by micro-cap MLPs, are there any gems left? At one brokerage firm, research on upstream MLPs is being “de-prioritized,” while at others coverage has been thinned down or dropped entirely as resources are reallocated elsewhere.

Obviously, the collapse in commodity prices was a primary factor in MLPs’ fall, as noted by Breitburn CEO Hal Washburn in a statement saying negotiations were continuing with creditors.

“The prolonged decline in commodity prices that began in 2014 has placed significant financial stress on today’s oil and gas industry,” said Washburn. “Our long-lived, low-decline portfolio of diverse assets continues performing in line with expectations, but the current outlook for commodity prices makes our existing debt burden unsustainable.”

Failure to hedge

Other factors, including hedging strategies designed to offset the impact of lower commodity prices, were a major issue for some MLPs, according to John Ragozzino, senior equity analyst at New York-based Drexel Hamilton LLC.

“There was a period during 2013-2014 when the commodity futures curve was so backwardated that some MLP managements became hesitant to secure the typical fixed-price swap contracts that normally they would have used to hedge future production,” Ragozzino said. “The temptation was to wait for the market to return to a more normalized futures curve rather than to take a $20 per barrel discount to the spot price on production volumes going out 36 to 48 months. As a result, they deviated from the traditional hedging discipline.

“At the time, the probability of seeing prices fall as low as they have, and as quickly as they have, seemed almost impossible; and so they waited. Fast forward to today, and the combined effects of the violent correction in oil prices and the prior period of abnormally backwardated futures prices have left a significant number of upstream MLPs ‘caught with their pants down’,” he continued.

“Now companies face an imminent ‘hedge cliff’ in 2017. Upstream MLPs are either far more exposed to market prices, or they’ve hedged volumes at prices significantly below levels that they could have locked in a couple of years ago. Even with distributions suspended, there are MLPs that are levered to the point that they’re unable to service their debt.”

Kevin Smith, senior vice president with Raymond James & Associates, recalled the MLPs’ dilemma over locking in hedges that would, in turn, also lock in cuts in distributions to investors.

“You had some management teams that were very reluctant to hedge into a distribution cut,” said Smith. “If they hedged at certain levels—levels lower than the front end of the curve, but in retrospect attractive—they would have been guaranteeing a distribution cut. Instead, they hoped the commodity curve would turn out to be wrong, in essence liquidating their hedge books.”

A number of MLPs may be able to survive the downturn, but it will take a substantial amount of time for them to return to health.

Leaving hedging strategies aside, Smith was quick to note that issues impairing MLPs—unusually high commodity volatility coupled with leverage—have been far from unique to the MLP sector.

“People say the upstream MLP model is broken, and it is in the recent commodity price environment,” he said. “But people forget that the E&P model is largely broken in this environment, as well. The recent downturn has been a stress on the industry in general. It’s not as if upstream MLPs are the only entities that we’re seeing filing for bankruptcy. Balance sheets weren’t set up to handle this much volatility, with oil dropping from $100 per barrel to $26.”

Expectations are that debt levels, which historically have been between 3.5 and 4.5x EBITDA, according to Smith, will be worked lower industrywide. “I think there is going to be a push to get firms down to 2.5 to 3.0x,” he observed. Previously, MLPs tended to carry higher debt levels based on what were perceived as their “very stable cash flows,” which stemmed from shallower declines in production profiles combined with robust hedging programs.

For those MLPs still carrying too much debt, the path to improving their balance sheets through asset sales—assuming a sufficiently attractive price can be found—is likely limited, said Smith.

“The problem is that selling producing properties in the current market is not delevering. If you sell an asset for less or equal to its borrowing base value, that does not help a company’s leverage or liquidity,” he observed. “Most upstream MLPs do not have a meaningful amount of undeveloped acreage to sell that the market covets. Instead, MLPs are largely going to have to try to wait out the storm until oil and gas prices improve.”

A viable business model

Assuming Raymond James’ forecasts as to the timing and magnitude of a commodity price rebound are on target—forecasts that he acknowledged were “bullish”—Smith anticipated a number of MLPs would be able to emerge from the downturn. He noted, however, that “it’s going to take more than a year for a lot of these companies to become healthy again.”

MLPs that Smith viewed as likely candidates to weather the downturn were (in alphabetic order), EV Energy Partners LP, Legacy Reserves LP, Memorial Production Partners LP, Mid-Con Energy Partners LP and Vanguard Natural Resources LLC.

Raymond James’ commodity price deck calls for the WTI price of crude to reach $65 per barrel (bbl) in the fourth quarter of this year and to average $75/bbl in 2017. For natural gas, the price deck projects a Henry Hub price of $2.30 per thousand cubic feet (Mcf) in the fourth quarter and an average of $2.65/Mcf for 2017. Long-term prices (post-2017) are projected to ease back to $70 for WTI and $2.50 at Henry Hub.

“I think there’s still a viable business model for acquiring mature oil and gas properties and kicking off the excess cash flow to investors,” observed Smith. “There’s always a market for mature oil and gas properties that don’t need a lot of maintenance. It doesn’t have to be in an MLP wrapper; it could be in a C-Corp wrapper, and you could do it effectively.”

Are any upstream MLPs likely to be gems that truly shine?

“It’s happened before; I’m sure it can happen again. When we think where oil and gas prices could go, there’s a path for them to pay down debt and re-start the distribution process,” said Smith. “They may well surprise people with the distribution growth they’re able to put out at the beginning. And if we’re right on the financial restructuring, there’s going to be lots of mature assets that ultimately come to market, and somebody’s got to consolidate those assets.”

At FBR Capital Markets & Co., senior research analyst Chad Mabry covers small and mid-cap E&Ps as well as a shrinking base of upstream MLPs. The firm maintains research on several MLPs but recently dropped coverage of five upstream names, including Linn Energy. The issue, said Mabry, is that the upstream MLP sector is “facing an identity crisis,” with “weaknesses in the structure having been exposed.”

One issue that has recently emerged to potentially impact investors is “cancellation of debt income,” also known by the acronym CODI. This occurs when debt is bought back at a discount, or exchanged for equity, with the imputed gain then passed along to unitholders due to the status of MLPs as “pass-through” entities. In certain cases, Mabry is concerned that investors may be exposed to a tax liability related to CODI, depending on their cost basis, which may warrant additional consideration.

“That’s a liability coming at you out of left field that compounds what otherwise is an already pretty disastrous situation,” he said. “That doesn’t happen if you’re a C-Corp buying back debt at a discount.”

Mabry said MLP managements teams “seem to remain largely committed to the MLP structure for the longer term, and still see it as the appropriate structure for those types of assets.” While Linn Energy was among the first to suspend its distribution, even Memorial Production Partners—the “best hedged” of the MLPs, with hedges extending through 2019—also had to “drastically reduce its distribution due to the cash flow impact and what it’s done to their leverage ratios,” he noted.

“These days, it’s all about liquidity and borrowing base redeterminations,” he observed. “And if the lending group says, ‘You can’t make those distributions any more,’ it can become sort of a self-fulfilling prophecy. The stock trades down, and at some point it doesn’t make sense to pay out a distribution that yields, say, 20%. Why send all that cash out the door?”

The “identity crisis” comes into play again, said Mabry, as analysts turn to varying ways to value MLPs.

“Previously, MLPs benefited from a dividend discount model-type of valuation, which represented a significant premium to a standard NAV estimate. But if you don’t have a distribution, that model is no longer relevant,” he said. “Most of the MLPs still can’t justify a valuation on a NAV basis by my estimates. If they roll into a C-Corp., they’ll fall into a value category rather than growth. But tending to be over-levered with marginal assets isn’t a recipe for outperformance in this environment, either.”

Mabry currently has two MLPs with Outperform ratings: Memorial Production Partners and Black Stone Minerals. Memorial Production Partners still has a distribution, albeit now reduced to 12 cents annually, he said, and is “very well hedged for the next few years. And I expect them to add opportunistically to their hedge book.”

Black Stone Minerals went public only last year. “They came out, paid down their debt and set a distribution schedule that included a 9% CAGR in projected distributions through 2019,” according to Mabry. “And we think that is sustainable, because Black Stone Minerals hasn’t been burdened by the $100 per barrel oil baggage to the extent that other MLPs have been.”

If various factors, including tax implications, mean managements remain largely committed to their current MLP structure, what developments could await MLPs?

Several analysts have pointed to a possible hybrid structure involving a distribution made up of a fixed component and some kind of variable component.

This possible solution resonates with Drexel Hamilton’s Ragozzoni. It could open up new avenues for this beaten-down group.

“The reliance on a fixed distribution model, given the cyclicality and extreme volatility of commodity markets, doesn’t make sense over the long terms,” said Ragozzino. “Even with robust hedge programs in place, over the course of a full commodity cycle, you would likely have to see a complete reset of the distribution each time we reach a sustained low point, because the ability to continue hedging at prices supportive of past distribution level disappears.

However, to the extent that investors start to view these instruments as quasi-variable distribution payers, he thinks the model can still work. “The existence of an investment vehicle that ultimately returns capital to the investor in the form of cash distributions represents, in a sense, the final resting place for mature, no-growth assets,” he said.

If capital markets allow upstream MLPs to acquire these types of assets—and in doing so permit E&Ps to monetize mature assets to help fund growth-oriented unconventional resource plays—then a natural, symbiotic relationship can exist between MLP buyers and C-Corp sellers, according to Ragozzino. “For E&Ps, the ability to divest such assets and redeploy the proceeds in the next growth project is a useful tool. That said, whether or not we’ll see a return of the upstream MLP model is uncertain, given the tremendous losses experienced by retail investors of late.”

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