The Newest Twist in U.S. Energy Has Roots in the Past

The U.S. oil and gas industry is abuzz with a new phenomenon: the upstream limited partnership. But putting upstream (exploring, developing, and producing) oil and gas assets in a yield-based, tax-exempt structure isn't an entirely new idea. Here we will detail the history of these structures to highlight their benefits, risks, and broader industry implications.

The Roots of the Upstream Limited Partnerships
A long time ago, in a country not so far away, an investment idea took off: Take mature oil- and gas-producing properties, package them up in a tax-exempt vehicle, and sell publicly traded units to investors who are seeking regular income distributions. Thus marked the birth in 1986 of the Canadian income trust--specifically, the oil and gas income trust. Over the next 20 years, income trusts in a variety of industries sprouted up, and they enjoyed a meteoric rise in valuation and investor acceptance until 2006, when the Canadian government stopped the buck. Fearing that every corporation would eventually convert to a tax-advantaged trust, the government proposed a 2011 end to the tax benefits of the income trust structure.

The end of the story? It's not even the beginning. Though George Lucas has shown us the folly of the prequel, we'll go even further back, to 1981, when  Apache (APA) rolled up a number of oil- and gas-producing assets into the first American master limited partnership. The LP structure is attractive because the LP does not pay tax on distributions to unitholders, unlike corporations which issue dividends out of after-tax income. In addition, unitholders can often defer taxes on a portion of those distributions in what is known as a return of capital.

Armed with these structural advantages, many more limited partnerships came to market in the 1980s, including ones for the Boston Celtics and Burger King. However, the Revenue Act of 1987 put an end to limited partnerships outside of specific industries such as real estate and natural resources. And the 1986 collapse in oil prices decimated the upstream oil and gas LPs. Unable to maintain distributions, upstream LPs either reincorporated into or merged with traditional exploration and production corporations. Leaving even more of a bitter taste was the misrepresentation of limited partnerships as extremely safe investments by Prudential Bache, which would later be punished via a $1.5 billion settlement with the SEC.

The Rise of a New Wave of LPs
Fast forward to 2006, with energy prices near record-highs and the market hungry for yield-based investments. Starting with Linn Energy , a wave of new upstream LPs hit the market. (For our purposes, we'll include the similarly tax-advantaged limited liability companies under the LP umbrella.) The market was cautious at first, but the new LPs proclaimed this time would be different, due to increased hedging flexibility and lessons learned from the 1980s. The new LPs would seek to hold low-risk, long-life reserves with low capital requirements. And so far, they've generally stuck to these principles.

In recent months, valuations for the upstream LPs have soared, with yields compressing and multiples expanding. Institutions are buying in and acquisitions are fueling distribution hikes. With assets enjoying a premium valuation under the tax-advantaged LP structure, exploration and production companies are chomping at the bit to spin out mature reserves into LPs--and are getting rewarded by the market as a result. For example,  Pioneer Exploration's (PXD) stock jumped 8% the day it announced it was creating two LPs.  XTO Energy  saw its stock jump 6% when it said it was considering rolling some of its newly acquired  Dominion Resources (D) assets into an LP. Other companies actively pursuing or considering LPs include  Exco Resources (XCO),  Encore Acquisition , and  Whiting Petroleum .

Upstream limited partnerships are by nature acquisitive. This is because, right now, the LP itself resembles a perfect arbitrage machine. Since the tax-advantaged LPs command valuations far superior to assets outside the LP, the LP can issue richly valued units to fund cheap acquisitions. As long as LPs can access capital--that is, as long as investors still want to buy units--those LPs will be able to grow at prodigious rates. Witness the $600 million private placement Atlas Energy Resources LP  used to partially fund its $1.2 billion purchase of  DTE Energy's (DTE) natural-gas assets. The deal is expected to increase Atlas' reserve base by more than 300% and daily production by 200%. If history is any indication, this is only a sign of things to come. Billions of mature producing assets could be bought up or spun out into LPs over the next few years.

The Atlas deal highlights the upside potential of limited partnerships. Atlas units closed 15% higher in the session following the announcement of the DTE deal. The jump was in response to the expected 34% hike in annual distributions brought about by the accretion of the deal. Early in the lives of these limited partnerships, sudden growth and unit price appreciation could be easily attained.

The Past Isn't Even Past: What Happens Next
But history also offers a number of lessons. The saga of the Canadian income trust provides an excellent case study for the future of the limited partnership in the United States.

First, the proliferation of upstream limited partnerships will ultimately lead to increasing competition for assets. Acquisition prices will likely bound higher as more LPs enter the bidding. This could be accompanied by a deterioration in the quality of assets held by LPs, as assets become scarcer and as owners of marginal assets try to capitalize on premium valuations by shoving them into LPs. These assets might have higher operating costs, lower output prices, or steeper declines that necessitate higher levels of maintenance and reinvestment capital.

Competition will also spur the quest for size. In general, the bigger LPs will not only benefit from lower cost of capital, but they will be able to go after larger acquisitions or projects. However, "size at any cost" is a dangerous strategy. It will be easy to overpay for assets, to dilute operational efficiencies, to buy assets that don't end up meeting expectations. In addition, buying assets at what might be the top of the cycle could be problematic for LPs that pay for deals with debt. In a cyclical downturn, servicing debt could compound problems.

Canada also witnessed the gradual disappearance of the intermediate (medium-sized) upstream corporation. Once a growing junior producer reached a certain size, it would either convert to a trust or be purchased by one. This stratified upstream capital spending, with smaller corporations taking on the risk to explore and the trusts buying mature assets and developing them. But once the immense producer  EnCana (ECA) began to consider forming an income trust, the government decided to act (or react), which brings us to the risks of the upstream LP.

Regulatory changes could someday take away the tax advantages of the upstream limited partnership. The Canadian government acted to stem tax leakage brought about by the conversion of its biggest companies to income trusts. The U.S. government might have bigger fish to fry right now--but who's to say what's down the road?

Beyond the tax issue, however remote, lie other risks. If oil and gas prices were to fall for a prolonged period, the LPs' hedges could run out, and they wouldn't be able to sustain their revenues, which might lead to distribution cuts. Also, the yield-driven valuations of the LPs make them susceptible to interest rate risk; if interest rates rise, investors demand higher yields from risky investments, and unit prices have to fall to compensate.

What's the Verdict?
We currently cover one upstream LP,  BreitBurn Energy Partners , and it's trading well above our estimate of its fair value. But opportunities will certainly lie ahead in the upstream limited partnership space. Upstream corporations could reap immense benefits by harvesting their mature assets. The LPs could grow at astronomic rates. All that remains is to see whether this sequel has a better ending than the ones that have come before.