MASTER Limited Partnerships (MLPs) have gone from being an exciting sector of the business to a point where there are a lot of questions about how the model operates and whether or not it’s effective for businesses that have taken it over the past few years, according to Bob Broxson, managing director in BDO Consulting’s Dispute Advisory Services Practice.
In his presentation, “The Changing Landscape of Terminal Business Models,” Broxson said that MLP growth was ratcheted up by the extensive shale basins that were developed. Broxson spoke on MLPs during the International Liquid Terminals Association’s 37th Annual International Operating Conference held June 12 and 13 in Houston, Texas.
“The energy market figured out how to make it work, and the thing that really made it work was prices,” he said. “In the early 2000s, we were short of natural gas and crude oil in the United States. Gas prices were going through the roof, and crude prices were even higher. Liquids prices were going through the roof. Refined products were having a heyday. We started seeing a tremendous amount of investment.
“A lot of you will look at me and say, ‘We do terminal business, and that’s really downstream, not midstream.’ But I would make an argument that a midstream company is a company that has pipes, terminals, and all of those same types of assets that you have in what is in the trade known as downstream.”
He added that MLP growth came with natural gas, crude oil, and liquids, but the transition into the MLP structure really started in the early 1990s, when major oil companies divested of many midstream assets in order to raise returns on capital.
“The truth is that major oil and gas companies do not get paid for pipe,” Broxson said. “They get paid for pulling the product out of the ground and making it available to the market. Funny enough, in the last few years we’ve seen a few major oil companies form partnerships. We’re talking about Shell and Marathon. They’ve decided that this is not such a bad model.
“Midstream companies were the natural buyers, with shareholder value propositions of low growth, steady dividend payments, and low risk based on fee-based pipeline assets. Master Limited Partnerships emerged as tax-efficient structures for distributing cash to unit owners, further lowering the cost of capital of midstream companies and allowing them to pay more for fee-based midstream assets than C-Corporations could justify.”
He said two major innovations combined to accelerate growth:
• Kinder Morgan recognized that greater value could be created by reserving a portion of the cash flow for growth investments.
• Enterprise Products deconstructed oil and gas value chains and invented new opportunities for fee-based revenue streams.
“So let’s just say, if I go from the natural gas side, I’ll charge a fee for a gathering system,” he said. “I have compression to get that gas into the pipe, I’ll charge for the compression. I will charge for processing and any kind of purification processes that need to go on. As that goes down the line, if I have to go through a terminal for liquids or whatever, I’m going to charge a terminaling fee. They determined they could create from all of those pieces greater value for their assets.
“So we saw the valuation of those assets go really high because each one became an individual business unit. It makes sense from the perspective that what you used to charge a dollar for, one end to the other, you could now charge $1.25 or $1.50, because people are just paying for the individual process. And it made it easy for these companies to raise money. Well, I’ve got this terminaling business that’s making this. I’ve got a storage business that’s making this. And each one has its own ability to raise funds.
“Both of these companies were pretty innovative. In the case of Kinder, an MLP is supposed to deliver consistent increasing dividends to their unit holders. Right? Is that really the way this model should work?
“Over the past several years, new organic growth opportunities have proliferated from the growth in tight oil and gas developments, many in geographies with limited existing infrastructure. There have been challenges to the MLP as the most efficient model, particularly as these companies grow. We’ve seen some people transition away from that.”
He said that when one thinks about natural gas in the United States, it’s easy to think that we have the most sophisticated infrastructure in the entire world. The problem we have is that all the new gas supply that came into the market was not located where those pipes were.
“If you think about in the Northeast, where we have the Marcellus and Utica plays and all these liquids and all this gas and some oil are coming into the market, the pipe infrastructure is not built to have gas there,” he said. “The pipe infrastructure in the United States is built to go from the Gulf Coast to the Northeast in a telescoping manner, so if you have demand in Boston that’s greater than what you get through a certain size of pipe, it’s not going to get there. That has created a significant issue, not just for infrastructure development. It’s like, ‘Who’s going to pay for this infrastructure?’ None of the generators want to pay. And utilities don’t want to build it because they won’t pay for it. So you’ve opened up a bit of a conundrum. But I think that’s being worked out.”
He said there are still companies in this industry that continue to build new infrastructure and new projects in order to make it more efficient and extract value from the market—and most of the companies are MLPs.
There are two types of companies involved in an MLP:
• A limited partner. “It has some limited distributions of cash flow. They receive periodic distributions from the general partner.”
• A general partner. “It runs the company and basically collects a fee based on how well that company does. They receive compensation based on how well this company is doing. Think about a curve that runs from your left to the right forever, called distributions. As long as those distributions are high and to the right, then that general partner is doing really well and those incentive distribution rights grow and grow and grow.”
He said that part of the problem they’re facing today is that 90% of an MLP’s assets must be derived from “qualifying” sources such as real estate, natural resources, and commodities.
Here’s the most important point: An MLP doesn’t pay taxes.
“All income and deductions pass through to unit holders—no ‘double taxation,’ ” he said. “What effect does it have on that company? That company has a lower cost of capital. Because they don’t pay taxes. They have a lower way to average the costs of capital.
“Let’s put this in practical terms,” Broxson said. “Let’s say that these two companies—a C-Corporation and an MLP—want to make the exact same amount of money. They want to make $50. The impact of that is for a C-Corporation, they would have to generate $120 in revenue to get to that same amount of money, where an MLP would only have to generate $100. That’s an oversimplified example, but I don’t think people understand that that’s the crux of what makes an MLP work.”
He said that traditionally, MLPs have rewarded the general partner for growth through what are known as Incentive Distribution Rights (IDRs). As the Limited Partnership performance improves, more of the profit is shared with the general partner.
“The IDRs provide significant value to the general partner, but can be a hindrance to the growth of the businesses controlled by the MLP,” he said. “As a result of this burden, many MLPs have eliminated these distributions, by either buying out the general partner or moving to a C-Corp model.”
He said MLPs appear to have a 1% to 2% cost of capital advantage over C-Corps.
“A lot of that is because when you look at an MLP’s beta—in finance, a beta is what shows the volatility in a company’s earnings—if you have an MLP and are charging mostly fixed fees for your service, it would tell you the risk and volatility is lower than an exploration company,” he said. “The beta of an E&P company is about 50% higher. The reason is an MLP is expecting they will make a lower rate of return than an exploration company or a C-Corp, so they can charge stable fees and bring in stable revenues. Lower beta, lower cost capital.”
He said MLPs have a 5% EBITDA return disadvantage vs. C-Corps, but tax and WACC advantages give them a 3% capital spread advantage.
“That means if you and I are in the market and I’m an MLP and you’re a C-Corp, and I want to bid for an asset and you want to bid for the same asset, I can pay a whole lot more for it than you can,” he said. “I have a lower expectation of return, I have a lower cost of capital, so I can borrow more money and can take that money and invest in those assets.
“This all works really well when the market is good. Everybody has always been worried, ‘What if the interest rates were to rise? What would that do to an MLP?’ It could have some effect. But I would argue that one of the big problems and challenges MLPs have is that they are too successful and they start buying assets under the model I just described and they take on more and more risk. As a result of that, they start getting squeezed, their beta goes up. So you can go and look at any of the large MLPs and you can see a lot of them will have taken on more and more risk. Their investors start running from them and that creates a problem.”
He gave these tips for structuring for investment and growth
• Not all projects are qualified for MLP treatment.
• At times MLPs may need to execute a new “greenfield” project.
• Large MLPs are sufficiently capitalized to fund their own growth by creating an “incubator” company for future asset growth.
• Smaller MLPs may need to look at outside sources of capital and asset development to accomplish growth objectives
• Sources of capital can include private equity, bank financing, or bonds. ♦