How the Pioneer of Hydraulic Fracturing changed the MLP Landscape
George P. Mitchell 1919 - 2013
The year 2013 will be remembered for many things, but in the oil and gas sector it will be remembered for the passing of one of the historic figures of the industry, George P. Mitchell, pioneer of the hydraulic fracturing technique to unlock hydrocarbon reserves from shale formations. Frankly, when the history of U.S. business is written in 100 years, we believe this innovation will be considered one of the most consequential of the late 20th century. Fracturing is credited with putting the U.S. on track to be the largest producer of hydrocarbons in the world in a few years, surpassing even Saudi Arabia. The resulting massive increase in domestic oil, gas, and natural gas liquids production is being felt in numerous fundamental ways throughout the economy. Electric generating capacity powered by natural gas is supplanting coal-fired generators, leading to dramatic reductions in carbon output. Plentiful and cheap natural gas and natural gas liquids have sparked a boom in new chemical and fertilizer capacity in the U.S., changing the landscape of the world chemical and food industries. Cheap energy is also a factor in revitalizing American manufacturing, as many industries locate facilities in the U.S. to capitalize on this competitive advantage. Other implications of this innovation on currencies, trade, and politics are only now starting to be felt and can only be guessed at what they may ultimately be.
George Mitchell lived long enough to see the fruits of his labors start to make an impact. His story is a classic American success story. A poor Greek immigrant, he graduated first in his class from Texas A&M University with a degree in Petroleum Engineering. He founded Mitchell Energy & Development, an independent exploration and production company credited with many major conventional oil and gas finds. In the early 1980s, against the advice of many of his peers and conventional wisdom, he started experimenting with hydraulic fracturing in the Barnett Shale around Dallas/Ft. Worth. After nearly 20 years of experimentation, with funding help from the Department of Energy, Mitchell found success in using the technique in combination with recently invented horizontal drilling methods to unleash prodigious quantities of hydrocarbons from previously inaccessible shale formations.
It is fitting that MLP investors salute the accomplishments of George Mitchell as one implication of hydraulic fracturing of shale formations is the need for new midstream infrastructure to store, process, and transport massive new quantities of hydrocarbons hydraulic fracturing has spawned. The proliferation of attractive new investment opportunities in the midstream energy sector has fueled an increase in capital spending and acquisition opportunities for existing companies as well as presented an opportunity for new companies to be established. These attractive new investment opportunities have helped post impressive returns for publicly listed MLPs and midstream energy infrastructure companies over the last several years.
A Record Year for MLP Capital Raising
MLPs raised a record amount of capital in 2013 fueled by IPOs, acquisitions, and new organic capital projects. The fourth quarter saw over $4.1 billion in MLP equity public offerings bringing total MLP equity issuance to nearly $36 billion last year. This does not include equity raised in “at the market” programs where companies sell steadily but continuously in the public markets, subject to SEC guidelines. This method has become very popular with MLPs which have steady capital raising needs, and we estimate that the amount raised “at the market” tripled in 2013 over 2012 to nearly $5 billion. The IPO market was particularly busy in the fourth quarter with nine MLPs or C-Corp equivalents coming public, bringing the 2013 total to 22 new companies in our universe. The fourth quarter saw the largest MLP IPO offering in history with the $2.9 billion offering of Plains GP Holdings, LP, the General Partner of Plains All American Pipelines. MLPs also raised a significant amount of bonds as both investment-grade and non-investment grade MLPs continued to take advantage of record low interest rates to lock in long term financing at favorable terms. Companies issued low cost debt mainly to fund construction projects and to refinance higher cost debt, both of which should increase the available cash flow for distribution going forward.
New MLP dedicated investment vehicles continue to funnel funds into the MLP asset class. In November, a new closed-end fund raised $826.3 million, which with leverage should inject nearly $1.1 billion in new funds into the public MLP markets. MLP dedicated open-end funds, ETNs and ETFs also continue to grow significantly and this past quarter was no exception. Open-end mutual funds focusing on MLPs are the newest and fastest growing source of funds to the sector, with over $9 billion invested in these new vehicles alone. While the growth in MLP-focused open-ended funds is dramatic, many of these new investment vehicles are relatively young and are still a small fraction of the total sector market capitalization.
Underlying this need for capital is the requirement for infrastructure to develop new hydrocarbon basins. The U.S. Energy Information Administration continues to increase its estimates of domestic oil production unleashed by new drilling technologies in unconventional formations; in December in its Annual Energy Outlook, it projects that U.S. oil production will increase to 9.5 million barrels a day, near the all-time high for the U.S. set in 1970. As for gas production, where the U.S. is already the largest producer in the world, it forecasts continued increases over the next 25 years. The current abundance of new hydrocarbons from different geographies has, we believe, created many good investments for MLPs and midstream energy infrastructure companies.
A significant development worth noting in the MLP space is the number of energy exploration and production (“E&P”) companies making moves to monetize their midstream assets by selling these assets to existing MLPs or spinning them off into new MLPs. The E&P sector appears to be following the example set by refiners which showed significant value creation and uplift to share prices by a similar monetizing of midstream assets starting some years ago. E&P companies that have established MLPs to monetize their midstream assets include Anadarko with Western Gas Partners, EQT Corporation with EQT Midstream, and QEP Resources with QEP Midstream Partners. This trend was further highlighted in the quarter by Devon Energy’s announcement of an innovative deal to merge its midstream assets with those of Crosstex Energy, LP, creating a new GP and LP and essentially bypassing the usual IPO process for a new midstream MLP. This $5 billion deal was very well received by shareholders of Devon and Crosstex and should close in the first quarter of 2014. By monetizing its midstream assets with an MLP, Devon is able to raise funds for its E&P capex program while at the same time creating an entity (the MLP) that is a much more economical way to finance its midstream needs. As more and more E&P companies understand the advantages of this structure, we expect to see more of them use the MLP structure.
A number of MLPs announced material new capital investments. Kinder Morgan announced it was initiating the regulatory approval process for the Trans Mountain Pipeline, a $5.4 billion project to transport oil from the oil sands of Alberta west over the Rockies to export facilities in British Columbia. El Paso Pipelines will move forward with a $500 million expansion of its Elba Island LNG terminal (jointly owned with Royal Dutch Shell) pending FERC approval. Oneok announced during the quarter an additional $650-780 million of Williston Basin (Bakken shale) growth capital projects, building on its impressive array of projects in that area. Buckeye Partners added to its liquid terminal business by buying 20 terminals from Hess Petroleum, including one Caribbean facility in St. Lucia that should be synergistic with Buckeye’s existing BORCO terminal. NGL Energy Partners acquired Gavilon, a midstream company focused on crude and refined products for $900 million in early December. Energy Transfer Equity and Energy Transfer Partners announced more details on their financing plans for their $11 billion St. Charles LNG facility; in particular, they announced that they would create a new public entity to own the facility.
Politics Promotes Gridlock - Again
We continue to believe that a major change in the tax status of MLPs is not likely to occur any time soon. The greatest threat to the MLP tax status has always been a general tax reform that rewrites the corporate tax code and in the process impacts the MLP structure. However, this prospect probably just became much less likely as Senator Max Baucus recently announced he will retire early to accept the Ambassadorship to China. Senator Max Baucus is the Chairman of the Senate Finance Committee, which is charged with overseeing tax legislation, and he had expressed that his greatest wish was that Congress pass a general tax reform before his retirement at the end of 2014. No Max Baucus probably means no tax reform, which in our view probably means status quo prevails with the MLP tax structure for the time being.
Baucus’ likely replacement as Chair of the Senate Finance Committee is the environmentally oriented Ron Wyden of Oregon, who might improve the prospects for the current bill before the Senate to expand the MLP tax structure to renewable energy investments. The upshot is that we believe it is more likely in the near term that the MLP structure might be expanded rather than restricted. That said, predicting what is going to come out of Washington is always anyone’s guess; but at this point we guess that the tax status of MLPs is relatively safe from political interference.
Long Term Outlook: Positive
As we look into the future, we continue to believe that over the next five years the MLP/midstream energy infrastructure market should be able to generate real annual returns through a combination of yield and price appreciation. We believe valuations, while not as attractive as they were a year ago, are still attractive relative to most other asset classes. The average MLP yield is about 5.8%, down from about 6.6% at the beginning of 2013 but still fairly high. Given the recent rise of interest rates, spreads of MLP yields versus Treasuries, REITS, corporate bonds, and high yield bonds have compressed from unusually high levels but still remain above or close to the long-term average. We think the outlook for distribution growth is also healthy, driven by accretive capital projects and the availability of asset acquisitions. So despite the sharp run up this year, our positive outlook for the next twelve months remains intact.
While rates on fixed income, REITs, and utility securities rose in the quarter, they are still absolutely low in a relative and historic context. In contrast, while MLP yields are lower than before, we feel they still appear attractive to the yield oriented investor. We believe that the demographic trend of an aging population retiring and expecting to live off their investments will result in a wider investor base seeking out the potential income generation of the MLP asset class. We believe the growth in the distribution that MLPs/midstream energy infrastructure assets offer is a further attraction to those wishing to stay ahead of inflation and earn positive real returns as well as a buffer to rising rates in the long term.
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