In today's energy midstream master limited partnerships (MLPs), debt and equity capital are needed to feed demands for growth to increase distributions to investors and to replace available cash paid to limited partners each quarter. Fortunately for the midstream MLPs, accessing capital, through debt or equity markets, currently is not a problem, as the financial success of the low-risk entities continues to attract new revenues.

MLPs are the fastest growing element in the midstream business and the dominant builders and owners of midstream infrastructure expansions. High yields, commodity price risk management and tax efficiency have made MLPs attractive financial structures. Most MLPs are involved in processing, transporting and storing crude oil, natural gas and natural gas liquids—activities that can limit direct exposure to commodity prices depending on contract structure. Where shifting oil and gas prices expose midstream firms to changes in processing or fractionation spreads, MLPs tend to hedge out a significant portion of that risk.

"Since MLPs pay out the majority of their cash flow in the form of distributions, but spend significant capital to grow, they are highly dependent on the debt and equity capital markets," says Michael Blum, an analyst for Wells Fargo Securities.

"MLPs are generally thought to have a lower cost of capital than C-corporations, all else being equal, due to their tax-advantaged partnership structure and initial low cash flow outlay to the general partner of 2%."

“Post credit crisis, the enormous secular growth opportunity facing the MLP sector has met declining debt capital costs as shown by persistently low revolving-credit rates, driven by historically low short-term benchmark rates.” — Ethan Bellamy, director and senior research analyst, Robert W. Baird Co.

However, this cost-of-capital benefit is temporary, and exists only when the MLP is at the lower incentive distribution level, he says. This advantage erodes over time due to the incentive distribution rights (IDRs).

"As the MLP increases its distribution, it must pay a greater percentage of its total cash flow to the general partner," Blum explains. "Thus, paradoxically, as the MLP is more successful in raising distributions, its cost of capital increases and this advantage erodes away."

IDRs allow the holder, typically the general partner (GP), to receive an incentive, or an increasing percentage, of quarterly distributions once target distribution thresholds have been achieved. In some partnerships, a GP can receive as much as 50% of every incremental dollar paid to limited partnership unit holders.

Investment-grade MLPs

Today, only 15 midstream MLPs are rated investment grade. Yields on non-investment-grade MLPs are higher because there's more perceived risk and, as a result, their cost of financing is higher for both debt and equity. The extent that an MLP can move from non-investment grade to investment grade improves its valuation and lowers its capital cost.

"It's all up to the rating agencies, but, in general, you have to have a certain size and scope, your cash flows have to be of a certain stability and your balance sheet has to be of certain metrics," Blum explains. "From a size perspective, I think that is $250 to $350 million in EBITDA (or earnings before interest, income taxes, depreciation, amortization and accretion). From a balance-sheet perspective, it means having a debt-to-EBITDA ratio of 4-times or less. And, in general, cash flow needs to be mostly derived from fee-based activities."

Ethan Bellamy, a director and senior research analyst for Robert W. Baird Co., notes that MLPs have been a great conduit for efficiently applying capital to the market. "Post credit crisis, the enormous secular growth opportunity facing the MLP sector has met declining debt capital costs as shown by persistently low revolving-credit rates, driven by historically low short-term benchmark rates."

Bellamy says that Baird estimates that the average MLP is paying London Interbank Offered Rate (LIBOR) plus an average of 216 basis points (at press time) for revolving debt, which is "very attractive" when considering the array of projects that can produce mid-digit unlevered returns.

"While the lack of a robust economic recovery and heightened volatility driven by Eurozone fragility might have been expected to encourage deleveraging, we haven't seen it. The debt-to-equity ratio of the MLP sector has remained relatively stable, likely because low borrowing costs are too alluring to pass up," he says.

Enormous sector expansion, both through organic growth and acquisitions, is made all the more profitable by the enhanced return on equity (ROE) produced by cheap credit. In stark contrast to consumer credit, corporate lending appears "as healthy as it has ever been," particularly for strong cash flow generators like MLPs.

"We have seen a number of general partner buy-ins by limited partners, but we don't think this is a one-way trend," says Bellamy. "You buy-in your GP for a few reasons. First, you've grown distributions so much that you enter the high splits and start to ramp up the cost of capital for the partnership materially. A GP buy-in eliminates this issue and can make the partnership more competitive in the acquisition market.

"Second, we saw a wave of rollups driven in part by concerns that tax legislation could negatively impact the incentive payments to the general partner. Rather than take a big potential tax hit, some GPs opted to eliminate the risk and take money off the table. This issue has largely passed as a concern now.

"Third, and most important and underappreciated, we see the GP roll up as the final stage in a private-equity life-cycle plan. If you are a private-equity investor, you maximize your returns by bringing the LP public, growing distributions, bringing the GP public, growing distributions further, and then taking out the GP once growth begins to slow."

Bellamy explains that, in this sense, a private-equity firm will have three windows of value realization—the initial public offering (IPO) of the LP, the IPO of the GP and the final disposition of the GP. "While it is never that clean or simple, the potential returns from a successful execution of this strategy over the life cycle of an investment make it clear to us that we will continue to see both GP rollups and new GP IPOs."

Midstream dominates MLPs

In the U.S., the oil and natural gas midstream sector accounted for 45% of the number of all MLPs, while the exploration and production (E&P) sector accounted for 12%, according to Mary Lyman, executive director of the National Association of Publicly Traded Partnerships (PTP), a trade association. That's a reversal from 1990, when E&Ps accounted for 21% and midstream 10%.

At yearend 2011, there were 100 MLPs or PTPs traded on public exchanges and 76 of those are energy related. The exact statistics vary with daily stock fluctuations, but total market capitalization of the MLPs and PTPs was estimated at $301.2 billion, with the energy and natural resources sector accounting for about 93%.

“Since MLPs pay out the majority of their cash flow in the form of distributions, but spend significant capital to grow, they are highly dependent on the debt and equity capital market.” — Michael Blum, analyst, Wells Fargo Securities

Midstream accounted for about 69% of total MLP capitalization, compared to E&P MLPs, which, even with a rebound since 2006, accounted for just less than 5.5%. Midstream MLPs totaled an estimated market capitalization of about $207 bllion.

The terms MLPs and PTPs are often used interchangeably, however. MLPs typically refer to those partnerships that operate under the natural resources exemption for publicly traded partnerships in the Internal Revenue Code. PTPs, a broader term, encompass MLPs as well as real estate and financial partnerships that operate outside of energy.

Two 2011 IPOs

The two new midstream MLPs, Inergy Midstream LP and Rose Rock Midstream LP, each held IPOs in December 2011. Inergy Midstream LP was spun off from Inergy LP and consists of northeast storage and transportation properties, including four natural gas storage facilities in upstate New York, all in proximity to the Marcellus shale, with a combined working-gas capacity of 41 billion cubic feet (Bcf). The IPO priced 16 million units at $17 per unit. The unit sales represent about 21.6% of the midstream entity's value, with Inergy LP, the general partner, holding the remaining units.

Rose Rock is a spin-off of SemGroup Corp., a publicly held company that moves energy through a network of pipelines, terminals and storage tanks. The IPO of 7 million units, or about 41% of the enterprise value, was priced at $20 per unit. SemGroup Corp. will indirectly own the remaining equity interests in Rose Rock Midstream, including the general partner interest and the related incentive distribution rights. Earlier in 2011, SemGroup rejected an unsolicited bid to be acquired by Plains All American Pipeline LP for $24 a share, or about $1 billion.

Also in December 2011, EQT Corp. said it would spin off its pipeline division (Equitrans), and sell shares or units beginning in 2012 to raise up to $300 million to fund EQT's E&P efforts of its Marcellus shale interests. EQT believes that maintaining control of midstream assets and future developments is integral to its E&P operations. Analysts expect that IPO to raise about $300 million.

Industry's largest MLP

Even among MLPs, companies often cite some uniqueness, related to capital access, as a competitive advantage. One of the newer midstream MLPs, Chesapeake Midstream Partners LP, touts its relationships with Chesapeake Energy Corp. and Global Infrastructure Partners (GIP), as a competitive advantage.

Chesapeake Midstream was started with about $1.2 billion worth of Chesapeake Energy's pipelines. GIP invested about $588 million initially when Chesapeake Midstream was formed in 2009. The venture went public in 2010, with more than 24 million common units offered at $21 each. Since then, Chesapeake Midstream has benefitted from drop-down acquisitions.

Mike Stice, chief executive of Chesapeake Midstream, says that Chesapeake's drop-down of assets will continue to occur once a year with the MLP largely staying away from third-party acquisitions aside from bolt-ons.

"What we're finding, more often than not, is that when other parties are buying into a basin, they're paying quite a bit of premium for that. Frankly, we don't need to pay and compete for that premium because of our relationship with Chesapeake," Stice says. "We have entered into long-term gas gathering agreements with Chesapeake and Total that include minimum volume commitments, periodic fee redeterminations and other contractual provisions that are intended to support the stability of our cash flows."

In April 2011, the company obtained $350 million senior unsecured notes at a rate of 5.875%, due 2021. That yield equated to a 240 basis points spread versus U.S. 10-year treasuries. In October 2011, Chesapeake Midstream priced an underwritten public offering of 10 million common units representing limited partner interests owned by GIP, which offered the common units to the public at $26.65 per unit. Also in October, Chesapeake Midstream declared a cash distribution of $0.375 per limited partner unit for the 2011 third quarter. The third quarter distribution represents an increase of 3.4% compared to the 2011 second quarter. In November, it projected its 2011 earnings would be about $340 million.

"Chesapeake Midstream is targeting a 2.5-times debt-to-EBITDA ratio, which will be achieved by a 50-50 debt and equity funding of investments beyond the use of our current liquidity of $700 million," Stice says.

An example of the drop-down strategy occurred during the last week of 2011 when Chesapeake Midstream announced it will buy Appalachia Midstream Services from Chesapeake Energy for $865 million. Appalachia Midstream Services includes a 200-mile gathering system in the Marcellus Shale formation. That gathering system transports more than 1 Bcf per day and has 15-year contracts with gas producers.

Chesapeake Midstream will finance the acquisition with $600 million in cash drawn from its revolving credit facility and equity consideration of $265 million, increasing Chesapeake Energy's stake in the partnership to 46.1% from 42.3%. It was the second drop-down deal and comes a little more than a year after Chesapeake Midstream bought Louisiana pipelines in the Haynesville Shale from a Chesapeake Energy subsidiary for $500 million.

Chesapeake Midstream says the purchase makes it the industry's largest gathering and processing MLP by throughput volume.

Chesapeake Energy, the second largest U.S. producer of natural gas behind ExxonMobil Corp., and the country's most prolific gas-well driller, worked to sell assets and curtail spending in 2011 as part of its strategy to cut long-term debt by about 25%. Chesapeake Energy's chief executive, Aubrey McClendon, says the company plans to eventually sell gathering systems in production fields in Ohio, Texas, Oklahoma and Kansas to Chesapeake Midstream.

Eliminate the IDR

Another major MLP, Enterprise Energy Products LP, cites that low-cost, even relative to other midstream MLPs, is a competitive advantage for the company. Enterprise Products Co. and its privately held affiliates, together with management, own about 39% of the limited partner units.

To achieve its benchmark, Enterprise capped the GP's IDR at 25% in 2002, eliminating its 50%-top-tier split. The result was some $325 million of annual savings in cash distributions that would have gone to the general partner, based on an annualized third quarter 2010 distribution rate of $2.33. Cumulative savings from third-quarter 2004 through third-quarter 2010 was $826 million.

Then, on November 22, 2010, Enterprise took an even more dramatic step by eliminating IDR payments when it merged with its general partner, Enterprise GP Holdings LP. The cash savings from eliminating the IDR payments to the general partner increases the intrinsic value of Enterprise's limited partner units and significantly lowers Enterprise's long-term cost of capital, according to Michael Creel, president and chief executive.

“We expand infrastructure and cash flow as the shale play life cycles mature.” — Robert G. Phillips, chairman, president and chief executive, Crestwood Midstream Partners LP

Meanwhile, in 2001, Enterprise Products sold its Mississippi natural gas storage facilities, Petal Gas Storage LLC and Hattiesburg Gas Storage Co., for $550 million to Boardwalk HL Storage Co. LLC. The salt-cavern storage facilities have a combined working gas capacity of 18.7 Bcf.

"While we believe our Mississippi natural gas storage complex is one of the most attractive on the U.S. Gulf Coast, the complex is a standalone asset that does not integrate with our natural gas pipeline systems," Creel said when announcing that deal. "Including this transaction, we have sold approximately $1 billion of assets in 2011 that Enterprise acquired through mergers that were either standalone facilities or assets that were not strategic to our system."

Enterprise, in presentations made in November 2011, said it had completed $2.9 billion of capital projects in 2010 and 2011. Now, major capital projects under construction total about $4.5 billion. A driving force behind Enterprise's growth strategy is the petrochemical industry's growing demand for NGL-derived feedstocks, primarily ethane.

Also, in November, Creel told investors that Enterprise, which had completed its merger with Duncan Energy Partners in September, remains open to appropriate acquisitions, but will continue to focus its growth strategy on building new infrastructure rather than through acquisitions. Creel noted that acquisitions remain expensive because many MLPs don't appear to have many other ways to grow other than by acquiring assets.

Enterprise executive vice president and chief operating officer, Jim Teague, notes, "If you buy something, there is invariably something that you can't use or have to get rid of. We like building."

Growth by acquisitions

Crestwood Midstream Partners LP, formerly named Quicksilver Gas Services LP, cites its unique relationship with First Reserve Corp., a $20-billion global energy-focused private-equity firm, as a competitive advantage paving the path for capital access. Crestwood's general partner is owned and managed by Crestwood Holdings Partners LLC, a partnership between First Reserve and the Crestwood management team.

Crestwood's management team consists of midstream industry veterans led by Robert G. Phillips, former chief executive of several U.S. midstream energy entities, including Enterprise Products Partners, GulfTerra Energy Partners and El Paso Field Services. Phillips is chairman, president and chief executive of Crestwood's general partner.

"We expand infrastructure and cash flow as the shale play life cycles mature," says Phillips. "We lower our risk through long-term, fixed fee contracts. We align with experienced shale producers. We invest in diversified basins with core acreage dedications. We are a pure play, shale play, midstream company."

In October 2010, Crestwood Holdings acquired 100% of the general partner and about 62% of the common units of Quicksilver Gas Services LP for $701 million and changed the name to Crestwood Midstream Partners LP. The company plans to fund long-term growth with 50-50 debt-equity mix, plus retained cash flow, Phillips says. His financial objective is to keep long-term debt to adjusted EBITDA at less than 4-times, and maintain ample liquidity of greater than $100 million.

To grow the company, on February 1, 2011, Crestwood acquired the Las Animas gas-gathering system in the emerging liquids-rich Avalon shale in southeastern New Mexico for $5.1 million from a group of independent producers. The acquisition represented the first extension beyond the Barnett shale area for Crestwood Midstream.

On April 1, 2011, Crestwood completed a $338 million acquisition of assets in the Fayetteville shale and the Granite Wash from Frontier Gas Services LLC.

On November 1, Crestwood Midstream completed the acquisition of Tristate Sabine LLC from affiliates of Energy Spectrum Capital, Zwolle Pipeline LLC and the Tristate management. Crestwood Midstream paid $65 million at closing which was funded with available capacity under its revolving credit facility. An additional $8 million deferred purchase payment will be paid on November 1, 2012.

The assets include some 61 miles of high-pressure natural gas gathering pipelines and carbon-dioxide-treating facilities in Sabine Parish, Louisiana. Crestwood is also acquiring gathering and treating contracts on the Sabine system, which dedicate about 20,000 acres under long-term, fixed-fee arrangements. The system's capacity is being expanded to 100 million cubic feet (MMcf) per day of gathering and 80 MMcf per day of treating.

"The acreage dedicated to the Sabine system has produced some classic Haynesville-Bossier wells with large expected ultimate recoveries and high initial production rates over the past two years," says Phillips. "Many of these wells have been choked back due to system capacity constraints, which are being resolved with the current 12-inch-diameter expansion project."

On the financial front, Crestwood issued $200 million senior unsecured notes, in April 2011, at 7.75%, which are due in 2019. In May, Crestwood announced a public offering of 1,800,000 common units at $30.65 each, used to reduce indebtedness under its revolving credit facility and for general partnership purposes.

"We increased the third quarter 2011 distribution to $0.48 per unit, which represents a 14% increase over the $0.42 per unit distribution for the third quarter of 2010, due to continued increases in volumes, adjusted EBITDA and distributable cash flow," explains Phillips.

30-year anniversary

Energy MLPs marked their 30-year anniversary of existence in 2011. Surprisingly, E&P companies initiated and grew the first MLPs in the 1980s. The first MLP was launched in 1981 by Apache Oil Co. to raise capital from small investors by offering them a partnership investment in an affordable and liquid security.

During the late 1980s and the 1990s, E&P MLPs fell into disfavor with investors as many of the original oil and gas MLPs left the market because they were unable to maintain distributions as oil and natural gas prices dropped.

Midstream MLPs became favored, with some E&Ps spinning off their midstream assets and nearly depleting the E&P MLPs until 2006. E&P MLPs, exploiting long-lived reservoirs and using hedging tools, began rebounding.