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February 24, 2010

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MLP Basics V - Subsector Overview

This post will initiate what I hope to be a routine Wednesday post.  This week, I’ll continue with the MLP basics series of posts.  Other posts on the subject of MLP basics will include: history of performance, discussion of prevailing valuation techniques, a discussion of publicly traded general partners, and a summary of institutional ownership of MLPs, and the history of PIPEs into MLPs.  If you have any suggestions for additional topics or any questions you’d like answered, let me know and I’ll do a post on it.

Today’s post will focus on the characteristics of the assets underlying MLPs, and on organizing the different types of assets into groups.  Let’s start with the 3 broad buckets of natural resources: upstream, midstream and downstream.  Upstream refers to the exploration and production of oil and gas from the wellhead.  Midstream refers to the gathering, treating, processing, transportation or storage of a product after it is produced, but before it gets distributed to the end use market for consumption.  Downstream, for me at least, refers to the sale of products after they are refined or processed.  Some people include refining in downstream, but I include refining in midstream.

All MLPs fall into either the upstream or midstream categories.  Based on the natural resource in question and the method of transportation, MLP assets can be categorized into several other more narrow subsectors, which I’ve outlined below.  Generally speaking, the closer to the wellhead an MLP’s assets are (i.e. the further upstream), the more commodity price exposure they have (if left to operate unhedged).
So, below, I’ll list the sectors, then summarize some of the key points of the upstream subsector.


MLP Subsectors

  1. Upstream
    • Natural Gas and Crude Oil
    • Coal
  2. Midstream
    • Natural Gas
      • Gathering and Processing, NGLs
      • Compression
      • Natural Gas Pipelines
    • Crude Oil
      • Crude Oil Pipelines
      • Refining
      • Refined Product Pipelines
    • Propane and Heating Oil
    • LNG
    • Marine Transportation
  3. Other
  4. General Partnership Interests


Upstream MLPs

Natural Gas and Crude oil
Upstream natural gas and oil MLPs operate assets that exploit and develop oil and natural gas producing properties.  The oil and natural gas produced from the wellheads of these MLPs is sold to various third parties.  Key characteristics of this subsector include:

  • Modern upstream MLPs typically do not engage in exploration, focus on exploiting mature fields in mature basins with low production decline rates and high reserves to production ratios (reserve life)
  • Annual production required to replace is low, production is replaced via low risk development opportunities
  • Production replacement drilling expense is what most of these MLPs consider their annual maintenance capex
  • Predictable production stream of natural gas and oil

The other main variables to cash flow of these upstream MLPs are (1) drilling / operating costs, and (2) the prices that they can get for the natural gas or oil they produce.  Variability in commodity prices can be mitigated through active hedging programs.  Upstream natural gas and oil MLPs typically lock in prices for 70% or more of their anticipated production for 2-3 years forward.  But attention must be paid to when their hedges roll off and at for what prices they’ve locked in for their hedges, as some MLPs have hedged for 2010 and 2011 at oil prices above $100 per barrel and natural gas prices above $8 per MMbtu.

The primary growth driver for these MLPs is their ability to acquire additional mature reserves at reasonable prices. Because of the need to find assets to acquire in order to grow, E&P MLPs with parent companies with assets to sell down the MLP tend to be more attractive than independent E&P MLPs.  ENP, EVEP, PSE have significant parent companies, while VNR, LINE and LGCY do not have access to intercompany assets.  Also, growth could come from commodity price increases for the portion of their production that remains unhedged (or for all of their production if you take the long term view).
Primary risks include:

  • Inability to find acquisition opportunities
  • Sustained decline in commodity prices
  • Unattractive prices for hedges

Upstream MLPs compensate for their higher business risk by operating more conservatively than other MLPs (carrying lower debt levels and higher distribution coverage levels).

There are three coal related MLPs: ARLP, NRP and PVR.  ARLP is the only MLP that directly mines coal itself.  ARLP’s business is similar to the natural gas and oil MLPs above, except that ARLP cannot hedge its prices, instead ARLP must rely on long-term contracts (1-3 years, with fixed prices) and a mix of those contracts to ensure that only a portion of its production is up for new contract each year.

The other two coal-related MLPs are actually coal royalty businesses, which means they engage in long-term leases with coal producers that provides those producers the right to mine coal reserves on that MLP’s property in exchange for royalty payments.  The royalty agreements specify payments based on volume of coal produced and the price at which that coal is sold.  These MLPs have no operating costs, and their operating costs consist primarily of administrative and corporate expenses.

Drivers for coal MLPs:

  • Electricity demand (~90% of coal in US is consumed by electric utilities)
    • Generally dependent on economic growth
  • Weather, which affect demand for electricity
  • Relative price of natural gas compared with coal, as some utilities can switch between the two fuels based on which is cheapest
  • Environmental regulations which can raise costs for production of coal and can reduce demand from utilities
  • Demand (predominantly international) for steel, which uses metallurgical coal in its production
    • Driven by construction demand in China currently

Risks are (1) sustained cheap natural gas prices relative to coal prices, (2) sustained economic recession, (3) declining coal prices, and (4) environmental regulations.

Next week: overview of midstream subsector.


Disclosure: Curbstone currently has a position in ENP. Also, Curbstone Group does not know your personal financial situation, so the information contained in this post represents the opinions of the staff of Curbstone Group, and should not be construed as personalized investment advice.

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