When Ambition Exceeds Means: Incentives And The Limits To MLP Growth

By Chris Ross, Executive Professor, C.T. Bauer College of Business & Vikram Enjam, MBA Candidate, C.T. Bauer College of Business

Midstream master limited partnerships, or MLPs, rode the boom in oil prices, offering investors low risk and tax advantages with slow but steadily increasing distributions. That growth stalled with the 2015 price collapse, and a recent study has offered some lessons on how this unique form of publicly traded company can best be structured to ensure long-term success.

The initial growth was mainly inorganic, as MLPs acquired midstream assets divested by the major oil companies. The shale revolution opened new growth opportunities to “replumb” oil and gas supply chains by connecting growing oil and gas production to established demand centers. This building boom for pipelines and other midstream infrastructure allowed MLPs to boost their distributions to investors.

Plunging prices in 2015 acted as a stress test on this more expansive value proposition. Companies with gas processing assets structured as “percent of proceeds” contracts suffered from the shrinking spread between oil and natural gas prices. Low prices raised questions about whether oil and gas production growth could be sustained, possibly leading to fewer “replumbing” opportunities.

That prompted a series of transactions as MLPs were acquired, merged or changed from master limited partnerships to C-Corp structures.

At the University of Houston’s Bauer College of Business, we were interested in what caused these transactions and what was different about the companies that were acquired compared to those that remained in the MLP structure.

A student research project examined the 2014 and 2015 financial results of a set of MLPs. Our study of 13 master limited partnerships over the period of dramatically dropping commodity prices offered some lessons about which corporate structures seemed best fitted for different corporate strategies.

We found the companies studied all lost unit-holder value, with the weakest performer, Targa, losing over 60% of its total unit-holder value (TUR) from the end of 2014 to end 2015, while the company with the least erosion in value, Magellan, lost just 10% (Figure 1). It is also noteworthy that three of the four worst-performing MLPs were among those involved in transactions that changed their corporate status.

Source: S&P Capital IQ and UH Bauer Research

We also collected financial data from 2014 and 2015 to see whether financial performance might account for the relative loss of total unit-holder returns. Our set of MLPs included nine (solid bars) which had a general partner awarded incentive distribution rights (IDRs) under the partnership agreement, designed to encourage the general partner to grow distributions to all invested partners, and four (striped bars) that had no incentive distribution obligations (striped bars).

Specifically, we looked at the following:

  • “GP Take” at end 2015, calculated by Alerian as the proportion of total distributions at the end of 2015 paid to the general partner, including IDRs.
  • 2014 pay-out ratio calculated as total distributions paid/distributable cash flow to see whether high pay-out of cash flow in 2014 was linked to high or low total unit-holder returns in 2015.
  • Capital spending/total assets to see whether erosion of total unit-holder returns in 2015 was linked to high or low capital spending on organic growth during 2014.
  • Net acquisition and divestiture expenditures to see whether they were viewed differently from capital spending.