The Future Of MLPs - When Your Customer Goes Bankrupt

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Includes: AMLP, CEQP, CHK, ETE, WMB, WPZ
by: Small Cap Capital

Summary

A recent announcement by Chesapeake Energy brought further decline to MLP valuation.

Understanding of the legal framework of gathering/processing agreements and its implication from a practical perspective are essential.

Views on MLP valuation and where it settles in the medium term.

On Feb. 8, 2016, Chesapeake Energy (NYSE:CHK) confirmed that it has retained Kirkland & Ellis to help restructure its $9.8 billion debt load. Based on today's environment and continued headlines of E&P bankruptcies, the news was perceived as a prelude for CHK's ultimate demise (it was already a potential bankruptcy candidate even prior to this announcement). While CHK's name alone carries gravitas, Energy Transfer Equity (NYSE:ETE) and Williams Partners (NYSE:WPZ) also plummeted on the news.

CHK, ETE, WPZ - February 8, 2016

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For those who do not follow the space, CHK used to own a midstream subsidiary, Access Midstream, for which CHK was the anchor tenant on the system. Access Midstream was sold to Global Infrastructure Partners in 2009 and subsequently sold to Williams (WMB, WPZ). As a result, Williams is heavily reliant on CHK as a key counterparty, and CHK's bankruptcy could heavily impair the value of Williams (~$13 billion undiscounted commitments from CHK). In late 2015, Energy Transfer announced an acquisition of Williams for $38 billion, which has not closed yet. In conclusion, CHK's bankruptcy could prevent the deal from closing (rightfully so, despite the exorbitant breakup fee). On the same day, ETE also announced that its CFO, Jamie Welch, is stepping down.

The recent - and currently ongoing - commodity price crash, among other things, has made investors skeptical about whether MLPs truly possess a utility-like characteristic (for this article, more specifically gathering and processing midstream assets). At face value, there are many overlapping characteristics from a contractual point of view - long-term contracts (10+ years in many cases) with protections such as acreage dedication, take-or-pay fee structure, minimum volume commitments ("MVC"), deficiency fee re-rates, and even inflation escalators in some cases. An important contractual provision that is either explicitly stated or has been widely assumed as an implicit provision is the concept of "covenants running with the land." This concept is applicable when ownership of the land changes hands, but has surfaced as an extremely important element in light of many E&P companies filing for bankruptcy. MLPs took a beating with commodity price decline and fading volume growth prospects - but now, the strength and viability of the contract itself is being questioned in light of continuing bankruptcies in the oil patch.

Before a dive into this in more detail, just a quick disclaimer: I am neither a lawyer nor a restructuring expert. Furthermore, while I write this article with intellectual integrity, there are no reps on accuracy and it contains my personal opinion.

There are a couple of elements around the strength of a gathering/processing agreement in the context of bankruptcy of the producer.

1. Survival of the gathering/processing agreement: A gathering/processing agreement is an executory contract, which under bankruptcy code is a contract on which performance remains due on both sides. Under bankruptcy, debtor (company that filed) may elect to assume or reject its executory contracts (with court approval), including gathering/processing agreements. The caveat here is that the court does not have the ability to cherry-pick certain provisions of an agreement - you can either outright accept or reject. If you are simply amending terms as part of the negotiation, this is behind-the-scenes negotiation, not the discretion of a bankruptcy court.

Risk: The debtor may elect to reject the gathering/processing agreement.

2. Remedies for non-payment: When a company files for bankruptcy, leading up to the point of filing, oftentimes it accrues payables that never get paid. Like most contracts, gathering/processing agreements have remedies and default provisions that permit exercise of such remedies by the counterparty, such as drawing on line of credit, litigation, termination of service, etc. However, once a company files for bankruptcy, due to automatic stay, the counterparty runs into difficulties around exercising such remedies. Furthermore, payables prior to filing are treated as pre-petition unsecured claims, and depending on how the bankruptcy case is resolved, the counterparty may never receive those payments (oilfield service contracts are different, because many times, they have mechanic's and materialman's liens against the mortgage and could encumber the oil & gas property - sometimes, this can prime senior debt claims). However, as a remedy during the period of bankruptcy, because gathering/processing providers are "critical" vendors, it is likely that gathering/processing fees are treated as administrative expense, and therefore, can be paid during bankruptcy.

Risk: Midstream providers may not be able to seek remedies for default or non-payment and may be required to continue their services throughout bankruptcy. This is not mutually exclusive with #1, as even with performance throughout bankruptcy, the contract may ultimately get rejected at the end of the bankruptcy process.

3. Covenants running with the land (or does it?): The concept itself means that covenants contained in the agreement cannot be separated from the land. So if a buyer comes and buys an acreage position from a producer that has an acreage dedication to XYZ Midstream, the next buyer is still subject to that acreage dedication. This restrictive covenant is either explicitly stated in gathering/processing agreements or has been implicitly understood to be true. In essence, if covenants are running with the land, the contract itself is part of the property/mineral interest rather than simply a service agreement. In early February, with respect to Sabine's (OTCPK:SOGCQ) bankruptcy case, Judge Shelley Chapman said she was inclined to rule that the gathering agreements do not contain covenants running with the land. If she were to rule in such way, that would serve as the basis for rejecting the gathering agreement (although, I suppose there are other ways of rejecting an agreement and it is highly circumstance-specific). If ruled in such a way, while I am not sure if this is the first ruling to state that covenants do not run with the land for a gathering/processing agreement, it would certainly corroborate other Chapter 11 situations where debtors are seeking to reject gathering/processing agreements.

Risk: Not only does this provide a basis for rejecting a contract under bankruptcy, one can sell producing wells and acreage to another buyer free and clear of midstream commitments (as it relates to the gathering/processing agreement).

These points do not encompass all pressure points in the context of bankruptcy, but are what I consider to be highly relevant points that determine the dynamics between debtor and midstream provider during bankruptcy. As with any legal language, everything is situation- and contract-specific, with lots of caveats and uncertainties that make one believe anything is possible. In today's environment, and especially under the context of bankruptcy, naturally people interpret these provisions with the worst-case scenario in mind and apply them across the entire sector. Now, to caveat this - yes, anything is truly possible. Every contract can be broken, new owners can be free of prior commitments, and service fees can be substantially reduced.

So, from an investor perspective, these are "real" risks. However, more importantly, the plethora of headline news and "risk" overhang are meaningless if you cannot somehow quantify the extent of such risks in light of changing market valuation. Now, there is no formulaic way of precisely predicting the probability of a "rejection" or the extent to which gathering/processing fees are reduced. In order to at least evaluate the likelihood of these events and understand the leverage dynamics in a hypothetical negotiation scenario, one has to understand the economics of the acreage position as well as the availability of competing midstream systems.

Below are two extreme hypothetical scenarios:

1. Good/economic acreage with no alternative midstream solutions: The debtor (E&P producer) has prolific acreage position and sees itself resuming drilling once commodity price is in a ~$40 oil / ~$2.50 gas price environment. In any case, the debtor wants to reduce MVC given that it does not see its production volume meeting the MVC for a while or wants to reduce the fee structure to improve margins and better position itself for future drilling. The midstream provider knows that there are no alternatives in the area, and without a gathering/processing system, the most prolific rock is worthless if there is no commercial outlet. The producer threatens rejection of the contract. The midstream provider knows that there is economic damage if volumes do not come from a certain producer. In any case, there are no alternatives, and not being able to transport and market hydrocarbon kills an E&P company. Also, a $0.10 reduction in gathering or processing fee is not a material value driver when it comes to drilling incentives. No "new" entrant in their right mind will build out a new system and spend tens of millions of dollars (if not more) to capture the debtor's volume - and if they do, they will have to charge a significant amount of fee as well to justify their capital spend. The midstream provider holds its line and does not budge while the debtor risks the timing of emergence from bankruptcy and millions in legal fees. There is back and forth negotiation, but the debtor walks away either outright accepting the gathering/processing agreement or gets a mini-victory by reducing MVC or gathering fee by a nominal amount.

2. Bad/uneconomic acreage with numerous alternative midstream solutions: The debtor has uneconomic acreage position (at least certain parts that correspond with a certain gathering/processing agreement at issue) and does not see itself drilling until commodity price is in a ~$100 oil / ~$4.50 gas price environment. In fact, it is contemplating shutting in certain parts of its existing production due to bloated cost structure and uneconomic marketing arrangements. The only way it at least keeps flowing existing production and/or gives the new equity owner of the company some future option value is if it gets rid of all MVC and materially lowers the gathering/processing fee. The debtor approaches the midstream provider, lays out its plan and conveys that there are numerous readily available alternatives to transport its hydrocarbon. Lastly, the debtor gives a hard deadline for a final response and concurrently prepares an argument to reject the gathering/processing agreement in court. The midstream provider either does not believe in the debtor's position or understands the reality that volume reductions are coming anyway, but would rather retain some production volume at a reduced rate given its capital investments are sunk cost. The midstream provider either agrees for a material reduction in MVC and/or fee structure or the debtor elects to reject the gathering/processing agreement in court.

These are two extreme scenarios, and most situations will fall somewhere in between. However, one thing to note is that midstream companies do, in fact, have a lot of leverage in these negotiations, and while looking at a state-wide or county-wide map might make it seem like there is a lot of midstream competition, even few miles of pipeline build-out costs a lot of money, and not all midstream systems have the same downstream interconnections (added complexity for the producer). In conclusion, while there are extreme scenarios (e.g., Sabine is pursuing an outright rejection of one gathering contract, and Quicksilver (NYSE:KWK) may be pursuing one as well), the likely outcome is not as draconian as it may seem just by reading the legal language.

There are nuanced elements such as quantity of volume (is it small enough that the producer would rather just truck its liquids and be more economic than to be burdened with large quantities of MVC?; on the flip side, is it large enough that it attracts a competing midstream system to spend the capital and still offer an attractive rate structure that beats the incumbent system?), type of hydrocarbon (you almost always have to pipe gas), type of gathering (is it wellhead which is stickier or do you tie in to a gathering system from a centralized distribution point such that you can divert volumes to a competitor just by "tying in"), level of aggressiveness of creditor group/management of debtor and midstream provider, restructuring plan (pursuing Section 363 sale or just emerge on a status-quo basis with a new capital structure), etc. Lastly, under any circumstance, prolonged bankruptcy process is extremely expensive, and nickel and diming over gathering/processing fee is only worth it when the situation merits such time commitment, as existing agreement terms are egregiously uneconomic.

Quick MLP valuation thoughts:

My opinion is that current yields already imply negative growth from a volume point of view. In fact, in a world where some of the largest midstream companies trade near 20% distribution yield (despite near 1.0x distribution coverage), equity valuation is pricing in secular (quasi-permanent) decline. While equities are valued with some remote possibility of default baked in (current valuations are low, not just in MLP terms but in terms of any sector), MLP credit yields certainly do not reinforce this argument (some of the highest distribution yielding names still have credit yields in the low teens). I guess there could be tremendous arbitrage opportunity on the credit side, and maybe these names are all short candidates on the credit side (I don't think so, but maybe I am wrong).

We are now 18 months in since the commodity price crash started, and we have not seen almost any reduction in supply volumes (which is what ultimately matters for MLPs). Now, the consensus is that despite the longer-than-expected lead time in volume reduction, US supply decline is coming. I agree with this, but my argument is that current valuation already prices this in. Some of the most bullish cases call for less than 10% reduction in oil production in the U.S. and nominal decline or flat volumes for natural gas production. If I had to make a bold call, you do not have to bake in too high of negative growth in terms of valuation (in the long run). Some may say that volume declines will be higher than these near-term bull cases, but my counter-argument is that prices will then recover (it's circular, but this is Macroeconomics 101). So if you are a stock picker, negative growth will only disproportionately impact names with weak geographic footprint (not a uniform distribution) and counterparty (almost all counterparties have distress risk, but there is a difference in magnitude, and rock quality does not change with commodity price). Absent some change in global sentiment around geopolitical risk or surprise data from China, I think there are more headline risks to come - so even if MLP valuations recover, I think it first goes down even further before it recovers. So I am waiting and monitoring closely, but I think FOMO will kick in at some point, and I may invest in some names that I believe are well positioned or may just pick up the index (i.e., the ALPS Alerian MLP ETF (NYSEARCA:AMLP)). On the flip side, even if the commodity price recovers, I do not think the level of recovery will be like post 2008; there is just simply too much over-build in terms of midstream, and I think there isn't much headroom for U.S. supply growth in aggregate from a drilling inventory point of view (there is headroom, but not like 2008 or during the peak shale boom). I think in a full recovery scenario, sector valuation gets reset to cost of capital minus nominal long-term growth rate (maybe 8-10%?), with some spread element to interest rate - so maybe distributions get cut in the interim and it does not go back to yielding 3-4%, but will be re-rated at levels that still merit attractive upside from today's valuation.

AMZ Index

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Additional reading: Bankruptcy dockets and news related to names including Sabine Oil, Samson Resources, Quicksilver Resources, Magnum Hunter (OTCPK:MHRCQ), Swift Energy (NYSE:SFY) (and probably many more notable names that will file shortly), and Raging Capital's presentation on Crestwood Equity (NYSE:CEQP) - I don't agree with everything, but it's a good read.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.