BreitBurn Energy Partners: Tax Implications Could Result In An Avoidance Of Voluntary Restructuring

| About: Breitburn Energy (BBEPQ)

Summary

Debt repurchases could result in unitholders incurring taxes that are several times BreitBurn's current unit price. Large-scale debt repurchases seem unlikely as a result.

A restructuring could incur even larger taxes for unitholders as the company needs to eliminate over half its debt to be viable long term with $70 oil.

A voluntary restructuring may be avoided as much as possible unless BBEP is converted into a C corporation.

This appears to be a positive for the bonds as it increases the chance that interest payments will continue to be made.

Common units remain a poor long-term investment option based on risk/reward compared to the bonds and long-term oil call options.

Although there has been some discussion about the potential for BreitBurn Energy Partners (BBEP) to repurchase its debt, the tax implications to common unitholders make such a move impractical. The marginal tax costs for unitholders if BreitBurn repurchases all its unsecured debt could be as much as triple (depending on one's tax bracket) the company's current unit price. Thus, a large-scale debt repurchase seems unlikely.

The tax implications also appear to act as a disincentive for BreitBurn to restructure, as doing so as an MLP may result in a tax bill for unitholders up to five times BBEP's current unit price. I have previously believed that it is very likely that BreitBurn will need to restructure due to its very high leverage, but the tax implications may result in the company trying to hold off on restructuring (unless it is forced to) until the end of 2017 or later while also potentially preparing to convert into a C corporation before any restructuring occurs.

Implications Of Debt Repurchases

If BreitBurn repurchases its $1.155 billion in unsecured debt at an average of 13 cents on the dollar, that would result in $1 billion in cancellation of indebtedness income. This would mean that potentially up to $4.68 per unit in income would be passed on to common unitholders as ordinary income.

The reduction in debt would probably serve to increase the value of BreitBurn's common units, but probably not enough to cover the tax bill resulting from the cancellation of indebtedness income. I've previously discussed how it would probably take $80+ oil for BreitBurn's common units to have more than minimal value in the long term. Reducing total debt to around $1.8 billion would give BBEP's common units some value starting at around $65+ oil instead. Still, the results appear to be challenging for common unitholders.

For example, at $75 oil long term, BreitBurn's common units might be worth roughly $3 per unit based on a 6x EV/EBITDA multiple and $1.8 billion in net debt. This is around $2.25 per unit more than BreitBurn's current price. However, the company's unitholders would also be dealing with taxes on $4.68 per unit in ordinary income now, which would offset much of the gains even if oil goes back up to $75.

So if BreitBurn does repurchase unsecured debt at a major discount right now, unitholders would be faced with an increase in 2016 income taxes that is perhaps two or three times the company's current value. To make up for the taxes, oil would likely need to reach $70+ in the future. BreitBurn would still be heavily leveraged even if it can reduce net debt to $1.8 billion, so there is still a significant risk of restructuring even if it repurchases unsecured debt at a discount.

On Restructuring

Restructuring would represent a double hit to BreitBurn's unitholders. In that case, unitholders would face the tax hit caused by the cancellation of indebtedness income and also likely see the value of the units wiped out. I've previously considered BreitBurn a prime candidate for restructuring due to its very high leverage ratio (which is around 8x without hedges at $70 oil), which makes BBEP unsustainable with its current debt load unless oil gets back to the $85, $90 level. However, the tax issue appears to be a major disincentive to restructuring BreitBurn as is. BBEP would need to eliminate over half of its debt to be viable in a $70 oil world, and that would result in the cancellation of indebtedness income of over $7 per unit.

Therefore, management's course of action right now appears to involve attempting to pay down its credit facility as much as possible to avoid a potential forced restructuring. If BreitBurn can keep its credit facility lenders content, it may be able to last until late 2017 without restructuring. If oil prices do not appear to be rebounding to the $80s by then, the next step would potentially be converting to a C corporation and then restructuring. This would trigger the deferred taxes, but would avoid passing on the cancellation of indebtedness income from the restructuring on to unitholders. The conversion and restructuring combo could occur before late 2017, but unlike Linn Energy (LINE), there isn't a ready-made C corporation such as LinnCo (LNCO) available for BreitBurn, so it would have to do more work to get this done. The conversion from an MLP to a C corporation also appears to have "little precedent" in recent years, so there's uncertainty around that too.

Bonds and Units

There really does not appear to be a compelling reason to own BreitBurn's common units over its bonds in the long run. If BreitBurn restructures or repurchases debt at a discount as an MLP, common unitholders are left with a substantial tax burden. This is in addition to any potential losses from the investment in the units, so the total loss could be well above 100%. The disincentives for BBEP to restructure while it is an MLP may prompt it to postpone any restructuring efforts until it is entirely inevitable, which would be a positive for the bonds as interest payments would continue in the meantime.

Given the additional tax risks involved with the common units and the fact that the bonds are trading at only 10 cents on the dollar, it appears that the only reason to own the common units over the bonds if you are in it for the long term (as opposed to trading) is if you are very certain that oil is going back up to $90+ within a couple years. If one thought that there was a 70% chance that oil would reach $90 within a couple years, the bonds would make more sense. The preferred units also offer little long-term value compared to the bonds, as they are inferior to the bonds yet are triple the price currently.

Even if one did believe there was a very high chance that oil reaches $90+ within a couple years, the common units appear to be an inferior investment to out-of-the-money oil futures options. The oil futures options offer similar potential returns without the risk of restructuring or special tax bills.

Conclusion

BreitBurn's options around debt repurchases appear to be limited due to the tax consequences to unitholders from doing so. As well, the tax consequences may result in an avoidance of voluntary restructuring unless it can convert from an MLP to a C corporation. The disincentive towards restructuring is a positive for the bonds as it increases the chances that interest payments will continue. The common and preferred units appear markedly inferior to the bonds from a risk/reward perspective while the common units also appear inferior to long-term oil call options for those inclined to gamble in search of a large payback. The common units only appear suitable for high-risk, shorter-term trading purposes.

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

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