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Consolidation and Divestiture in the Oil and Gas Industry – Modern Structures

Gregory M. Bopp Bracewell & Giuliani LLP [email protected] 713.221.1511 September 2012

www.bgllp.com | Houston Austin Dallas Connecticut New York San Antonio Washington, D.C. Seattle Dubai London We Know Energy ® 2

Modern Structures/Transactions are Driving the Oil and Gas Industry • Master Limited Partnerships (MLPs) – lots of midstream

with increasing amount of upstream • Royalty Trusts – alternative form of upstream financing • Private Equity Investment – both midstream and upstream • Split-Up of Integrated Companies – separating upstream

from downstream/midstream


MASTER LIMITED PARTNERSHIPS


What is an MLP? • State law partnership or limited liability company

• Publicly traded and listed on a major stock exchange • Equity is commonly referred to as “units” as opposed to stock • Subject to SEC reporting requirements and Sarbanes-Oxley

• Treated as a partnership for federal income tax purposes (no entity level tax) • Must satisfy qualifying income requirement – includes all

midstream and upstream activities


90 Currently Trading Natural Resource MLPs

Midstream (47)

Exploration & Production (14)

Propane/Refined Fuel Distribution

(7)

Marine Transportation (6)

Royalty Trusts in MLP Form (5)

Other (Coal, Fertilizer, Frac

Sand, Timber) (11)

Source: National Association of Publicly Traded Partnerships website


Existing Natural Resource MLPs

• Midstream (entire midstream value chain) • Pipelines - natural gas, crude oil,

refined petroleum products, natural gas liquids (NGLs)

• Gathering • Natural Gas Processing • Treating and Dehydration • Fractionation • Storage • Terminals • Compression

• Marketing • Upstream (exploration and production) • Coal • Propane (retail distribution) • Shipping/marine transportation • Liquefied Natural Gas (LNG) • Refining • Asphalt • Fertilizer • Oilfield Services • “Pure-play” GP


Strong Sponsor Incentive to Create an MLP • Partial monetization of assets without giving up control

• Sponsor retains control through ownership of general partner

• Favorable IPO valuation (higher multiples for MLPs as compared to C-corps) • Premium placed on yield • More cash to distribute to investors because no entity level tax

• Incentive equity structure for sponsor – IDRs • As distributions increase, sponsor gets a greater percentage

• Access to capital markets

• Tax efficient – no entity level tax • More cash to distribute to investors (resulting in higher yield) • Lower cost of capital – enhanced competitiveness with respect to acquisitions • Tax efficient monetization of sponsor assets (IPO & thereafter via “drop downs”)


Strong Investor Demand

• MLP sector total return compound annual growth rate (CAGR) of 17% over the past 10 years

• Yield oriented security – low interest rate environment – investors seeking yield and income growth

• Additional sources of MLP equity capital - closed-end MLP funds

• Aggregate energy MLP market capitalization ~ $300 billion ($20 billion in 2000)

Source: Bloomberg (data as of August 31, 2012)


Strong Business Environment for MLP Growth • Growth of unconventional

shale plays is fueling the need for midstream infrastructure

• Significant gap between expected future production and existing gathering/processing and pipeline capacity

• Interstate Natural Gas Association of America (INGAA) study (June 2011) forecasted over $250 billion in additional investment in U.S. oil and gas infrastructure over the next 25 years


Strong Business Environment for MLP Growth Midstream Energy Infrastructure Investment Forecast through 2035

Source: INGAA and Simmons & Company


Recent Expansion of the MLP Asset Class • Historically, MLP’s have owned stable cash flow generating assets with

limited commodity price exposure (“Traditional MLP”) • Interstate and intrastate pipelines/storage • Gathering, processing and fractionation (commodity price exposure limited

by contract terms) • E&P (long-lived production coupled with hedges)

• Recently, MLPs have been formed with assets that are subject to significant commodity price exposure (“Variable MLP”) • Northern Tier Energy LP – refining • Alon USA Partners LP – refining (currently in registration) • Petrologistics LP – propane dehydrogenation • CVR Partners LP – nitrogen fertilizer manufacturing • Rentech Nitrogen Partners LP – nitrogen fertilizer manufacturing


COMPARISON OF “TRADITIONAL” AND “VARIABLE” MLP STRUCTURES


Side-By-Side Comparison

Sponsor

General Partner

MLP

Op Subs (assets)

Public

100% Common + Subordinated Units

Common Units

Sponsor

General Partner

MLP

Op Subs (assets)

Public

100% Common Units

Common Units Non-Economic GP 2% GP + Incentive

Distribution Rights

Traditional MLP Variable MLP


Comparison of Capital Structure – Traditional vs. Variable MLP

• Variable MLP

• Common units owned by public and sponsor

• NO subordinated units owned by sponsor

• Non-economic general partner interest owned by sponsor

• NO incentive distribution rights owned by sponsor

• Traditional MLP

• Common units owned by public and sponsor

• Subordinated units owned by sponsor • 2% general partner interest owned by

sponsor • Incentive distribution rights owned

by sponsor

Key Point – public unitholders and sponsor are “in the same boat”


Cash Distributions – Traditional vs. Variable MLP • Traditional MLP

• Required to distribute 100% of “available cash” each quarter

• Cash distribution support from sponsor

• During the subordination period (up to 5 years), common units have the right to receive a “minimum quarterly distribution” or “MQD,” plus arrearages from prior quarters, before subordinated units receive the MQD (common = preferred)

• Incentive distribution rights (IDRs) – general partner receives increasing percentage of quarterly distributions (“high splits” – 15%, 25%, 50%) after the MQD and certain target distribution levels have been reached

• Variable MLP

• NO requirement to distribute cash on a quarterly basis (“policy” only)

• NO cash distribution support from sponsor (“on your own”)

• NO incentive distribution rights

Key Point – not structured to consistently maintain or increase distributions over time


Likely Profile – Traditional vs. Variable MLP

• Traditional MLP

• Stable cash flow businesses (e.g., pipelines)

• Limited commodity price exposure (use of hedging and other arrangements)

• Multiple asset MLP (e.g., multiple assets of a particular type/geographic diversity – “large asset footprint”)

• Retail investors (prefer consistent and predictable cash distributions)

• Variable MLP

• Volatile/cyclical/seasonal cash flow businesses (e.g., refineries, oilfield services)

• Commodity price exposure • Single asset MLP (e.g., stand alone

refinery) • Institutional investors (able to

weather the ups and downs)

Key Point – existing variable MLPs are trading at premium valuations; therefore, will likely see additional interest in the structure


Comparison Chart – Traditional vs. Variable MLP Traditional MLP Variable MLP

Capital Structure

- Common units owned by public Yes Yes

- Subordinated units owned by sponsor Yes No

- 2% general partner interest owned by sponsor Yes No

- Incentive distribution rights (IDRs) owned by sponsor Yes No

Cash Distributions

- Required to distribute 100% of “available cash” Yes No

- Cash distribution support from sponsor Yes No

Business and Investor Profile

- Stable cash flow business Yes No

- Commodity price exposure Limited Significant

- Predominant investors Retail Institutional


ROYALTY TRUSTS


What is a Royalty Trust? • State law trust created by a sponsor that conveys a royalty interest in

minerals to the trust • Trust is administered by a trustee

• Publicly traded and listed on a major stock exchange • Equity is commonly referred to as “units” as opposed to stock • Units are sold in an IPO and proceeds are distributed to sponsor

(essentially a monetization/financing by sponsor of E&P assets) • Subject to SEC reporting requirements

• Either ignored or treated as a partnership for federal income tax purposes (no entity level tax) • Tax characterization depends on classification of trust as a fixed

investment trust or a non-fixed investment trust


General Characteristics of a Royalty Trust • Pass-through tax treatment similar to an MLP • Distributes cash flow to unitholders similar to an MLP (yield oriented

security) • Liquidating vehicle – no additional assets added to structure once it is

initially set up • Different types of royalty interests can be placed in a royalty trust

• Perpetual royalty • Net profits interest • Term royalty (production payment)

• Examples of modern day royalty trusts include • Chesapeake Granite Wash Trust • SandRidge Permian Trust


PRIVATE EQUITY INVESTMENT


Private Equity Investment - Overview • Significant investment by private equity into the midstream and upstream space

• Many funds are dedicated solely to midstream and/or upstream investments – lots of dry power to invest

• Attracted to experienced management teams with a proven track record of success

• Upstream - low natural gas prices attract private equity investors with an appetite to get in at the bottom and with a long-term outlook of gas prices

• Midstream – large CAPEX infrastructure projects attract private equity investors interested in stable cash flow with a favorable return on equity

According to PwC, private equity interest in the U.S. oil and gas industry marked at least a 20 year high during the first quarter of 2012, as the volume of M&A reached 11 transactions with a total deal value of $11.5 billion, a 267% increase in volume compared to the same period in 2011


Benefits of Private Equity Investment • Ability to invest a substantial amount of capital in a single transaction

• Compare MLP dependence on capital markets

• Structural flexibility – structure of PE investment can be customized for each situation (not a “one size fits all” approach)

• Outright purchase of assets • Joint venture with strategic player – preferred equity, ORRI, etc. • Accumulation of assets followed by an MLP IPO


PE Investment – Outright Purchase

• Kinder Morgan/El Paso sale of El Paso’s E&P business to affiliates of Apollo Global Management, Riverstone and Access Industries for ~ $7.15 billion

• Prior to announcement of KMI/EP merger, EP had planned to spin-off it’s E&P business to the EP shareholders

• Spin-off was scuttled because of merger and instead E&P business was sold to Apollo

• Large asset footprint/diverse asset base, including Eagle Ford, Altamont, Wolfcamp, South Louisiana Wilcox and Haynesville

Kinder Morgan/El Paso

Apollo/Riverstone/Access Industries Sale of E&P business


PE Investment – JV/Preferred Share Structure

• As part of its asset monetization strategy, CHK sold preferred shares of a newly formed subsidiary, plus a 3.75% ORRI in the first 1,000 new net wells to be drilled, for $1.25 billion

• Purchasing investment group was led by GSO Capital Partners (an affiliate of the Blackstone Group), TPG Capital, Magnetar Capital and EIG Global Energy Partners

• JV owns approximately 245,000 net leasehold acres in the Cleveland and Tonkawa unconventional liquids-rich tight sand plays in Roger Mills and Ellis counties, Oklahoma

• The preferred shares are entitled to receive an initial annual distribution of 6%, payable quarterly • CHK has an option exercisable prior to 3/31/2019 to repurchase preferred shares for cash in

whole or in part at any time, at a valuation equal to the greater of a 9% IRR or a return on investment of 1.35%

Chesapeake Energy Corporation

GSO/TPG/Magnetar/EIG

CHK Cleveland Tonkawa LLC

Common Preferred + 3.75% ORRI

$1.25 billion

Contribution of 245,000 net leasehold acres in the Cleveland and Tonkawa plays


PE Investment – PE + MLP

• Lime Rock Resources formed an MLP, LRR Energy LP, to own E&P properties with long-lived, predictable production profiles

• Lime Rock is a private equity fund that acquires mature, low-risk producing oil and natural gas properties with long-lived production profiles

• Creating an MLP allowed Lime Rock to monetize a portion of its assets without giving up control and gives Lime Rock an upside interest in the MLP assets

• Lime Rock has a portfolio of E&P assets that it can ”drop down” to the MLP

Lime Rock Management LP

LRR Energy LP (NYSE: LRE) Public

Lime Rock Resources

Fund I

LP Interest

LP Interest GP Interest + IDRs

Contribution of oil & gas properties


SPLIT-UP OF INTEGRATED COMPANIES


Why Split Up? • Perception that integrated companies (upstream, midstream and downstream) are

undervalued by the market

• Integrated majors trade at a lower earnings multiple than stand-alone E&P companies and independent refiners

• Split up creates independent companies that each focus on a single line of business and can be valued as part of a “pure-play” peer group

• Shareholder preference for simplicity • Belief that independent companies will be better positioned to pursue individually focused

business strategies

• Goal is to unlock shareholder value

• Alternatives – sell to third party or create MLP (size limitations)


Example of Recent Spilt-Up • ConocoPhillips – pre-split was the nation’s third largest oil company

• Post-split – 2 independent public companies • ConocoPhillips (NYSE: COP) – largest North-American based independent E&P company • Phillips 66 (NYSE: PSX) – one of the world’s largest independent downstream companies

ConocoPhillips

Split-up

E&P (ConocoPhillips)

Refining & Marketing,

Midstream, and Chemicals

(Phillips 66)


Example of Recent Spilt-Up • Marathon Oil Corporation

• Post-split – 2 independent public companies • Marathon Oil Corporation (NYSE: MRO) • Marathon Petroleum Corporation (NYSE: MPC) – nation’s 5th largest refiner

Marathon Oil Corporation

Split-up

E&P (Marathon Oil Corporation)

Refining/Marketing and Midstream

(Marathon Petroleum Corporation)


Circular 230 TO ENSURE COMPLIANCE WITH THE REQUIREMENTS IMPOSED BY THE INTERNAL REVENUE SERVICE IN CIRCULAR 230, WE INFORM YOU THAT ANY FEDERAL TAX ADVICE CONTAINED IN THIS PRESENTATION IS NOT INTENDED TO BE USED, AND CANNOT BE USED, FOR THE PURPOSE OF (A) AVOIDING PENALTIES UNDER THE INTERNAL REVENUE CODE, OR (B) PROMOTING, MARKETING OR RECOMMENDING TO ANOTHER PARTY ANY TRANSACTION OR MATTER ADDRESSED HEREIN.


Key Bracewell Contacts Presenter: Gregory M. Bopp Partner - Houston T: 713.221.1511 E: [email protected] Other Key Contacts: G. Alan Rafte Michael S. Telle William S. Anderson Partner - Houston Partner - Houston Partner - Houston T: 713.221.1411 T: 713.221.1327 T: 713.221.1122 E: [email protected] E: [email protected] E: [email protected] Charles H. Still Gary W. Orloff Mark K. Lewis Partner - Houston Partner - Houston Partner - Washington, DC T: 713.221.3309 T: 713.221.1306 T: 202.828.5834 E: [email protected] E: [email protected] E: [email protected]

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