Capital structure matters in the real world, contra the fantasy world of the Modigliani-Miller Theorem and its impossible assumptions of zero transaction costs, zero taxes, uniform borrowing costs, and information symmetry (which implies symmetry of risk and uncertainty perception and market outlook, yet another impossibility).
Capital structure matters because in the real world operating earnings are never consistent across time, nor are they predictable beyond the immediate future. Operating earnings ebb and flow, and they will eventually ebb into the red. Capital structure will dictate whether you hang around until operations improve to the point earnings flow back into the black.
We learn in Finance 101 that debt always amplifies return; it always amplifies risk, because debt, no matter how plentiful and cheap, must always be serviced. Equity, on the other hand, involves no legal obligation. It's simply investor capital and retained earnings over time. Equity, bottom guy on the obligation totem, is flexible. Debt, on the other hand, is an unyielding taskmaster.
U.S. oil & gas companies, particularly MLPs, and their investors, are learning a painful lesson in capital structure, why it matters, and why it matters a lot.
Listed U.S. exploration and production firms carry $260 billion in debt, double the load in 2009. These upstream producers couldn't load up on debt and expand fast enough when West Texas Intermediate crude was priced above $100/barrel and natural gas was priced above $6 per million BTUs. With WTI priced below $35/barrel and natural gas price below $2.20/mmBTU, these firms can't write off their profligacy fast enough.
Breitburn Energy Partners (BBEP) serves as both poster child and cautionary tale. Breitburn is one of many small-cap exploration and production MLPs that populate the U.S. shale sector. Breitburn's business is to acquire properties and extract oil and natural gas. Its assets consist primarily of producing and non-producing oil and natural gas reserves located in seven producing regions spread from Florida to California.
Timidity isn't a Breitburn trait. Gross property, plant, and equipment has nearly quadrupled over the past fives years, growing to $8.1 billion from $2.1 billion. The debt to finance the expansion more than kept pace. Long-term debt of $528 million in 2010 has swelled to $3.0 billion today. Breitburn has been equally aggressive issuing equity. Units outstanding totaled 56.9 million in 2010. Today, the number exceeds 211.8 million. Grow-or-die appears to be the exploration MLP mantra.
From late 2010 through mid-2014 – when oil was frequently quoted at $100/barrel and natural gas was mostly quoted above $3.50/mmBTUs – Breitburn's units held near $20 each, and this was despite massive dilution. Quarterly distributions increased to $0.50 per unit from $0.39 per unit. (Breitburn switched to monthly distributions in 2014.)
Then began the great downturn in the third quarter of 2014. All hell broke lose. Thirty-dollar/barrel oil apparently fails to jibe with the exploration MLP business model, It also appears $60/barrel, $50/barrel, and $40/barrel oil is hard to live with as well. Breitburn's $0.17-per-unit monthly distribution at the end of 2014 gave way to an $0.08-per-unit distribution to start 2015. Three months later, S0.08 gave way to $0.04. Three months after that $0.04 gave way to nothing.
When you're valued exclusively on your ability to distribute cash to unitholders, as most MLPs are, you'll find that unit market price correlates perfectly with distribution amount.
As for Breitburn's unit price, let's just say that it would take four month's of $0.17-per-unit distributions to buy one Breitburn unit today. Breitburn's equity market- cap -- $1.1 billion in 2010 -- posts at $140 million in early February 2016. Long-term debt, meanwhile, stands firm at $3 billion. You do the math. (And if you don't want to do the math, Breitburn's long-term debt exceeds its equity 20-fold.)
Breitburn's great big pile of debt must be serviced, and that requires cash. The latest quarterly report, ended Sept. 30, showed Breitburn had $51 million in interest expense. The cash balance was $12 million. Cash from operations flowed in at $136 million, but only because of a one-time $1.3 billion impairment charge (so the past five years -- the good times -- have really been a fiction). The well -- literally speaking -- risks running dry.
As is so often the case, when you need a cash infusion most -- to survive -- you're least likely to get it. As you'd expect, Breitburn, like so many other exploration MLPs, is capital-market pariah these days. Breitburn could issue another 211 million units -- double what's currently outstanding -- and it still wouldn't raise $150 million. (Assuming, of course, the current unit price holds, which is another fiction.) As for tapping debt markets, forget it. Lenders are unwilling to lend to the Breitburns of the world at even payday-loan rates.
“The market can remain irrational longer than you can remain solvent,” Lord John Maynard Keynes never said. The quote is apocryphal, and like so much of Keynesian economics, it's wrong. You can remain solvent longer than the market remains irrational with the right capital structure. And if your industry is prone to long-winded booms and busts, it's probably a good idea to take busts into consideration when structuring capital.
Capital structure matters because in the real world operating earnings are never consistent across time, nor are they predictable beyond the immediate future. Operating earnings ebb and flow, and they will eventually ebb into the red. Capital structure will dictate whether you hang around until operations improve to the point earnings flow back into the black.
We learn in Finance 101 that debt always amplifies return; it always amplifies risk, because debt, no matter how plentiful and cheap, must always be serviced. Equity, on the other hand, involves no legal obligation. It's simply investor capital and retained earnings over time. Equity, bottom guy on the obligation totem, is flexible. Debt, on the other hand, is an unyielding taskmaster.
U.S. oil & gas companies, particularly MLPs, and their investors, are learning a painful lesson in capital structure, why it matters, and why it matters a lot.
Listed U.S. exploration and production firms carry $260 billion in debt, double the load in 2009. These upstream producers couldn't load up on debt and expand fast enough when West Texas Intermediate crude was priced above $100/barrel and natural gas was priced above $6 per million BTUs. With WTI priced below $35/barrel and natural gas price below $2.20/mmBTU, these firms can't write off their profligacy fast enough.
Breitburn Energy Partners (BBEP) serves as both poster child and cautionary tale. Breitburn is one of many small-cap exploration and production MLPs that populate the U.S. shale sector. Breitburn's business is to acquire properties and extract oil and natural gas. Its assets consist primarily of producing and non-producing oil and natural gas reserves located in seven producing regions spread from Florida to California.
Timidity isn't a Breitburn trait. Gross property, plant, and equipment has nearly quadrupled over the past fives years, growing to $8.1 billion from $2.1 billion. The debt to finance the expansion more than kept pace. Long-term debt of $528 million in 2010 has swelled to $3.0 billion today. Breitburn has been equally aggressive issuing equity. Units outstanding totaled 56.9 million in 2010. Today, the number exceeds 211.8 million. Grow-or-die appears to be the exploration MLP mantra.
From late 2010 through mid-2014 – when oil was frequently quoted at $100/barrel and natural gas was mostly quoted above $3.50/mmBTUs – Breitburn's units held near $20 each, and this was despite massive dilution. Quarterly distributions increased to $0.50 per unit from $0.39 per unit. (Breitburn switched to monthly distributions in 2014.)
Then began the great downturn in the third quarter of 2014. All hell broke lose. Thirty-dollar/barrel oil apparently fails to jibe with the exploration MLP business model, It also appears $60/barrel, $50/barrel, and $40/barrel oil is hard to live with as well. Breitburn's $0.17-per-unit monthly distribution at the end of 2014 gave way to an $0.08-per-unit distribution to start 2015. Three months later, S0.08 gave way to $0.04. Three months after that $0.04 gave way to nothing.
When you're valued exclusively on your ability to distribute cash to unitholders, as most MLPs are, you'll find that unit market price correlates perfectly with distribution amount.
As for Breitburn's unit price, let's just say that it would take four month's of $0.17-per-unit distributions to buy one Breitburn unit today. Breitburn's equity market- cap -- $1.1 billion in 2010 -- posts at $140 million in early February 2016. Long-term debt, meanwhile, stands firm at $3 billion. You do the math. (And if you don't want to do the math, Breitburn's long-term debt exceeds its equity 20-fold.)
Breitburn's great big pile of debt must be serviced, and that requires cash. The latest quarterly report, ended Sept. 30, showed Breitburn had $51 million in interest expense. The cash balance was $12 million. Cash from operations flowed in at $136 million, but only because of a one-time $1.3 billion impairment charge (so the past five years -- the good times -- have really been a fiction). The well -- literally speaking -- risks running dry.
As is so often the case, when you need a cash infusion most -- to survive -- you're least likely to get it. As you'd expect, Breitburn, like so many other exploration MLPs, is capital-market pariah these days. Breitburn could issue another 211 million units -- double what's currently outstanding -- and it still wouldn't raise $150 million. (Assuming, of course, the current unit price holds, which is another fiction.) As for tapping debt markets, forget it. Lenders are unwilling to lend to the Breitburns of the world at even payday-loan rates.
“The market can remain irrational longer than you can remain solvent,” Lord John Maynard Keynes never said. The quote is apocryphal, and like so much of Keynesian economics, it's wrong. You can remain solvent longer than the market remains irrational with the right capital structure. And if your industry is prone to long-winded booms and busts, it's probably a good idea to take busts into consideration when structuring capital.
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