The price of crude may not be what it once was, but the magic of creative finance is alive and well in the oil patch.
Amid predictions that already weak oil prices will drop further in the next few years, many oil companies have been searching for new ways to keep their stockholders happy and to defend themselves against takeovers. This quest increasingly has led to the use of a device known on Wall Street by the initials MLP.
MLP stands for "master limited partnership." Big energy companies, including Diamond Shamrock Corp. and Sun Co. Inc., have unveiled various forms of the MLP. In general, these partnerships are designed to increase returns to stockholders without generating the huge debts that have typified recent oil-industry mergers and corporate stock buyback programs.
Investors generally like MLPs because they provide an opportunity to invest directly in producing energy properties while obtaining certain tax benefits. Although in many ways an MLP resembles a typical energy company engaged in oil exploration and production, current tax laws governing partnerships enable it to pass along various benefits to shareholders that a corporation cannot.
Managements prefer MLPs because, among other reasons, they can be set up to provide a defense against an unwanted takeover bid by putting valuable assets beyond the reach of a hostile bidder. And even though the assets technically are placed in a separate entity, corporate management continues to control them through the MLP's ties to the corporation that created it.
Diamond Shamrock recently invited a small group of energy and business writers to see its offshore Gulf of Mexico oil rigs near here. The Gulf of Mexico meeting was part of Diamond's drive to improve the public's understanding of all MLPs, which have surged in popularity this year, and to explain the features of its own version.
Billions of dollars worth of MLPs have been created in the past six months. One industry source said about 26 MLPs currently are trading and another dozen are under active consideration. Before April, only 12 were trading.
"We know of no other vehicle that can improve the return to our stockholders, increase our cash flow and improve our prospects for growth in the long run," said Diamond Shamrock President J. L. Jackson.
"It provides our stockholders with tangible growth in investment income without the 'fire sale' of assets or crippling increase in debt that have accompanied so many of the forced restructurings of oil and gas companies in recent years," added William H. Bricker, the company's chairman.
Diamond Shamrock officials and other proponents are anxious to distinguish MLPs from another type of oil-industry partnership called a royalty trust. Royalty trusts, which are far more passive arrangements, have been criticized for passing on most of the income from wells to investors, retaining nothing to finance exploration and development of new reserves.
"A master limited partnership is a true long-term future exploration and production activity," said McCarter Middlebrook, Diamond's vice president of taxes. "We produce the properties that are already producing. We bring on stream production from the properties that have already been discovered and, finally, we explore for new properties."
Another element that makes MLPs unusual is that they provide several benefits that previously had not been combined in one investment vehicle, according to an analysis by Kidder, Peabody & Co.
Corporations "create MLPs for several reasons: in hopes of enhancing the market's perceived value of oil and gas assets under a partnership format rather than a corporate structure, as a capital-raising mechanism, as a vehicle in restructuring and as a defense against hostile takeover attempts," Kidder said. Here's how Diamond's MLP works and how it fits into the company's financial restructuring:
Diamond's MLP, which is called Diamond Shamrock Offshore Partners Ltd. (DSP), consists of Gulf of Mexico oil and gas properties that used to belong to Diamond Shamrock Corp. Diamond transferred these properties to DSP in return for 88 percent ownership of DSP and nearly $100 million in cash raised by selling the other 12 percent of DSP to the public.
DSP units are traded publicly on the New York Stock Exchange. DSP unit holders have a stake in the new company.
The creation of DSP is only one part of Diamond's restructuring. The company also plans to repurchase up to $200 million worth of its own shares before the end of next year, and it has increased the dividend on its common stock from $1.76 to $1.90 a share.
Primarily because of falling energy prices, Diamond Shamrock's restructuring also includes an $810 million noncash charge against earnings this year to reduce the value of oil and gas assets on its balance sheet that have been hurt by falling energy prices.
How can Diamond simultaneously repurchase shares, raise its dividend, spin off Gulf of Mexico oil and gas assets, take a charge against earnings, pass along additional stock value and tax benefits to stockholders, and not incur significant debt or do anything else that appears to hurt the company or its stockholders? The answer demonstrates how creative corporate finance is designed to work in the world of MLPs.
Diamond Shamrock, a large diversified energy company whose stock is traded on the New York Stock Exchange, has many assets, including oil, natural gas and coal reserves, oil refineries and pipelines, retail gas stations, and unrelated chemical operations that produce products for the automobile and housing industries. The company's management and investment bankers believed Diamond Shamrock's stock price did not fully reflect the underlying value of certain of these assets, especially its Gulf of Mexico oil and gas properties.
To highlight those assets and use the magic of finance to "create" value for its shareholders, Diamond spun off the Gulf of Mexico assets to a separate company, DSP, that now is trading as a separate company on the New York Stock Exchange. Even though total assets remain about the same, they now are organized differently to try to get a higher total stock market valuation.
Through special dividends, Diamond gave its stockholders units in DSP. Diamond management believes that a stockholder with Diamond Shamrock Corp. stock and the DSP units will get better financial returns than he or she would have without creation of the new entity.
Another key benefit is that the corporation saves cash even though its stockholders' dividends increase. That's because the dividend is now paid in a different way. Diamond Shamrock used to pay stockholders a cash dividend of $1.76 a year. Instead, Diamond Shamrock now pays stockholders $1 a share in cash and 90 cents worth of DSP units annually. Those stockholders who prefer all cash can notify the company, so they receive the entire $1.90 a share in cash, rather than the combination of cash and DSP units. This new dividend method, and Diamond's stock buyback program, save the corporation about $100 million annually by reducing the cash payout for dividends.
To finance future exploration activity for DSP, 12 percent of DSP was sold to the public for about $100 million. This allows DSP to start life debt-free and with almost $100 million in cash for exploration. DSP also provides a pure play for investors who want a direct investment in Gulf of Mexico offshore properties rather than stock in one of the large diversified energy companies.
Another advantage of the DSP structure is the tax benefits that flow to unit holders. Regular stock dividends paid to Diamond Shamrock Corp. stockholders are fully taxable. But under the tax laws, DSP unit holders generally will receive DSP cash dividend payments tax free.
In addition, DSP tax losses or gains, special drilling-related tax deductions and tax credits flow directly to unit holders for inclusion on their individual tax returns. Diamond makes all the complicated tax-related calculations for unit holders.
"By creating its MLP, Diamond Shamrock transfers tax benefits to unit holders," said Erica Eager, an analyst with New York-based Carl H. Pforzheimer & Co. and an expert on MLPs. "For investors, the thing that makes the MLP different from buying stock in a corporation is the tax benefits they receive."
Another major corporation that recently generated cash by creating an MLP is Sun Co. Its financial restructuring program included putting all of its domestic exploration and properties in an MLP, increasing its annual cash dividend on common stock from $2.30 a share to $3, and accelerating a stock buyback program in which the company is using cash to buy outstanding shares from the public as part of a program to increase the value of Sun's stock.
Whether the Diamond and Sun MLPs and others are good investments depends largely on the success of the MLPs in profitably discovering and marketing new oil and gas properties. Diamond, for example, has a major stake in making the MLP work because it owns 88 percent of the partnership and because its executives also manage the MLP. But in the absence of successful exploration efforts, Diamond's MLP could become a liquidating asset that simply distributes cash from existing properties to unit holders until its wells run dry.
Some residents of the oil patch are not as optimistic as Diamond and Sun about the future viability of energy exploration. One of those bears, Mesa Petroleum Co. Chairman T. Boone Pickens Jr., is using the MLP to take advantage of tax laws while curtailing all future energy exploration. Mesa Petroleum stockholders recently approved a plan to transfer the corporation's energy properties to an MLP that will distribute cash generated by existing energy properties to unit holders.