The Securities Litigation Expert Blog

Master Limited Partnership Bubble Now Well Documented

Posted by Jack Duval

Feb 21, 2013 3:05:00 AM

This blog post continues our expert analysis of complex investments and their regulation.

Two new reports are out documenting the bubble in shale gas and shale oil.  The first is "Shale and Wall Street" by Deborah Rogers and is published by the Energy Policy Forum.  (EPF)  The second is "Drill, Baby, Drill" by J. David Hughes and is published by the Post Carbon Institute.  (PCI)

The crux of these reports is that a bubble has formed due to: massive over-investment in shale gas extraction, heroic assumptions about shale gas and oil reserves, rapidly declining extraction rates, complex investment products used to finance the exploration, a flurry of Wall Street activity which generated large transactional fees for Broker-Dealers, and a wholesale lack of transparency.

Sounds a lot like the sub-prime bubble.

Our previous coverage of the MLP bubble can be found here, here, and here.

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Topics: Master Limited Partnerships, MLP, FINRA, shale oil, Energy Policy Forum, bubble, litigation, Senior Investors, investments, Master Limited Partnership, sub-prime, natural gas, shale gas, Compliance, Post Carbon Institute, Complexity

Shale Gas Bubble Evidence Continues to Grow

Posted by Jack Duval

Nov 13, 2012 2:24:59 AM

Geological consultant and energy expert, Arthur Berman, has an interview with with some frightening observations.  (Oilprice)  The most sobering may be the following:

A lot of investors from other parts of the world, particularly the oil-rich parts have been making somewhat high-risk investments in the United States for many years and, for a long time, those investments were in real estate.

Now these people have shifted their focus and are putting cash into shale. There are two important things going on here, one is that the capital isn't going to last forever, especially since shale gas is a commercial failure. Shale gas has lost hundreds of billions of dollars and investors will not keep on pumping money into something that doesn’t generate a return.

The second thing that nobody thinks very much about is the decline rates shale reservoirs experience. Well, I've looked at this. The decline rates are incredibly high. In the Eagleford shale, which is supposed to be the mother of all shale oil plays, the annual decline rate is higher than 42%.

They're going to have to drill hundreds, almost 1000 wells in the Eagleford shale, every year, to keep production flat. Just for one play, we're talking about $10 or $12 billion a year just to replace supply. I add all these things up and it starts to approach the amount of money needed to bail out the banking industry. Where is that money going to come from? Do you see what I'm saying?

Readers of this blog will know that we have been following the bubble in shale gas for a while now.  See our coverage here.

Compliance Issues

For those of you in broker-dealer or investment advisor compliance, heightened diligence as to both reasonable basis and customer specific suitability is advised. Rigorous due diligence should be prepared on these deals before being offered to any clients.  See our coverage of this here and here.

For individual customers, exposure to shale gas limited partnerships and other investments should be at very low percentages and only for the most speculative of clients.


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Topics: Arthur Berman, bubble,, Investment Advisors, investments, natural gas, shale gas, Compliance, Eagleford

Master Limited Parternship Warning from Morningstar

Posted by Jack Duval

Nov 12, 2012 3:36:40 AM

Morningstar has issued a research note warning investors about the ALPS Alerian MLP ETF (AMLP).  (Morningstar)  The reason?  Hot money is flowing into this ETF because the industry giant, JPMorgan Alerian MLP Index ETN (AMJ), has hit its $5 billion asset limit and stopped creating new units.  This means AMJ is now a closed-end fund and that shares will fluctuate above and below NAV.

Here's what Morningstar has to say about why an ETF structure (as opposed to an ETN structure) is bad for MLPs:

 However, AMLP is not the right vehicle for the majority of investors, and it represents one of the rare cases when buying the ETF structure makes very little sense.

Legally MLPs can make up only 25% of a portfolio registered under the Investment Company Act of 1940. Most mutual funds and ETFs are structured this way. To get around this issue, AMLP is actually structured as a corporation that pays income tax: Before return is passed on to the investor, it must be taxed at the corporate level. Although AMLP's prospectus expense ratio is 0.85%, its gross expense ratio (which accounts for these tax liabilities) is almost 5% as of September. As a result, AMLP has lagged its index significantly. Over the past year AMLP lagged by 10%, and since inception it trailed by a shocking 40%. The upside? When MLPs are down, AMLP declines less because it can reverse some of the deferred tax liabilities it has accrued. For all but the most risk-averse yet desperate-for-yield investors, this downside protection is not enough to make up for the fund's structural issues...

Because of legislation forbidding open-end funds from owning more than 25% of their portfolio in MLPs, AMLP is structured as a C-corporation and pays income tax at the corporate level. Any taxable income from the underlying MLPs is an annual tax liability, and upon the sale of the portfolio's shares they must also pay up at the corporate level. AMLP accounts for these tax liabilities in the NAV, meaning that the total return of the fund can and does trail the index by massive amounts.

Thus the C-Corporation structure eliminates the deferred tax structure inherent in a MLP and pays the taxes along the way.  By Morningstar's calculation, this comes to about 5 percent per year, and causes serious underperformance against the index.


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Topics: Master Limited Partnerships, MLP, AMJ, investments, Master Limited Partnership, Morningstar, natural gas, ETF, ETN, Alerian, AMLP

Moody's Master Limited Partner Research

Posted by Jack Duval

Nov 11, 2012 2:27:36 AM

Moody's has come out with research on Oil and Gas bond covenants and has come to the conclusion that MLPs offer the least investor protection.  (Finanzen)

"Our review of bonds issued between January 2011 and October 2012 showed that those of US midstream limited partnerships have the worst covenant quality," says Andrew Brooks, Moody's Vice President and co-author of the report, "Midstream MLP Covenants Offer Least Investor Protection; E&Ps Near US Average." "Investor protection is weakest in the areas of restricted payments and liens subordination, reflecting these firms' focus on high shareholder distributions and externally financed growth."

The Moody's research can be found here.  (You'll need a subscription or $550.)

The MLP focus on paying out earnings leaves those firms in a perpetual refinance cycle.  That is, they cannot self-fund because they distribute their earnings to their investors.  This is the paradox and the Achilles Heel of MLPs.  The very thing that makes them attractive to yield-starved investors is what makes them vulnerable to sharp (and pro-cyclical) declines.

See our previous coverage on MLPs here, here, here, here, and here.

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Topics: Master Limited Partnerships, MLP, Moody's, investments, Master Limited Partnership, natural gas, Oil and Gas

Shale Gas Pain Continues

Posted by Jack Duval

Oct 27, 2012 4:19:43 AM

Clifford Krauss and Eric Lipton continue the excellent New York Times coverage of the shale gas boom and bust.  (NYT) There are some fascinating revelations in the article:

1.  The drilling companies were forced under contract to keep drilling, even as the price of natural gas collapsed:

The land that the natural gas companies had leased, in most cases, came with “use it or lose it” clauses that required them to start drilling within three years and begin paying royalties to the landowners or lose the leases... and as with so many other shale gas players, Chesapeake struck so many complicated financial deals that it couldn’t stop ramping up the gas factory.

“At least half and probably two-thirds or three-quarters of our gas drilling is what I would call involuntary,” Mr. McClendon (of Chesapeake) acknowledged at one point.

2.  Valuing gas producers off of known reserves incintivized more drilling even it it was already unprofitable to pull it out of the ground:
The industry was also driven to keep drilling because of the perverse way that Wall Street values oil and gas companies. Analysts rate drillers on their so-called proven reserves, an estimate of how much oil and gas they have in the ground. Simply by drilling a single well, they could then count as part of their reserves nearby future well sites. In this case, higher reserves generally led to a higher stock price, even though some of the companies were losing money each quarter and piling up billions of dollars in debt.

It appears that the pain for drilling companies will continue for some time.

In separate news, investors in Ohio's Utica shale formation should beware that drillers succeeded in getting legislation passed that requires only annual disclosures about well extraction rates and volumes, as opposed to the quarterly reporting required in almost every other state.  (Reuters)

By this spring, a new energy bill being crafted by lawmakers initially included a clause that would have allowed regulators to publicly disclose quarterly energy production data. The current requirement calls for annual reporting.

But the clause was struck from the bill after discussions with the industry, a Reuters investigation has found. Instead the law, which took effect in August, explicitly bars the government from publishing the quarterly figures it now obtains.

Almost every other energy-producing state releases production data and drilling results on a monthly basis; even Saudi Arabia now self-reports its once-secret production volumes once a month. The latest Ohio figures for 2011 provide information on only five wells. The volume of oil and gas pumping out of dozens of new wells drilled this year will not be available until April 2013, as much as 15 months after they were drilled.

This greatly reduces the transparency in Ohio investments.  Furthermore, because of the typical shale gas extraction rate decline (where the majority of the gas is extracted in the first year), this could lead to some nasty surprises.
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Topics: Master Limited Partnerships, MLP, drilling, limited partnerships, investments, natural gas, Chesapeake Energy, shale gas, Utica Shale, regulation.

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