MIDSTREAM CAPITAL FORMATION

CAPIT

ALFORMATIO

N

2015

CF

F I N A N C I N G T H E B U I L D O U T

June 2015

The REIT AlternativeThe innovative capital market spurred the move to midstream’s popular MLP structure.

Could real estate investment trusts be next?

By David Schulte, CFA

CAPIT

ALFORMATIO

N

2015

CF

Ayear ago, America’s energy

boom was hurtling forward with

a momentum no one ques-

tioned. The wave of unconventional explo-

ration and production was driving oil and

gas companies’ growing appetite for mid-

stream infrastructure. Capacity needed to

expand—and fast. Capital poured into the

midstream sector through varied private

and publicly traded vehicles.

Then came the second half of 2014 and

the first half of 2015.

After four years of growing volumes at

crude oil prices fluctuating around $100

per barrel (bbl), the commodity plunged

to around $50 per bbl by the start of 2015.

Exploration and production companies

retrenched, projects were canceled, capital

expenditures cut and more than 100,000

people were laid off. Some midstream

operators fretted about the solvency of

their upstream partners and future

demand in the midstream sector seemed

less certain.

June 2015 | www.MidstreamBusiness.com | CAPITAL FORMATION

Wyoming’s majestic Wind River Rangeprovides a backdrop for oil and gas activity along the Pinedale Anticline.All photos courtesy of CorEnergy Infrastructure Trust Inc.

CAPITAL FORMATION | www.MidstreamBusiness.com | June 2015

The energy capital markets have reacted

dramatically since the summer of 2014.

The S&P 500 Energy Index of large-cap

and mid-cap companies lost 22% of its

value. The Tortoise MLP Index retreated

18% from its summer peak through the

first quarter of 2015. In place of steady

growth, investment in MLP funds and ex-

change traded funds (ETFs) fluctuated be-

tween inflows and outflows. These public

markets remain volatile, reacting to daily

news on energy supply and demand.

No longer is abundant capital a given in

the energy sector, whether upstream or

midstream. More than ever, cash is a

precious ingredient that E&P companies

need to deploy for optimum return. Re-

ducing operating costs or making costs

more predictable is a priority. As a result,

many energy companies are looking for

transactions to restructure balance sheets

or operations.

Despite the bumpy road in 2014 to

2015, we believe the long-term fundamen-

tals are intact for midstream energy. U.S.

oil and gas production continues to grow,

and infrastructure needs in the coming

years will be immense.

So what do the challenging times today

mean for capital formation? Let’s look first

at the nature of midstream assets, then the

evolution of capital markets for midstream

investment and finally at recent develop-

ments and what lies ahead.

Midstream characteristicsMidstream energy assets are a type of in-

frastructure—physical components of the

interrelated systems that are essential to

gathering, processing, transporting and

storing society’s supply of energy. These

midstream assets and the associated serv-

ices perform critical functions for energy

producers on the upstream side and energy

distribution channels downstream.

From a capital market perspective,

the midstream sector has four basic char-

acteristics:

� Long-lived physical infrastructure es-

sential to customers’ ability to get en-

ergy to market;

� Recurring revenues based on toll-road

or utility-like models and long-term

contracts;

� Demand tied mostly to volumes and

less sensitive to commodity price

swings; and

� High barriers to competitive entry,

such as fixed costs and proximity to

customers.

Based on recurring revenues and pre-

dictable operating costs, investment in as-

sets like pipelines and storage facilities

offers potentially attractive, risk-adjusted

total returns. At CorEnergy, we target total

returns from energy infrastructure of 8%

to 10% per year.

The midstream sector appeals to in-

vestors seeking cash income as a large com-

ponent of total return, although energy

infrastructure does offer growth potential

over time.

Capital markets developmentIn the two decades I have worked with en-

ergy infrastructure, the capital market

mechanisms and structures for investing in

midstream assets have evolved. The mar-

kets always innovate in response to needs

for capital formation, and innovative fi-

nancial structures have emerged—and will

continue to come along—in midstream

energy. These vehicles deliver greater effi-

ciency in capital deployment, as well as

suitability for the varied needs of the

world’s investors.

I have been a witness to these changes,

first helping fund energy startups as a pri-

vate equity manager, then developing MLP

portfolios as a co-founder of Tortoise Cap-

ital Advisors, and recently helping our

team create CorEnergy Infrastructure

Trust, the first publicly traded Real Estate

Investment Trust (REIT) focusing on en-

ergy infrastructure.

Midstream assets began as systems

within integrated oil and gas companies.

But starting in the 1980s, private equity

firms emerged to focus on capital forma-

tion specifically for support systems in the

40

50

60

70

80

90

100

110

120

130

Jan-14 Apr-14 Jul-14 Oct-14 Jan-15 Apr-15

Tortoise MLP Index S&P 500 Energy Index WTI Crude Price

CCRRUUDDEE PPRRIICCEE VVSS.. EENNEERRGGYY SSTTOOCCKKSS

Source: CorEnergy Infrastructure Trust Inc.

June 2015 | www.MidstreamBusiness.com | CAPITAL FORMATION

energy sector. For investors, funding mid-

stream infrastructure through private

equity funds meant buying into private eq-

uity rounds—illiquid investments in un-

traded vehicles, often with 10-year terms,

which also could be undiversified from a

portfolio viewpoint.

Then we began to see MLPs in the 1990s,

and these publicly traded partnerships have

been major enablers for the buildout of en-

ergy infrastructure. For investors, MLPs

added liquidity and diversification via a

broader portfolios of assets. Today, more

than 120 U.S. energy MLPs have a total eq-

uity value of more than $500 billion. Still,

some investors avoid MLPs—largely over

tax suitability issues.

Another innovation came a decade ago.

Tortoise Capital Advisors LLC and others

began creating closed-end funds to invest in

MLPs, offering still more liquidity and di-

versification. Today, about 40 closed-end

and open-end funds offer investors portfo-

lios of energy MLPs.

The REIT structureOnce again, need is spawning capital mar-

kets innovation. The tax-advantaged struc-

ture of a REIT holding energy infrastructure

assets. In 2007, the Hunt family obtained a

private letter ruling from the Internal Rev-

enue Service (IRS) confirming that a util-

ity’s transmission and distribution assets

could constitute real estate assets. In 2010,

the Hunt interests formed InfraREIT as a

privately held REIT, and the Texas company

went public through an IPO in late January.

In 2011, Tortoise collaborated with Rick

Green, former chairman of Aquila Inc., to

develop a publicly listed REIT as a vehicle

for institutions and retail investors to di-

rectly access energy infrastructure. The re-

sult was CorEnergy Infrastructure Trust

Inc., an NYSE-listed company. Green is now

executive chairman of CorEnergy.

Since then, CorEnergy has built a grow-

ing portfolio of midstream and downstream

energy infrastructure, funding a liquids

gathering system in Wyoming; an interstate

natural gas pipeline in Missouri and Illinois;

a rail, truck and marine terminal in Oregon;

a natural gas distribution system in Mis-

souri; and salt water disposal wells in

Wyoming and North Dakota.

Investors are intrigued by the REIT struc-

ture. It offers the yield characteristics of mid-

stream energy assets, a risk profile based on

stable fixed-fee leases and mortgages and

growth prospects—plus a simple tax regimen

involving ordinary income shown on an IRS

Form 1099. The tax-advantaged structure is

a good match for infrastructure investors

seeking current income as a large component

of total return, because U.S. regulations ex-

empt REITs from income taxes at the corpo-

rate level as long as they distribute at least

90% of their income to investors.

Innovation in capital formationEach new step in the evolution of capital

structures also offers distinct characteris-

tics for midstream operators, whether

integrated oil and gas companies, explo-

ration and production independents

with assets in gathering and storage or

midstream businesses such as pipelines

and terminals.

Especially in today’s volatile environ-

ment, going to the equity or debt markets

may not be the most desirable option

for some energy companies. Many opera-

tors are looking at strategic transactions

for opportunities to monetize midstream

assets and redeploy capital to higher-return

E&P activities, growth capital for acquisi-

tions or expansion or even exit funding.

In considering a transaction to benefit

the balance sheet or profit and loss, a com-

pany might examine several key character-

istics of prospective partners for funding or

operating midstream assets:

� Experienced partners—Management

teams that have operations experience,

including engineering and regulatory

expertise, in addition to financial or

deal-making skills.

� Long-term commitment—Contracted

agreements such as long-term triple-

net leases to ensure permanent solu-

tions for operational needs—and

predictable costs.

� Operational control—A priority for

some upstream and midstream com-

panies seeking funding while continu-

ing to run midstream operations

critical to their core business.

� Competitive cost of capital—Optimiz-

ing capital costs by working with a tax-

advantaged corporate entity and

structuring a deal blending equity, debt

and terminal value.

One thing is certain: Capital markets will

continue to innovate and in the next 20

years, the midstream sector will see new op-

portunities and options emerging for capi-

tal formation. �

David Schulte CFA, is president and CEO

of CorEnergy Infrastructure Trust Inc.

This tank battery forms part of CorEnergy’s mid-stream assets in Wyoming’s Pinedale Anticline.

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