Item 1A. Risk Factors
Our business involves a high degree of risk.
Limited partner interests are inherently different from the capital stock of a corporation, although many of the business risks to which we are subject are similar to those that would be faced by a corporation engaged in a similar business.
You should consider and read carefully all of the risks and uncertainties described below, together with all of the other information contained in this Form 10‑K, including the financial statements and the related notes appearing at the end of this Form 10‑K. If any of the following risks, or any risk described elsewhere in this Form 10‑K, were to occur, our business, financial condition or results of operations could be adversely affected.
If any of the following risks, or any risk described elsewhere in this Form 10‑K, were to occur, our business, financial condition or results of operations could be adversely affected. The risks below are not the only ones facing the Partnership. Additional risks not currently known to us or that we currently deem immaterial may also adversely affect us. This Form 10‑K also contains forward‑looking statements, estimates and projections that involve risks and uncertainties. Our actual results could differ materially from those anticipated in the forward‑looking statements as a result of specific factors, including the risks described below. Also, please read “Cautionary Note Regarding Forward-Looking Statements.”
The risk factors in this Form 10-K are grouped into the following categories:
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Risks Related to Our Midstream Business;
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Risks Related to Our Production Business;
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Risks Related to Financing and Credit Environment;
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Risks Related to Our Cash Distributions;
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Risks Related to Regulatory Compliance;
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Risks Related to an Investment in Us and Our Common Units; and
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Risks Related to Our Midstream Business
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Because the majority of our total revenue in general and substantially all of our revenue relating to the operation of our midstream business is derived from Sanchez Energy, any development that materially and adversely affects Sanchez Energy’s operations, financial condition or market reputation could have a material and adverse impact on us.
Sanchez Energy is our most significant customer and accounted for approximately 71% of our total revenue and substantially all of our midstream business revenue for the year ended December 31, 2018. We are dependent on Sanchez Energy as our only current customer for utilization of Western Catarina Midstream. In addition, Sanchez Energy is the primary customer for utilization of the Carnero Gathering Line, the Raptor Gas Processing Facility and the Seco Pipeline. We expect that a majority of revenues relating to these assets will be derived from Sanchez Energy for the foreseeable future. As a result, any event, whether in our area of operations or otherwise, that adversely affects Sanchez Energy’s production, drilling and completion schedule, financial condition, leverage, market reputation, liquidity, results of operations or cash flows may adversely affect our revenues and cash available for distribution. Accordingly, we are indirectly subject to the business risks of Sanchez Energy, including, among others:
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a reduction in or slowing of Sanchez Energy’s development program, especially on Sanchez Energy’s Catarina Asset, which would directly and adversely impact demand for our gathering and processing services;
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a decline in the price of natural gas, NGLs or oil, which have been extremely volatile for over two years and have recently declined rapidly;
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Sanchez Energy’s ability to finance its operations and development activities;
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the availability of capital on an economic basis to fund Sanchez Energy’s exploration and development activities;
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Sanchez Energy’s ability to replace reserves;
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Sanchez Energy’s drilling and operating risks, including potential environmental liabilities;
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Sanchez Energy’s retention and operation of its current assets, including Sanchez Energy’s Catarina Asset and Comanche asset;
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the speculative nature of drilling wells;
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transportation capacity constraints and interruptions;
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adverse effects of governmental and environmental regulation; and
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losses from pending or future litigation.
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A reduction in the price of natural gas, NGLs or oil could cause Sanchez Energy to record oil and natural gas property impairments, which would adversely affect its future business and development. Sanchez Energy utilizes the successful efforts method of accounting to account for its oil and natural gas exploration and development activities. Under this method of accounting, a company is required when facts and circumstances indicate that the carrying value may not be recoverable to determine whether the book value of its oil and natural gas properties (excluding unevaluated properties) is less than or equal to the estimated undiscounted future net cash flows using management’s expectations of future oil and natural gas prices. If net capitalized costs exceed estimated undiscounted future net cash flows, the measurement of impairment is based on estimated fair value, using estimated discounted future net cash flows. For the year ended December 31, 2018, Sanchez Energy recorded $6.6 million in proved property impairments. Sanchez Energy could incur additional non-cash impairments to its proved oil and natural gas properties in 2019 if the price of natural gas, NGLs or oil declines. These impairments, along with a substantial and sustained decline in oil and natural gas prices, may materially and adversely affect its future business, financial condition, results of operations, liquidity or ability to finance planned capital expenditures.
We are subject to the risk of non-payment or non-performance by Sanchez Energy, including with respect to the Gathering Agreement and the Seco Pipeline Transportation Agreement. During 2018, Sanchez Energy’s stock price declined significantly from a high closing price of $5.99 per share on January 12, 2018 to a low closing price of $0.25 per share on December 27, 2018. In October 2018, Sanchez Energy announced the appointment of two board members with considerable experience in the areas of turnaround management and financial restructuring. In November 2018, Moody’s Investors Service downgraded Sanchez Energy’s corporate family rating from B3 to Caa1. In addition, in December of 2018, Sanchez Energy announced that it had engaged Moelis & Company LLC as a financial advisor to explore strategic alternatives to strengthen its balance sheet and maximize the value of the company. In February 2018, trading in Sanchez Energy’s common stock was suspended on the NYSE and the NYSE notified Sanchez Energy that it’s common stock is subject to delisting proceedings. We cannot predict the extent to which Sanchez Energy’s business or relationship with us would be impacted from a NYSE delisting, failure to implement a viable strategic alternative or if conditions in the energy industry were to further deteriorate, nor can we estimate the impact that such events would have on Sanchez Energy’s ability to execute its drilling and development program or perform under its various commercial agreements with us, but such events could have materially adverse consequences. Any material non-payment or non-performance by Sanchez Energy would reduce our ability to make distributions to our unitholders.
In addition, due to our relationship with Sanchez Energy, our ability to access the capital markets, or the pricing or other terms of any capital markets transactions, may be adversely affected by any further impairment to Sanchez Energy’s financial condition or its credit ratings.
Any material limitation on our ability to access capital as a result of such adverse changes at Sanchez Energy could limit our ability to obtain future financing under favorable terms, or at all, or could result in increased financing costs in the future. Similarly, we believe the material adverse changes at Sanchez Energy have negatively impacted our unit price
and could continue to do so, limiting our ability to raise capital through equity issuances or debt financing, and may negatively affect our ability to engage in, expand or pursue our business activities, and could also prevent us from engaging in certain transactions that might otherwise be considered beneficial to us.
Because of the natural decline in production from existing wells, our success depends, in part, on Sanchez Energy’s ability to replace declining production. Any decrease in volumes of natural gas, NGLs and oil that Sanchez Energy produces or any decrease in the number of wells that Sanchez Energy completes could reduce throughput volumes that could adversely affect our business and operating results.
The volumes that support our facilities depend on the level of production from wells connected to our facilities, which may be less than expected and will naturally decline over time. To the extent Sanchez Energy reduces its activity or otherwise ceases to drill and complete wells, especially on Sanchez Energy’s Catarina Asset, revenues for our gathering and processing services will be directly and adversely affected. In addition, volumes from completed wells will naturally decline and our cash flows associated with these wells will also decline over time. In order to maintain or increase throughput levels on our facilities, we must obtain new sources of natural gas, NGLs and oil from Sanchez Energy or other third parties. The primary factors affecting our ability to obtain additional sources of natural gas, NGLs and oil include (i) the success of Sanchez Energy’s drilling activity in our areas of operation, (ii) Sanchez Energy’s acquisition of additional acreage and (iii) our ability to obtain additional dedications of acreage from Sanchez Energy or new dedications of acreage from other third parties.
We have no control over Sanchez Energy’s or other producers’ levels of development and completion activity in our areas of operation, the amount of reserves associated with wells connected to our facilities or the rate at which production from a well declines. We have no control over Sanchez Energy or other producers or their development plan decisions, which are affected by, among other things:
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the availability and cost of capital;
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prevailing and projected prices for natural gas, NGLs and oil;
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demand for natural gas, NGLs and oil;
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geologic considerations;
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environmental or other governmental regulations, including the availability and maintenance of drilling permits and the regulation of hydraulic fracturing; and
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the costs of producing natural gas, NGLs and oil and the availability and costs of drilling rigs and other equipment.
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Under the terms of the lease covering Sanchez Energy’s Catarina Asset, Sanchez Energy is subject to annual drilling and development requirements. For example, at the present time, the lease requires Sanchez Energy to drill 50 wells per year (with the ability to bank up to 30 wells from a prior period). In addition, Sanchez has various continuous drilling commitments under the leases covering the Comanche asset. If Sanchez Energy fails to meet these minimum drilling commitments, Sanchez Energy could forfeit its acreage under the applicable lease not held by production. Such a forfeiture could impact Sanchez Energy’s ability to develop additional acreage and replace declining production.
Fluctuations in energy prices can also greatly affect the development of reserves. Declines in commodity prices could have a negative impact on Sanchez Energy’s development and production activity, and if sustained, could lead Sanchez Energy to materially reduce its drilling and completion activities. Sustained reductions in development or production activity in our areas of operation could lead to reduced utilization of our services.
Due to these and other factors, even if reserves are known to exist in areas served by our facilities, Sanchez Energy and other producers may choose not to develop, or be prohibited from developing, those reserves. If reductions in
development activity result in our inability to maintain the current levels of throughput on our facilities, those reductions could reduce our revenue and cash flow and adversely affect our ability to make cash distributions to our unitholders.
The Gathering Agreement contains provisions that can reduce the cash flow stability that the agreement was designed to achieve.
The Gathering Agreement is designed to generate stable cash flows for us over the life of the minimum volume commitment contract term while also minimizing direct commodity price risk. Under the minimum volume commitment, subject to certain adjustments, Sanchez Energy has agreed to ship a minimum volume of natural gas, NGLs and oil on Western Catarina Midstream or, in some cases, to pay a minimum monetary amount, over certain periods during the term of the minimum volume commitment, which is the first five years of the 15-year term of the Gathering Agreement (or through 2020). In addition, the Gathering Agreement also includes a minimum quarterly quantity, which is a total amount of natural gas, NGLs and oil that Sanchez Energy must flow on Western Catarina Midstream (or an equivalent monetary amount) each quarter during the minimum volume commitment term. If Sanchez Energy’s actual throughput volumes are less than its minimum volume commitment for the applicable period, it must extend the minimum volume commitment term on a nominal volume basis, but to no longer than the original five years (subject to certain exceptions), or, in some cases, make a shortfall payment to us at the end of that contract quarter, as applicable. The amount of the shortfall payment is based on the difference between the actual throughput volume shipped, processed or offset through an extension of the minimum volume commitment term for the applicable period and the minimum volume commitment for the applicable period, multiplied by the applicable fee. To the extent that Sanchez Energy’s actual throughput volumes are above its minimum volume commitment for the applicable period, the Gathering Agreement contains provisions that allow Sanchez Energy to use the excess volumes as a credit to shorten the minimum volume commitment term, but to no less than four years. Through December 31, 2018, total excess oil and gas volumes from Sanchez Energy have shortened the primary terms of the volume commitments by 279 and 222 days respectively.
Under certain circumstances, it is possible that the combined effect of the minimum volume commitment provisions could result in our receiving substantially reduced revenues or cash flows from Sanchez Energy in a given period. In the most extreme circumstances:
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we could incur operating expenses with substantially reduced corresponding revenues from Sanchez Energy; or
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Sanchez Energy could cease shipping throughput volumes at a time when its aggregate minimum volume commitment has been satisfied with previous throughput volume shipments, which could be in as early as four years.
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If either of these circumstances were to occur, it would have a material adverse effect on our results of operations and financial condition and cash flows and our ability to make cash distributions to our unitholders.
Interruptions in operations at our facilities or facilities that Targa operates on behalf of the Carnero JV may adversely affect operations and cash flows available for distribution to our unitholders.
Any significant interruption at any of our facilities or the facilities that Targa operates on behalf of the Carnero JV, or in our ability or Targa’s ability on behalf of the Carnero JV, as applicable, to gather, treat or process natural gas, NGLs and oil, would adversely affect operations and cash flows available for distribution to our unitholders. Operations at impacted facilities could be partially or completely shut down, temporarily or permanently, as the result of circumstances not within our control, such as:
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unscheduled turnarounds or catastrophic events at physical plants or pipeline facilities;
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restrictions imposed by governmental authorities or court proceedings;
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labor difficulties that result in a work stoppage or slowdown;
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a disruption or decline in the supply of resources necessary to operate a facility;
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damage to facilities resulting from natural gas, NGLs and oil that do not comply with applicable specifications; and
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inadequate transportation or market access to support production volumes, including lack of availability of pipeline capacity.
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We may not be able to attract additional third-party volumes, which could limit our ability to grow and would increase our dependence on Sanchez Energy.
Part of our long-term growth strategy includes identifying additional opportunities to offer gathering, processing and transportation services to other third parties. Our ability to increase throughput on our facilities and any related revenue from third parties is subject to numerous factors beyond our control, including competition from third parties and the extent to which we have available capacity when requested by third parties. To the extent that we lack available capacity on our facilities for third-party volumes, we may not be able to compete effectively with third-party gathering or processing systems for additional volumes. In addition, some of our competitors for third-party volumes have greater financial resources and access to larger supplies of oil and natural gas than those available to us, which could allow those competitors to price their services more aggressively than us. Moreover, the underlying lease for the properties on which Western Catarina Midstream is located restricts Western Catarina Midstream to the handling of hydrocarbons produced on the properties covered by the lease.
We may not be able to attract material third-party service opportunities. Our efforts to attract new unaffiliated customers may be adversely affected by (i) our relationship with Sanchez Energy, certain rights that it has under applicable agreements and with respect to Western Catarina Midstream the fact that a substantial portion of the capacity of the facility will be necessary to service Sanchez Energy’s production and development and completion schedule, (ii) the current nature of our facilities, (iii) our desire to provide services pursuant to fee-based contracts and (iv) the existence of current and future dedications to other gatherers by potential third-party customers. As a result, we may not have the capacity or ability to provide services to third parties, or potential third-party customers may prefer to obtain services pursuant to other forms of contractual arrangements under which we would be required to assume direct commodity exposure.
All of our midstream assets are located in the Eagle Ford Shale in Texas, making us vulnerable to risks associated with operating in one major geographic area.
All of our midstream assets are located in the Eagle Ford Shale in Texas. As a result of this concentration, we may be disproportionately exposed to the impact of regional supply and demand factors, delays or interruptions of production from wells in this area caused by governmental regulation, market limitations or interruption of the processing or transportation of natural gas, NGLs or oil.
We do not intend to obtain independent evaluations of reserves of natural gas, NGLs and oil reserves connected to Western Catarina Midstream on a regular or ongoing basis; therefore, in the future, volumes of natural gas, NGLs and oil on the gathering system could be less than we anticipate.
We have not obtained and do not intend to obtain independent evaluations of the reserves of natural gas, NGLs and oil, including those of Sanchez Energy, connected to Western Catarina Midstream on a regular or ongoing basis. Moreover, even if we did obtain independent evaluations of the reserves of natural gas, NGLs and oil connected to Western Catarina Midstream, such evaluations may prove to be incorrect. Oil and natural gas reserve engineering requires subjective estimates of underground accumulations of oil and natural gas and assumptions concerning future oil and natural gas prices, future production levels and operating and development costs.
Accordingly, we may not have accurate estimates of total reserves dedicated to some or all of Western Catarina Midstream or the anticipated life of such reserves. If the total reserves or estimated life of the reserves connected to Western Catarina Midstream are less than we anticipate and we are unable to secure additional sources of natural gas, NGLs and oil, it could have a material adverse effect on our business, results of operations and financial condition and our ability to make cash distributions to our unitholders.
A shortage of equipment and skilled labor in the Eagle Ford Shale could reduce equipment availability and labor productivity and increase labor and equipment costs, which could have a material adverse effect on our business and results of operations.
Gathering and processing services require special equipment and laborers skilled in multiple disciplines, such as equipment operators, mechanics and engineers, among others. The increased levels of production in the Eagle Ford Shale may result in a shortage of equipment and skilled labor. If we experience shortages of necessary equipment or skilled labor in the future, our labor and equipment costs and overall productivity could be materially and adversely affected. If our equipment or labor prices increase or if we experience materially increased health and benefit costs for employees, our results of operations could be materially and adversely affected.
Distributions we receive from the Carnero JV may fluctuate from quarter to quarter as Targa, the operator, has certain discretion over the amount and timing of distributions, which could adversely affect our ability to pay distributions.
We received approximately $24.9 million in cash from the Carnero JV in the form of distributions during the year ended December 31, 2018. Targa, as the operator of the Carnero JV, has certain rights which permit it to affect the amount and timing of distributions to us. For example, Targa has certain discretion with regard to cash reserves and working capital adjustments that may cause the amount of our distributions to fluctuate from quarter-to-quarter. Fluctuations in the amount and timing of distributions from the Carnero JV could adversely affect our ability to pay distributions to our unitholders.
Our participation in joint ventures exposes us to liability or harm to our reputation resulting from failures by our partner.
In 2016, we purchased from Sanchez Energy a 50% equity interest in each of Carnero Gathering and Carnero Processing, each a joint venture that is 50% owned by Targa and operated by Targa. In May 2018, we executed a series of agreements with Targa and other parties pursuant to which, among other things: (1) the parties merged their respective 50% interests in Carnero Gathering and Carnero Processing to form an expanded 50 / 50 joint venture in South Texas, Carnero JV, (2) Targa contributed 100% of the equity interest in Silver Oak II to Carnero JV, which expanded the processing capacity of the joint venture from 260 MMcf/d to 460 MMcf/d, (3) Targa contributed certain capacity in the Carnero Gathering Line to Carnero JV resulting in the joint venture owning all of the capacity in the Carnero Gathering Line, which has a design limit (without compression) of 400 MMcf/d, and (4) Carnero JV received a new dedication from Sanchez Energy and its working interest partners of over 315,000 Comanche acres in the Western Eagle Ford pursuant to a new long-term firm gas gathering and processing agreement. We and Targa are jointly and severally liable for all liabilities and obligations of the Carnero JV. If Targa fails to perform or is financially unable to bear its portion of required capital contributions or other obligations, including liabilities stemming from claims or lawsuits, we could be required to make additional investments, provide additional services or pay more than our proportionate share of a liability to make up for Targa’s shortfall. Further, if we are unable to adequately address Targa’s performance issues, Sanchez Energy, the main customer on the facilities, may terminate its agreements, which could result in legal liability to us, harm our reputation and reduce cash flows generated from the Carnero Gathering Line and the Raptor Gas Processing Facility.
Increased competition from other companies that provide gathering services could have a negative impact on the demand for our services, which could adversely affect our financial results.
Our ability to flow a sufficient volume of throughput prior to and after the expiration of the Gathering Agreement to maintain current revenues and cash flows could be adversely affected by the activities of our competitors. Our facilities compete primarily with other gathering and processing systems. Some competitors have greater financial resources than us and may now, or in the future, have access to greater supplies of natural gas, NGLs and oil than we do. Some of these competitors may expand or construct facilities that would create additional competition for the services that we provide to Sanchez Energy or other future customers. In addition, Sanchez Energy or other future customers may develop their own facilities instead of using our midstream assets. Moreover, Sanchez Energy and its affiliates are not limited in their ability to compete with us outside of the dedicated areas.
All of these competitive pressures could make it more difficult for us to retain Sanchez Energy as a customer and/or attract new customers as we seek to expand our business, which could have a material adverse effect on our business, financial condition, results of operations and ability to make cash distributions to our unitholders.
If third-party pipelines or other midstream facilities interconnected to our facilities become partially or fully unavailable, our operating margin, cash flow and ability to make cash distributions to our unitholders could be adversely affected.
Our facilities connect to other pipelines or facilities owned and operated by unaffiliated third parties. The continuing operation of third-party pipelines, compressor stations and other midstream facilities is not within our control. These pipelines, plants and other midstream facilities may become unavailable because of testing, turnarounds, line repair, maintenance, reduced operating pressure, lack of operating capacity, regulatory requirements and curtailments of receipt or deliveries due to insufficient capacity or because of damage from severe weather conditions or other operational issues. In addition, if the costs to us to access and transport on these third-party pipelines significantly increase, our profitability could be reduced. If any such increase in costs occurs or if any of these pipelines or other midstream facilities become unable to receive or transport natural gas, NGLs or oil, our operating margin, cash flow and ability to make cash distributions to our unitholders could be adversely affected.
We do not own the land on which Western Catarina Midstream is located, which could result in disruptions to our operations.
We do not own the land on which Western Catarina Midstream is located, and we are, therefore, subject to the possibility of more onerous terms or increased costs to retain necessary land use if we do not have valid rights-of-way or if such rights-of-way lapse or terminate. We currently have certain rights to construct and operate our pipelines on land owned by third parties for a specific period of time and may need to obtain other rights in the future from third parties and governmental agencies to continue these operations or expand Western Catarina Midstream. Our loss of these rights or inability to obtain additional rights, through our inability to renew or obtain right-of-way contracts or otherwise, could have a material adverse effect on our business, results of operations, financial condition and ability to make cash distributions to our unitholders.
Our right-of-first-offer with Sanchez Energy for midstream assets is subject to risks and uncertainty, and thus may not enhance our ability to grow our business.
Pursuant to a right-of-first-offer, Sanchez Energy has agreed to offer us the right to purchase midstream assets that it desires to transfer to any unaffiliated person through 2030. Sanchez Energy is under no obligation to sell any assets to us or to accept any offer for its assets that we may choose to make. Furthermore, for a variety of reasons, we may decide not to exercise this right when it becomes available.
The acquisition of additional assets in connection with the exercise of our right-of-first-offer will depend upon, among other things, our ability to agree on the price and other terms of the sale, our ability to obtain financing on acceptable terms for the acquisition of such assets and our ability to acquire such assets on the same or better terms than third parties. We can offer no assurance that we will be able to successfully acquire any assets pursuant to this right.
Our operations could be disrupted if our or SOG’s information systems are hacked or fail, causing increased expenses and loss of revenue.
We face various security threats, including cybersecurity threats to gain unauthorized access to sensitive information or to render data systems unusable, threats to the security of our facilities and infrastructure, Sanchez Energy’s facilities and infrastructure or other third-party facilities and infrastructure, such as pipelines. The potential for such security threats has subjected our operations to increased risks that could have a material adverse effect on our business.
Our business is highly dependent on financial, accounting and other data processing systems and other communications and information systems, including such systems of SOG that we utilize pursuant to the Services Agreement. We process transactions on a daily basis and rely upon the proper functioning of computer systems. If a key system were hacked or otherwise interfered with by an unauthorized access, or were to fail or experience unscheduled downtime for any reason, even if only for a short period, our financial results could be affected adversely.
Additionally, we rely on information systems across our operations, including the management of processes and transactions. A disrupt to any information systems at our operating locations, or at Sanchez Energy’s or another third-party’s pipelines, terminals or operating locations, may cause disruptions to our operations.
These systems could be damaged or interrupted by a security breach, cyber-attack, fire, flood, power loss, telecommunications failure or similar event. Further, our business interruption insurance may not compensate us adequately for losses that may occur. Additionally, federal legislation relating to cybersecurity threats could impose additional requirements on our operations. Finally, our implementation of additional procedures and controls in response to such legislation or to otherwise monitor and mitigate security threats and to increase security for our information, facilities and infrastructure may result in increased capital and operating costs.
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Risks Related to Our Production Business
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Market conditions for oil, natural gas and NGLs are highly volatile. A sustained decline in prices for these commodities could adversely affect our revenue, cash flows, profitability and growth.
Prices for oil, natural gas and NGLs fluctuate widely in response to a variety of factors that are beyond our control, such as:
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domestic and foreign supply of and demand for oil, natural gas and NGLs;
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weather conditions and the occurrence of natural disasters;
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overall domestic and global economic conditions;
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political and economic conditions in countries producing oil, natural gas and NGLs, including terrorist attacks and threats, escalation of military activity in response to such attacks or acts of war;
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actions of the Organization of Petroleum Exporting Countries (“OPEC”) and other state‑controlled oil companies relating to oil price and production controls;
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the effect of increasing liquefied natural gas and exports from the United States;
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the impact of the U.S. dollar exchange rates on prices for oil, natural gas and NGLs;
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technological advances affecting energy supply and energy consumption;
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domestic and foreign governmental regulations, including regulations prohibiting or restricting our ability to apply hydraulic fracturing to our wells, and taxation;
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the impact of energy conservation efforts and alternative fuel requirements;
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the proximity, capacity, cost and availability of production and transportation facilities for oil, natural gas and NGLs;
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the availability of refining capacity; and
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the price and availability of, and consumer demand for, alternative fuels.
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Governmental actions may also affect prices for oil, natural gas and NGLs. In the past, prices for oil, natural gas and NGLs have been extremely volatile, and we expect this volatility to continue. Beginning in the latter half of 2014, oil prices declined precipitously, and continued to decline throughout 2015 as well as the start 2016. Although oil prices rebounded in 2017, they declined again in the second half of 2018. Such downward volatility has negatively affected the amount of our net estimated proved reserves and has negatively affected the standardized measure of discounted future
net cash flows of our net estimated proved reserves. For the year ended December 31, 2018, we did not record impairment on our oil and natural gas properties. During the same period in 2017, our non-cash impairment charges were approximately $4.7 million, to impair certain of our oil and natural gas properties in Texas.
In addition, our revenue, profitability and cash flow depend upon the prices of and demand for oil, natural gas and NGLs, and continued price volatility and low commodity prices, or a sustained drop in prices could negatively affect our financial results and impede our growth. In particular, sustained declines in commodity prices will:
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limit our ability to enter into commodity derivative contracts at attractive prices;
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reduce the value and quantities of our reserves, because declines in prices for oil, natural gas and NGLs would reduce the amount of oil, natural gas and NGLs that we can economically produce;
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reduce the amount of cash flow available for capital expenditures;
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limit our ability to borrow money; and
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make it uneconomical for our operating partners to commence or continue production levels of oil, natural gas and NGLs.
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Drilling for and producing oil and natural gas are costly and high-risk activities with many uncertainties that could adversely affect our business, financial condition, results of operation, operating cash flows and any ability to pay distributions to our unitholders.
Drilling activities are subject to many risks, including the risk that commercially productive reservoirs will not be discovered. Drilling for oil and natural gas can be uneconomic, not only from dry holes, but also from productive wells that do not produce sufficient revenues to be commercially viable. In addition, drilling and producing operations may be curtailed, delayed or cancelled as a result of other factors, including:
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the high cost, shortages or delivery delays of drilling rigs, equipment, labor and other services;
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unexpected operational events and drilling conditions;
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adverse weather conditions;
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facility or equipment malfunctions;
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piping, casing or cement failures;
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compliance with environmental and other governmental requirements;
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unusual or unexpected geological formations;
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loss or damage to oilfield drilling and service tools;
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loss of drilling fluid circulation;
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formations with abnormal pressures;
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environmental hazards, such as natural gas leaks, oil spills, compressor incidents, pipeline ruptures and discharges of toxic gases;
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accidents or natural disasters;
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blowouts, craterings and explosions;
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uncontrollable flows of oil, natural gas or well fluids;
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loss or theft of data due to cyber-attacks; and
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Any of these events can cause increased costs or restrict the ability to drill wells and conduct operations. Any delay in the drilling program or significant increase in costs could impact our ability to generate sufficient cash flows to operate our business. Increased costs could include losses from personal injury or loss of life; damage to or destruction or loss of property, natural resources, equipment, and data; pollution; environmental contamination; loss of wells; and regulatory penalties.
Unless we replace the reserves that we produce, our existing reserves will decline, which could adversely affect our production and adversely affect our cash from operations and our ability to pay distributions to our unitholders.
Producing oil and natural gas reservoirs are characterized by declining production rates that vary based on the reservoir characteristics and other factors. The rate of decline of our reserves and production included in our reserve report at the end of the most recently completed fiscal year will change if production from our existing wells declines in a different manner than we have estimated and may change when we make acquisitions and under other circumstances. The rate of decline may also be greater than we have estimated due to decreased capital spending or lack of available capital to make capital expenditures. Our future oil and natural gas reserves and production and, therefore, our cash flows and income, are highly dependent on our success in efficiently developing and exploiting our current reserves and economically acquiring additional recoverable reserves, as we do not intend to drill new wells. We may not be able to develop or acquire additional reserves to replace our current and future production at acceptable costs, which could adversely affect our business, financial condition, results of operations and ability to pay distributions to our unitholders.
Our estimated reserves are based on many assumptions that may prove to be inaccurate. Any material inaccuracies in these reserve estimates or underlying assumptions will materially affect the quantities and present value of our estimated reserves.
It is not possible to measure underground accumulations of oil and natural gas in an exact way. Oil and natural gas reserve engineering requires subjective estimates of underground accumulations of oil and natural gas and assumptions concerning future oil and natural gas prices, production levels and operating and development costs. Our independent reserve engineers do not independently verify the accuracy and completeness of information and data furnished by us. In estimating our level of oil and natural gas reserves, we and our independent reserve engineers make certain assumptions that may prove to be incorrect, including assumptions relating to:
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future oil and natural gas prices;
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operating and development costs;
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the effects of regulation;
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the accuracy and reliability of the underlying engineering and geologic data; and
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the availability of funds.
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If these assumptions prove to be incorrect, our estimates of reserves, the economically recoverable quantities of oil and natural gas attributable to any particular group of properties, the classifications of reserves based on risk or recovery and our estimates of the future net cash flows from our reserves could change significantly.
Our standardized measure is calculated using unhedged oil and natural gas prices and is determined in accordance with the rules and regulations of the SEC (except for the impact of income taxes as we are not a taxable entity). Over time, we may make material changes to reserve estimates to take into account changes in our assumptions and the results of actual drilling and production.
The reserve estimates that we make for fields that do not have a lengthy production history are less reliable than estimates for fields with lengthy production histories. A lack of production history may contribute to inaccuracies in our estimates of proved reserves, future production rates and the timing of development expenditures.
The present value of future net cash flows from our estimated proved reserves is not necessarily the same as the current market value of our estimated oil and natural gas reserves.
We base the estimated discounted future net cash flows from our estimated proved reserves on prices and costs in effect on the day of the estimate. However, actual future net cash flows from our oil and natural gas properties also will be affected by factors such as:
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the actual prices that are received for oil and natural gas;
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actual operating costs in producing oil and natural gas;
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the amount and timing of actual production;
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the amount and timing of capital expenditures;
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supply of and demand for oil and natural gas; and
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changes in governmental regulations or taxation.
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The timing of both production and the incurrence of expenses in connection with the development and production of oil and natural gas properties will affect the timing of actual future net cash flows from proved reserves, and thus, their actual present value. In addition, the 10% discount factor used when calculating our discounted future net cash flows in compliance with the Financial Accounting Standard Board’s Accounting Standards may not be the most appropriate discount factor based on interest rates in effect from time to time and risks associated with us or the oil and natural gas industry in general. Any material inaccuracies in these reserve estimates or underlying assumptions could materially affect the quantities and present value of our reserves, which could adversely affect our business, results of operations, financial condition and ability to pay distributions to our unitholders.
Future price declines or downward reserve revisions may result in additional write-downs of our asset carrying values, which could adversely affect our results of operations and limit our ability to borrow funds.
Declines in oil and natural gas prices may result in our having to make substantial downward adjustments to our estimated proved reserves. If this occurs, or if our estimates of development costs increase or production data factors change, accounting rules may require us to write-down, as a noncash charge to earnings, the carrying value of our properties for impairments. We capitalize costs to acquire, find and develop our oil and natural gas properties under the successful efforts accounting method. We are required to perform impairment tests on our assets periodically and whenever events or circumstances warrant a review of our assets. To the extent such tests indicate a reduction of the estimated useful life or estimated future cash flows of our assets, the carrying value may not be recoverable and therefore would require a write-down. We have incurred impairment charges in the past and may do so again in the future. Any impairment could be substantial and have a material adverse effect on our results of operations in the period incurred and our ability to borrow funds under our Credit Agreement, which in turn may adversely affect our ability to make cash distributions to our unitholders.
We depend on certain key customers for sales of our oil and natural gas. To the extent these and other customers reduce the volumes of oil or natural gas they purchase from us and are not replaced by new customers, our revenues and cash available for distribution could decline.
Our oil and natural gas production in Texas and Louisiana is marketed by the operators of our properties. To the extent these or other customers reduce the volumes of oil and natural gas that they purchase from us and are not replaced by new customers, or the market prices for oil and natural gas decline in our market areas, our revenues and cash available for distribution could decline.
Seasonal weather conditions may adversely affect our ability to conduct production activities.
Oil and natural gas operations are often adversely affected by seasonal weather conditions, primarily during periods of severe weather or rainfall, and during periods of extreme cold. Power outages and other damages resulting from tornados, ice storms, flooding and other strong storms or weather events may prevent wells from being operated in an optimal manner. These weather conditions may reduce oil and natural gas production, which could impact or reduce our future operating cash flows.
Shortages of drilling rigs, supplies, oilfield services, equipment and crews could delay operations and reduce our future operating cash flows and cash available to make future investments or to pay distributions.
Higher oil and natural gas prices generally increase the demand for drilling rigs, supplies, services, equipment and crews, and can lead to shortages of, and increasing costs for, drilling equipment, services and personnel. Shortages of, or increasing costs for, experienced drilling crews and equipment and services could restrict the ability to conduct the operations. Any significant increase in operating costs could reduce our revenues, operating cash flows and cash available to make future investments or to pay distributions.
Our oil and natural gas properties may be exposed to unanticipated water disposal or processing costs.
Where water produced from properties fails to meet the quality requirements of applicable regulatory agencies or wells produce water in excess of the applicable volumetric permit limit, the wells may have to be shut in or upgraded for water handling or treatment. The costs to treat or dispose of this produced water may increase if any of the following occur:
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permits cannot be renewed or obtained from applicable regulatory agencies;
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water of lesser quality or requiring additional treatment is produced;
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the wells produce excess water; or
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new laws and regulations require water to be disposed of or treated in a different manner.
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We may be unable to compete effectively with larger companies in the oil and natural gas industry, which may adversely affect our ability to generate sufficient revenue to allow us to pay distributions to our unitholders.
The oil and natural gas industry is intensely competitive with respect to acquiring productive properties, marketing oil and natural gas and securing equipment and trained personnel, and we compete with other companies that have greater resources. Many of our competitors are major independent oil and natural gas companies and possess and employ financial, technical and personnel resources substantially greater than ours. Those companies may be able to develop and acquire more productive properties than our financial and personnel resources permit. Our ability to acquire additional properties will be dependent on our ability to evaluate, select and finance the acquisition of suitable properties and our ability to consummate transactions in a highly competitive environment. Factors that affect our ability to acquire properties include availability of desirable acquisition targets, staff and resources to identify and evaluate properties and available funds. Many of our larger competitors not only drill for and produce oil and natural gas, but also carry on refining operations and market petroleum and other products on a regional, national or worldwide basis. These companies may be able to pay more for oil and natural gas properties and evaluate, bid for and purchase a greater number of properties than our financial or human resources permit. In addition, there is substantial competition for investment capital in the oil and
natural gas industry. Our inability to compete effectively with other companies could have a material adverse effect on our business activities, financial condition and results of operations.
Risks Related to Financing and Credit Environment
Our Credit Agreement has substantial restrictions and financial covenants and requires periodic borrowing base redeterminations.
We depend on our Credit Agreement (as defined below) for future capital needs. The Credit Agreement restricts our ability to obtain additional financing, make investments, lease equipment, sell assets and engage in business combinations. We are also required to comply with certain financial covenants and ratios. Our ability to comply with these restrictions and covenants in the future is uncertain and will be affected by the levels of cash flows from our operations and events or circumstances beyond our control, including events and circumstances that may stem from the condition of financial markets and commodity price levels. Our failure to comply with any of the restrictions and covenants under the Credit Agreement could result in an event of default, which could cause all of our existing indebtedness to become immediately due and payable. Each of the following is also an event of default:
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failure to pay any principal when due or any interest, fees or other amount prior to the expiration of certain grace periods;
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a representation or warranty made under the loan documents or in any report or other instrument furnished thereunder is incorrect when made;
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failure to perform or otherwise comply with the covenants in the Credit Agreement or other loan documents, subject, in certain instances, to certain grace periods;
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any event that permits or causes the acceleration of the indebtedness;
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bankruptcy or insolvency events involving us or our subsidiaries;
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certain changes in control as specified in the covenants to the Credit Agreement;
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the entry of, and failure to pay, one or more adverse judgments in excess of $2.5 million or one or more non-monetary judgments that could reasonably be expected to have a material adverse effect and for which enforcement proceedings are brought or that are not stayed pending appeal; and
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specified events relating to our employee benefit plans that could reasonably be expected to result in liabilities in excess of $2.5 million in any year.
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The Credit Agreement will mature on March 31, 2020. We may not be able to renew or replace the facility at similar borrowing costs, terms, covenants, restrictions or borrowing base, or with similar debt issue costs.
The amount available for borrowing at any one time under the Credit Agreement is limited to the separate borrowing bases associated with our oil and natural gas properties and our midstream assets. The borrowing base for the credit available for the upstream oil and natural gas properties is re-determined semi-annually in the second and fourth quarters of the year, and may be re-determined at our request more frequently and by the lenders, in their sole discretion, based on reserve reports as prepared by petroleum engineers, using, among other things, the oil and natural gas pricing prevailing at such time. The borrowing base for the credit available for our midstream properties is equal to the rolling four quarter EBITDA of our midstream operations multiplied by 4.5. Outstanding borrowings in excess of our borrowing base must be repaid or we must pledge other oil and natural gas properties as additional collateral. We may elect to pay any borrowing base deficiency in three equal monthly installments such that the deficiency is eliminated in a period of three months. Any increase in our borrowing base must be approved by all of the lenders.
Our Credit Agreement contains a condition to borrowing and a representation that no material adverse effect has occurred, which includes, among other things, a material adverse change in, or material adverse effect on the business, operations, property, liabilities (actual or contingent) or condition (financial or otherwise) of us and our subsidiaries who
are guarantors taken as a whole. If a material adverse effect were to occur, we would be prohibited from borrowing under the Credit Agreement and we would be in default under the Credit Agreement, which could cause all of our existing indebtedness to become immediately due and payable.
We may not be able to extend, replace or refinance our Credit Agreement on terms reasonably acceptable to us, or at all, which could materially and adversely affect our business, liquidity, cash flows and prospects.
Our Credit Agreement matures on March 31, 2020. We may not be able to extend, replace or refinance our existing Credit Agreement on terms reasonably acceptable to us, or at all, with our existing syndicate of banks or with replacement banks. In addition, we may not be able to access other external financial resources sufficient to enable us to repay the debt outstanding under our Credit Agreement upon its maturity. Any of the foregoing could materially and adversely affect our business, liquidity, cash flows and prospects.
We will be required to make substantial capital expenditures to increase our asset base. If we are unable to obtain needed capital or financing on satisfactory terms, our ability to make cash distributions may be diminished or our financial leverage could increase.
In order to increase our asset base, we will need to make expansion capital expenditures. If we do not make sufficient or effective expansion capital expenditures, we will be unable to expand our business operations and, as a result, we will be unable to maintain or increase our future cash distributions. To fund our expansion capital expenditures and investment capital expenditures, we will be required to use cash from our operations or incur borrowings. Such uses of cash from our operations will reduce cash available for distribution to our unitholders. Alternatively, we may sell additional common units or other securities to fund our capital expenditures. Our ability to obtain bank financing or our ability to access the capital markets for future equity or debt offerings may be limited by our or Sanchez Energy’s financial condition at the time of any such financing or offering and the covenants in our existing debt agreements, as well as by general economic conditions, contingencies and uncertainties that are beyond our control. Even if we are successful in obtaining the necessary funds, the terms of such financings could limit our ability to pay distributions to our unitholders. In addition, incurring additional debt may significantly increase our interest expense and financial leverage, and issuing additional limited partner interests may result in significant unitholder dilution and would increase the aggregate amount of cash required to maintain the then-current distribution rate, which could materially decrease our ability to pay distributions at the prevailing distribution rate. None of our general partner, Sanchez Energy or any of their respective affiliates is committed to providing any direct or indirect support to fund our growth.
Our Credit Agreement may restrict us from paying any distributions on our outstanding units.
We have the ability to pay distributions to unitholders under our Credit Agreement from available cash, including cash from borrowings under the Credit Agreement, as long as no event of default exists and provided that no distribution to unitholders may be made if the borrowings outstanding, net of available cash, under our Credit Agreement exceed 90% of the borrowing base, after giving effect to the proposed distribution. We have obtained waivers of the Credit Agreement limitation in the past and may need to do so in the future. Our available cash is reduced by any cash reserves established by the Board for the proper conduct of our business and the payment of fees and expenses. Our ability to pay distributions to our unitholders in any quarter will be solely dependent on our ability to generate sufficient cash from our operations and is subject to the approval of the Board.
Our ability to access the capital and credit markets to raise capital and borrow on favorable terms will be affected by disruptions in the capital and credit markets, which could adversely affect our operations, our ability to make acquisitions and our ability to pay distributions to our unitholders.
Disruptions in the capital and credit markets could limit our ability to access these markets or significantly increase our cost to borrow. Some lenders may increase interest rates, enact tighter lending standards, refuse to refinance existing debt at maturity on favorable terms or at all and may reduce or cease to provide funding to borrowers. If we are unable to access the capital markets on favorable terms, our ability to make acquisitions and pay distributions could be affected.
We are exposed to credit risk in the ordinary course of our business activities.
We are exposed to risks of loss in the event of nonperformance by our customers, vendors, lenders in our Credit Agreement and counterparties to our hedging arrangements. Some of our customers, vendors, lenders and counterparties may be highly leveraged and subject to their own operating and regulatory risks. Despite our credit review and analysis, we may experience financial losses in our dealings with these and other parties with whom we enter into transactions as a normal part of our business activities. Any nonpayment or nonperformance by our customers, vendors, lenders or counterparties could have a material adverse impact on our business, financial condition, results of operations or ability to pay distributions.
Our future debt levels may limit our flexibility to obtain additional financing and pursue other business opportunities.
We may incur substantial additional indebtedness in the future under our Credit Agreement or otherwise. Our future indebtedness could have important consequences to us, including:
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our ability to obtain additional financing, if necessary, for working capital, maintenance and investment capital expenditures, acquisitions or other purposes may be impaired or such financing may not be available on favorable terms;
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covenants and financial tests contained in our existing and future credit and debt instruments may affect our flexibility in planning for and reacting to changes in our business, including possible acquisition opportunities;
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increased cash flows required to make principal and interest payments on our indebtedness could reduce the funds that would otherwise be available to fund operations, capital expenditures, future business development or any distributions to unitholders; and
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our debt level may make us more vulnerable than our competitors with less debt to competitive pressures or a downturn in our business or the economy generally.
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Our ability to service our debt will depend upon, among other things, our future financial and operating performance, which will be affected by prevailing economic conditions and financial, business, regulatory and other factors, some of which are beyond our control. If our operating results are not sufficient to service our current or future debt, we will be forced to take actions such as reducing any distributions, reducing or delaying business activities, acquisitions, investments and/or capital expenditures, selling assets, restructuring or refinancing our indebtedness, or seeking additional equity capital or bankruptcy protection. We may not be able to affect any of these remedies on satisfactory terms or at all.
Periods of inflation or stagflation, or expectations of inflation or stagflation, could increase our costs and adversely affect our business and operating results.
During periods of inflation or stagflation, our costs of doing business could increase, including increases in the variable interest rates that we pay on amounts we borrow under our Credit Agreement. As we have hedged a large percentage of our future expected production volumes, the cash flows generated by that future hedged production will be capped. If any of our operating, administrative or capital costs were to increase as a result of inflation or any temporary or long-term increase in the cost of goods and services, such a cap could have a material adverse effect on our business, financial condition, results of operations, ability to pay distributions and the market price of our common units.
An increase in interest rates may cause the market price of our common units to decline and may increase our borrowing costs.
Like all equity investments, an investment in our common units is subject to certain risks. In exchange for accepting these risks, investors may expect to receive a higher rate of return than would otherwise be obtainable from lower-risk investments. Accordingly, as interest rates rise, the ability of investors to obtain higher risk-adjusted rates of return by purchasing government-backed debt or other interest-bearing securities may cause a corresponding decline in demand for riskier investments generally, including equity investments such as publicly-traded limited partnership interests. Reduced demand for our common units resulting from investors seeking other more favorable investment opportunities may cause the trading price of our common units to decline.
Higher interest rates may also increase the borrowing costs associated with our Credit Agreement. If our borrowing costs were to increase, our interest payments on our debt may increase, which would reduce the amount of cash available for our operating or capital activities or for any distribution to unitholders.
The provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act, the rules adopted thereunder and other regulations, including EMIR, may adversely affect our ability to hedge risks associated with our business, which may impact our results of operations and cash flows.
The swaps regulatory provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank Act”) and the rules of the Commodity Futures Trading Commission (“CFTC”) thereunder now in effect and adopted by the CFTC in the future may adversely affect our ability to manage certain of our risks on a cost effective basis. As mandated by the Dodd-Frank Act, the CFTC has proposed rules to set limits on the positions market participants may hold in certain core futures and futures equivalent contracts, option contracts or swaps for or linked to certain physical commodities, including certain oil and natural gas, subject to exceptions for certain bona fide hedging and other types of transactions. If the position limits in the proposed rules or other similar position limits are imposed, our ability to execute our hedging strategies described above could be compromised.
Under the provisions of the Dodd-Frank Act and rules adopted thereunder, we may have to clear on a designated clearing organization and execute on certain markets any swap that we enter into that falls within a class of swaps designated by the CFTC for mandatory clearing unless we qualify for an exception from such requirements as to such swap. The CFTC has designated six classes of interest rate swaps and credit default swaps for mandatory clearing, but has not yet proposed rules designating any class of physical commodity swaps or other class of swaps for mandatory clearing. Although we expect to qualify for the end-user exception from the mandatory clearing and trade execution requirements for the swaps that we enter into to hedge our commercial risks, if we were to fail to qualify for that exception as to a swap we enter into and were required to clear that swap, we would have to post margin with respect to such swap, our cost of entering into and maintaining such swap could increase and we would have less flexibility with respect to that swap than we would enjoy were the swap not cleared. Moreover, the application of the mandatory clearing and trade execution requirements and other swap regulations to other market participants, such as swap dealers, may change the cost and availability of the swaps that we use for hedging.
As required by the Dodd-Frank Act, the CFTC and the federal banking regulators have adopted rules requiring certain market participants to collect initial and variation margin with respect to uncleared swaps from their counterparties except as to any uncleared swaps as to which the counterparty qualifies for the end user exception from the mandatory clearing exception. Although those rules do not require initial margin to be collected from non-financial end users of uncleared swaps, an affected market participant must collect from its counterparty to any uncleared swap that is a non-financial end user, but that does not qualify for the end user exception with respect to that uncleared swap, variation margin with respect to that swap at those times and in those forms and amounts as the market participant determines appropriately addresses the credit risk posed by that counterparty and the risk of that swap. The requirements of those rules relating to initial margin are being phased through September 1, 2020. Were we not to qualify for the end user exception as to any of our uncleared swaps and otherwise have to post initial or variation margin as to our uncleared swaps in the future, our cost of entering into and maintaining swaps would increase. In addition, our counterparties that are subject to the regulations imposing the Basel III capital requirements on them may increase the cost to us of entering into swaps with them or contractually require us to post collateral or greater amounts of collateral
with them in connection with such swaps to offset their increased capital costs or to reduce their capital costs to maintain those swaps on their balance sheets.
The European Market Infrastructure Regulation (“EMIR”) includes regulations related to the trading, reporting, clearing of derivatives and providing margin with respect to derivatives. EMIR may result in increased costs for OTC derivative counterparties and also lead to an increase in the costs of, and demand for, the liquid collateral with respect to any swap to which we are a party and that is governed by EMIR. Therefore, EMIR may impact our ability to maintain or enter into derivatives with certain of our European counterparties.
The Dodd-Frank Act’s swaps regulatory provisions, the related rules described above and the record keeping, reporting and business conduct rules imposed by the Dodd-Frank Act on other swaps market participants, as well as EMIR and the regulations imposing the Basel III capital requirements on certain swaps market participants, could significantly increase the cost of derivative contracts (including through requirements to post margin or other collateral, which could
adversely affect our available liquidity), materially alter the terms of the derivative contracts that we enter into, particularly the provisions relating to the our need to provide margin with respect to, or collateralize our obligations under such derivative contracts, reduce the availability of derivatives to protect against certain risks that we encounter, reduce our ability to monetize or restructure our existing derivative contracts and to execute our hedging strategies. If, as a result of the swaps regulatory regime discussed above, we were to reduce our use of swaps to hedge our risks, such as commodity price risks that we encounter in our operations, our results of operations and cash flows may become more volatile and could be adversely affected.
Risks Related to Our Distributions to Unitholders
If we do not complete expansion projects or make and integrate acquisitions, our future growth may be limited.
Our ability to increase our distributions depends on our ability to complete expansion projects and make acquisitions that result in an increase in cash generated. We may be unable to complete successful, accretive expansion projects or acquisitions for any of the following reasons:
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an inability to identify attractive expansion projects or acquisition candidates or we are outbid by competitors;
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an inability to obtain necessary rights-of-way or governmental approvals, including from regulatory agencies;
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an inability to successfully integrate the businesses that we develop or acquire;
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an inability to obtain financing for such expansion projects or acquisitions on economically acceptable terms, or at all;
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incorrect assumptions about volumes, reserves, revenues and costs, including synergies and potential growth; or
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an inability to secure adequate customer commitments to use the newly developed or acquired facilities.
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We may not have sufficient available cash from operations to pay our quarterly distributions to unitholders following the establishment of cash reserves and the payment of fees and expenses.
The amount of available cash from which we may pay distributions is defined in both our Credit Agreement and our partnership agreement. The amount of available cash that we distribute is subject to the definition of operating surplus in our partnership agreement. Ultimately, the amount of available cash that we may distribute to our unitholders principally depends upon the amount of cash that we generate from our operations, which will fluctuate from quarter to quarter based on numerous factors described in this Form 10-K, including this Item 1A.“Risk Factors.” These and other factors that affect that amount that we can distribute include:
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the amount of revenue generated from our facilities;
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the amount of oil and natural gas that we produce;
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the demand for and the price at which we are able to sell our oil and natural gas production;
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the results of our hedging activity;
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the level of our operating costs;
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the costs that we incur to acquire midstream assets and oil and natural gas properties;
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whether we are able to continue our development activities at economically attractive costs;
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the borrowing base under our Credit Agreement as determined by our lenders;
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the amount of our indebtedness outstanding;
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the level of our interest expense, which depends on the amount of our indebtedness and the interest payable thereon;
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the amount of working capital required to operate our business and our ability to make working capital borrowings under our Credit Agreement;
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fluctuations in our working capital needs;
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the amount of cash reserves established by the Board for the proper conduct of our business, including the maintenance of our asset base and the payment of future distributions on our common units and incentive distribution rights; and
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the level of our maintenance capital expenditures.
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As a result of these factors, we may not have sufficient available cash to maintain or increase our quarterly distributions. The amount of available cash that we could distribute from our operating surplus in any quarter to our unitholders may fluctuate significantly from quarter to quarter and may be significantly less than any prior distributions that we have previously made. If we do not have sufficient available cash or operating cash flows to maintain or increase quarterly distributions, the market price of our common units may decline substantially.
In order for us to make a distribution from available cash under our Credit Agreement, our outstanding debt balances, net of available cash, must be less than 90% of our borrowing base, as determined by our lenders, after giving effect to the proposed distribution. We have obtained waivers of the Credit Agreement limitation in the past and may need to do so in the future. Our available cash excludes any cash reserves established by the Board for the proper conduct of our business and the payment of fees and expenses. We are subject to additional future borrowing base redeterminations before our Credit Agreement matures in March 2020 and cannot forecast the level at which our lenders will set our future borrowing base. If our lenders reduce our borrowing base because of any of the numerous factors generally described in this caption “Risk Factors,” our outstanding debt balances, net of available cash, may exceed 90% of the borrowing base, as determined by our lenders, and we may be unable to make quarterly distributions.
The amount of cash that we have available for distribution to our unitholders depends primarily upon our operating cash flows and not our profitability.
The amount of cash that we have available for distribution depends primarily on our operating cash flows, including cash from reserves and working capital (which may include short-term borrowings), and not solely on our profitability, which is affected by non-cash items. As a result, we may be unable to pay distributions even when we record net income, and we may pay distributions during periods when we incur net losses.
Oil and natural gas prices are very volatile. If commodity prices decline significantly for a temporary or prolonged period, our cash from operations may decline and may adversely impact our ability to invest in new midstream facilities, our financial condition and our profitability.
Our revenue, profitability and operating cash flows depend in part upon the prices and demand for oil and natural gas, and a drop in prices can significantly affect our financial results and impede our growth. Changes in oil and natural gas prices have a significant impact on the value of our reserves and on our operating cash flows and may also impact the fees generated by us from our midstream facilities. In particular, declines in commodity prices will directly reduce the value of our reserves, our operating cash flows, our ability to borrow money or raise capital and our ability to pay distributions and may indirectly reduce the cash flows from our midstream facilities. Prices for oil and natural gas may fluctuate widely in response to relatively minor changes in the supply of and demand for oil and natural gas, market uncertainty and a variety of additional factors that are beyond our control, such as:
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the domestic and foreign supply of and demand for oil and natural gas;
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the price and level of foreign imports of oil and natural gas;
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the level of consumer product demand;
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overall domestic and global economic conditions;
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political and economic conditions in oil and natural gas producing countries, including those in West Africa, the Middle East and South America;
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the ability of members of OPEC to agree to and maintain oil price and production controls;
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the impact of U.S. dollar exchange rates on oil and natural gas prices; technological advances affecting energy consumption;
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domestic and foreign governmental regulations and taxation;
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the impact of energy conservation efforts;
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the costs, proximity and capacity of oil and natural gas pipelines and other transportation facilities;
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the price and availability of alternative fuels; and
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the increase in the supply of natural gas due to the development of natural gas.
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In the past, the prices of oil and natural gas have been extremely volatile, and we expect this volatility to continue. If we raise our distribution level in response to increased operating cash flows during periods of relatively high commodity prices, we may not be able to sustain those distribution levels during periods of lower commodity price levels.
Our operations require capital expenditures, which will reduce any cash available for distribution to our unitholders.
We will need to make capital expenditures to maintain our facilities and infrastructure over the long-term. These expenditures could increase as a result of, among others:
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changes in labor and material costs;
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changes in leasehold and right-of-way costs; and
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government regulations relating to safety, taxation and the environment.
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Our capital expenditures will reduce the amount of cash that we may have available for distribution to our unitholders. In addition, our actual capital expenditures will vary from quarter to quarter.
Each quarter we are required to deduct estimated maintenance capital expenditures from operating surplus, which may result in less cash available for distribution to unitholders than if actual maintenance capital expenditures were deducted.
Our partnership agreement requires us to deduct estimated, rather than actual, maintenance capital expenditures from operating surplus. The amount of estimated maintenance capital expenditures deducted from operating surplus will be subject to review and potential change by the Board at least once a year. In years when our estimated maintenance capital expenditures are higher than actual maintenance capital expenditures, the amount of cash available for distribution to unitholders will be lower than if actual maintenance capital expenditures were deducted from operating surplus. If we underestimate the appropriate level of estimated maintenance capital expenditures, we may have less cash available for distribution in future periods when actual capital expenditures begin to exceed our previous estimates. Over time, if we do
not set aside sufficient cash reserves or have available sufficient sources of financing and make sufficient expenditures to maintain our asset base, we will be unable to pay distributions in full, if at all.
Our hedging activities could result in financial losses or could reduce our income, which may adversely affect our ability to pay distributions.
To achieve more predictable cash flows and to reduce our exposure to adverse fluctuations in the prices of oil and natural gas, our current practice is to hedge, subject to the terms of our Credit Agreement, a significant portion of our expected production volumes for up to five years. As a result, we will continue to have direct commodity price exposure on the unhedged portion of our production volumes. The extent of our commodity price exposure is related largely to the effectiveness and scope of our hedging activities. For example, the derivative instruments that we utilize are generally based on posted market prices, which may differ significantly from the actual oil and natural gas prices that we realize in our operations.
Our actual future production may be significantly higher or lower than we estimated at the time we entered into hedging transactions for such period. If the actual amount is higher than we estimate, we will have greater commodity price exposure than we intended. If the actual amount is lower than the nominal amount that is subject to our derivative financial instruments, we might be forced to satisfy all or a portion of our derivative transactions without the benefit of the cash flows from our sale or purchase of the underlying physical commodity, which may result in a substantial diminution of our liquidity. As a result of these factors, our hedging activities may not be as effective as we intend in reducing the volatility of our cash flows, and in certain circumstances may actually increase the volatility of our cash flows. In addition, our hedging activities are subject to the following risks:
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a counterparty may not perform its obligation under the applicable derivative instrument;
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there may be a change in the expected differential between the underlying commodity price in the derivative instrument and the actual price received; and
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the steps that we take to monitor our derivative financial instruments may not detect and prevent violations of our risk management policies and procedures.
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Acquisitions involve potential risks that could adversely impact our future growth and our ability to pay distributions to our unitholders.
Any acquisition involves potential risks, including, among other things:
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the risk of title defects discovered after closing;
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inaccurate assumptions about revenues and costs, including synergies;
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significant increases in our indebtedness and working capital requirements;
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an inability to transition and integrate successfully or timely the businesses we acquire;
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the cost of transition and integration of data systems and processes;
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potential environmental problems and costs;
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the assumptions of unknown liabilities;
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limitations on rights to indemnity from the seller;
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the diversion of management’s attention from other business concerns;
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increased demands on existing personnel and on our organizational structure;
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disputes arising out of acquisitions;
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customer or key employee losses of the acquired businesses; and
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the failure to realize expected growth or profitability.
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The scope and cost of these risks may ultimately be materially greater than estimated at the time of the acquisition. Furthermore, our future acquisition costs may be higher than those we have achieved historically. Any of these factors could adversely impact our future growth and our ability to pay distributions.
Inadequate insurance could have a material adverse impact on our business, financial condition, results of operations and ability to pay distributions to our unitholders.
We ordinarily maintain insurance against certain losses and liabilities arising from our operations; however, insurance against all operational risks is not available to us. In addition, we may elect not to obtain insurance if we believe that the cost of available insurance is excessive relative to the perceived risks presented. Losses could therefore occur for uninsurable or uninsured risks or in amounts in excess of existing insurance coverage. The occurrence of an event that is not fully covered by insurance could have a material adverse impact on our business, financial condition, results of operations and ability to pay distributions to our unitholders.
Risks Related to Regulatory Compliance
Potential regulatory actions could increase our operating or capital costs and delay our operations or otherwise alter the way we conduct our business.
Our business activities are subject to extensive federal, state, and local regulations. Changes to existing regulations or new regulations may unfavorably impact us, our suppliers or our customers. In the United States, legislation that directly impacts the oil and natural gas industry has been proposed covering areas such as emission reporting and reductions, hydraulic fracturing of wells, the repeal of certain oil and natural gas tax incentives and tax deductions and the treatment and disposal of produced water. The EPA has also ruled that carbon dioxide, methane and other greenhouse gases endanger human health and the environment. This allows the EPA to adopt and implement regulations restricting greenhouse gases under existing provisions of the federal Clean Air Act. In addition, provisions of the Dodd-Frank Act, which regulate financial derivatives, may impact our ability to enter into derivatives or require burdensome collateral or reporting requirements. These and other potential regulations could increase our costs, reduce our liquidity, impact our ability to hedge our future oil and natural gas sales, delay our operations or otherwise alter the way that we conduct our business, negatively impacting our financial condition, results of operations and cash flows.
We are subject to federal, state, and local laws and regulations as interpreted and enforced by governmental authorities possessing jurisdiction over various aspects of the production and transportation of oil and natural gas. The possibility exists that any new laws, regulations or enforcement policies could be more stringent than existing laws and could significantly increase our compliance costs. If we are not able to recover the resulting costs from insurance or through increased revenues, our ability to pay distributions to our unitholders could be adversely affected.
Our failure to obtain or maintain necessary permits could adversely affect our operations.
Our operations are subject to complex and stringent laws and regulations. In order to conduct our operations in compliance with these laws and regulations, we must obtain and maintain numerous permits, approvals and certificates from various federal, state and local governmental authorities. Failure or delay in obtaining regulatory approvals or leases could have a material adverse effect on our ability to develop our properties. In addition, regulations regarding conservation practices and the protection of correlative rights affect our operations by limiting the quantity of oil and natural gas we may produce and sell.
Increased regulation of hydraulic fracturing could result in reductions or delays in the production of natural gas, NGLs and oil by Sanchez Energy, which could reduce the throughput on our facilities and adversely impact our revenues.
A substantial portion of Sanchez Energy’s production of natural gas, NGLs and oil is being developed from unconventional sources, such as shale formations. These reservoirs require hydraulic fracturing completion processes to release the liquids and natural gas from the rock so it can flow through casing to the surface. Hydraulic fracturing is a well stimulation process that utilizes large volumes of water and sand (or other proppant) combined with fracturing chemical additives that are pumped at high pressure to crack open previously impenetrable rock to release hydrocarbons. Hydraulic fracturing is typically regulated by state oil and gas commissions and similar agencies. Various studies are currently underway by the EPA and other federal and state agencies concerning the potential environmental impacts of hydraulic fracturing activities. For example, the EPA issued an advanced notice of proposed rulemaking under the Toxic Substances Control Act in 2014 requesting comments related to disclosures for hydraulic fracturing chemicals. At the same time, certain environmental groups have suggested that additional laws may be needed to more closely and uniformly regulate the hydraulic fracturing process, and legislation has been proposed by some members of the U.S. Congress to provide for such regulation. We cannot predict whether any such legislation will ever be enacted and if so, what its provisions would be. If additional levels of regulation and permits were required through the adoption of new laws and regulations at the federal or state level, that could lead to delays and process prohibitions that could reduce the volumes of liquids and natural gas that move through our facilities, which in turn could materially adversely affect our revenues and results of operations.
Sanchez Energy may incur significant liability under, or costs and expenditures to comply with, environmental and worker health and safety regulations, which are complex and subject to frequent change.
As an owner, lessee or operator of gathering pipelines and compressor stations, we are subject to various stringent federal, state and local laws and regulations relating to the discharge of materials into, and protection of, the environment. Numerous governmental authorities, such as the EPA and analogous state agencies, have the power to enforce compliance with these laws and regulations and the permits issued under them, oftentimes requiring difficult and costly response actions. These laws and regulations may impose numerous obligations that are applicable to our and our customer’s operations, including the acquisition of permits to conduct regulated activities, the incurrence of capital or operating expenditures to limit or prevent releases of materials from our or our customers’ operations, the imposition of specific standards addressing worker protection, and the imposition of substantial liabilities and remedial obligations for pollution or contamination resulting from our and our customer’s operations. Failure to comply with these laws, regulations and permits may result in joint and several, strict liability and the assessment of administrative, civil and criminal penalties, the imposition of remedial obligations, and the issuance of injunctions limiting or preventing some or all of our operations. Private parties, including the owners of the properties through which our facilities pass and facilities where wastes resulting from our operations are taken for reclamation or disposal, may also have the right to pursue legal actions to enforce compliance, as well as to seek damages for non-compliance, with environmental laws and regulations or for personal injury or property damage. We may not be able to recover all or any of these costs from insurance or Sanchez Energy. In addition, we may experience a delay in obtaining or be unable to obtain required permits, which may interrupt our operations and limit our growth and revenues, which in turn could affect our profitability. There is no assurance that changes in or additions to public policy regarding the protection of the environment will not have a significant impact on our operations and profitability.
The operation of our facilities also poses risks of environmental liability due to leakage, migration, releases or spills from our facilities to surface or subsurface soils, surface water or groundwater. Certain environmental laws impose strict as well as joint and several liability for costs required to remediate and restore sites where hazardous substances, hydrocarbons, or solid wastes have been stored or released. We may be required to remediate contaminated properties currently or formerly operated by us or facilities of third parties that received waste generated by our operations regardless of whether such contamination resulted from the conduct of others or from consequences of our own actions that were in compliance with all applicable laws at the time those actions were taken. In addition, claims for damages to persons or property, including natural resources, may result from the environmental, health and safety impacts of our operations. Moreover, public interest in the protection of the environment has increased dramatically in recent years. The trend of more expansive and stringent environmental legislation and regulations applied to the oil and natural gas industry could continue, resulting in increased costs of doing business and consequently affecting profitability.
We may incur significant costs and liabilities as a result of pipeline integrity management program testing and any related pipeline repair or preventative or remedial measures.
The DOT has adopted regulations requiring pipeline operators to develop integrity management programs for transportation pipelines located where a leak or rupture could do the most harm in HCAs. The regulations require operators to:
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perform ongoing assessments of pipeline integrity;
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identify and characterize applicable threats to pipeline segments that could impact a high consequence area;
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improve data collection, integration and analysis;
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repair and remediate the pipeline as necessary; and
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implement preventive and mitigating actions.
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The 2011 Pipeline Safety Act, among other things, increases the maximum civil penalty for pipeline safety violations and directs the Secretary of Transportation to promulgate rules or standards relating to expanded integrity management requirements, automatic or remote-controlled valve use, excess flow valve use, leak detection system installation and testing to confirm the material strength of pipe operating above 30% of specified minimum yield strength in high consequence areas. Should our facilities fail to comply with DOT or comparable state regulations, we could be subject to substantial penalties and fines.
PHMSA has also published advanced notices of proposed rulemaking and notices of proposed rulemaking to solicit comments on the need for changes to its safety regulations as well as advisory bulletins. In April 2016, PHMSA issued a notice of proposed rulemaking that would expand integrity management requirements and impose new pressure requirements on currently regulated gas transmission pipelines and would also significantly expand the regulation of gas gathering lines, subjecting previously unregulated pipelines to requirements regarding damage prevention, corrosion control, public education programs, maximum allowable operating pressure limits and other requirements. In addition, in 2012, PHMSA issued an advisory bulletin providing guidance on the verification of records related to pipeline maximum allowable operating pressure, which could result in additional requirements for the pressure testing of pipelines or the reduction of maximum operating pressures. The adoption of these and other laws or regulations that apply more comprehensive or stringent safety standards could require us to install new or modified safety controls, pursue new capital projects, or conduct maintenance programs on an accelerated basis, all of which could require us to incur increased operational costs that could be significant. While we cannot predict the outcome of legislative or regulatory initiatives, such legislative and regulatory changes could have a material effect on our cash flows. Please read “Item 1. Business—Governmental Regulation—Pipeline Safety Regulation” for more information.
Because we handle oil, natural gas and other petroleum products in our business, we may incur significant costs and liabilities in the future resulting from a failure to comply with new or existing environmental regulations.
The operations of our wells, gathering systems, processing facilities, pipelines and other facilities are subject to stringent and complex federal, state and local environmental laws and regulations. Failure to comply with these laws and regulations may trigger a variety of administrative, civil and criminal enforcement measures, including the assessment of monetary penalties, the imposition of remedial requirements and the issuance of orders enjoining future operations. There is an inherent risk that we may incur environmental costs and liabilities due to the nature of our business and the substances we handle. Certain environmental statues, including RCRA, CERCLA and analogous state laws and regulations, impose strict, joint and several liability for costs required to clean up and restore sites where hazardous substances have been disposed of or otherwise released. In addition, an accidental release from one of our facilities could subject us to substantial liabilities arising from environmental cleanup and restoration costs, claims made by neighboring landowners and other third parties for personal injury and property damage and fines or penalties for related violations of environmental laws or regulations.
Moreover, the possibility exists that stricter laws, regulations or enforcement policies could significantly increase our compliance costs and the cost of any remediation that may become necessary, and these costs may not be recoverable from insurance.
Risks Inherent in an Investment in Our Common Units
Our general partner and its affiliates will have conflicts of interest with us. They will not owe any fiduciary duties to us or our common unitholders, but instead will owe us and our common unitholders limited contractual duties, and they may favor their own interests to the detriment of us and our other common unitholders.
Manager, an affiliate of SOG, owns and controls our general partner and appoints all but two of the directors of our general partner. Although our general partner has a duty to manage us in a manner that is not adverse to us and our unitholders, the directors and officers of our general partner have a fiduciary duty to manage our general partner in a manner that is beneficial to Manager and its affiliates. Conflicts of interest will arise between SOG, Manager and their affiliates, including our general partner, on the one hand, and us and our unitholders, on the other hand. In resolving these conflicts of interest, our general partner may favor its own interests and the interests of Manager and its affiliates over our interests and the interests of our unitholders. These conflicts include the following situations, among others:
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Neither our partnership agreement nor any other agreement requires Manager and its affiliates to pursue a business strategy that favors us or utilizes our assets. The directors and officers of Manager and its affiliates have a fiduciary duty to make these decisions in the best interests of the members of Manager and its affiliates, which may be contrary to our interests. Manager and its affiliates may choose to shift the focus of its investment and growth to areas not served by our assets.
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Our general partner is allowed to take into account the interests of parties other than us, such as SOG, Manager and their affiliates, in resolving conflicts of interest.
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Manager and its affiliates may be constrained by the terms of their respective debt instruments from taking actions, or refraining from taking actions, that may be in our best interests.
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Our partnership agreement replaces the fiduciary duties that would otherwise be owed by our general partner with contractual standards governing its duties, limit our general partner’s liabilities and restrict the remedies available to our unitholders for actions that, without such limitations, might constitute breaches of fiduciary duty.
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Except in limited circumstances, our general partner has the power and authority to conduct our business without unitholder approval.
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Disputes may arise under our commercial agreements with Manager, SOG and their affiliates.
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Our general partner determines the amount and timing of asset purchases and sales, borrowings, issuances of additional partnership units and the creation, reduction or increase of cash reserves, each of which can affect the amount of cash available for distribution to our unitholders.
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Our general partner determines the amount and timing of any capital expenditures and whether a capital expenditure is classified as a maintenance capital expenditure, which will reduce operating surplus, or an expansion or investment capital expenditure, which will not reduce operating surplus. This determination can affect the amount of cash that is distributed to our unitholders.
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Our general partner determines which costs incurred by it are reimbursable by us, the amount of which is not limited by our partnership agreement.
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Our general partner may cause us to borrow funds in order to permit the payment of cash distributions, even if the purpose or effect of the borrowing is to make incentive distributions.
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Our partnership agreement permits us to classify up to $20.0 million as operating surplus, even if it is generated from asset sales, non-working capital borrowings or other sources that would otherwise constitute capital surplus. This cash may be used to fund distributions to Manager as the holder of the incentive distribution rights.
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Our partnership agreement does not restrict our general partner from causing us to pay it or its affiliates for any services rendered to us or entering into additional contractual arrangements with any of these entities on our behalf.
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Our general partner intends to limit its liability regarding our contractual and other obligations.
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Our general partner and its controlled affiliates may exercise their right to call and purchase all of the common units not owned by them if they own more than 80% of our common units.
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Our general partner controls the enforcement of the obligations that it and its affiliates owe to us, including the obligations of SOG and its affiliates under their commercial agreements with us.
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Our general partner decides whether to retain separate counsel, accountants or others to perform services for us.
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Our general partner may elect to cause us to issue common units to Manager in connection with a resetting of the target distribution levels related to our incentive distribution rights without the approval of the Conflicts Committee or our unitholders. This election may result in lower distributions to our common unitholders in certain situations.
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Our general partner has a limited call right that may require unitholders to sell their common units at an undesirable time or price.
If at any time our general partner and its controlled affiliates hold more than 80% of any class of outstanding limited partner interests, then our general partner will have the right, which it may assign or transfer in whole or in part to any of its controlled affiliates or to us, but not the obligation to acquire all, but not less than all, of such class of limited partner interests held by unaffiliated persons at a price equal to the greater of (1) the average of the daily closing price of our common units over the 20 trading days preceding the date three days before notice of exercise of the limited call right is first mailed and (2) the highest per-unit price paid by our general partner or any of its controlled affiliates for common units during the 90-day period preceding the date such notice is first mailed. As a result, unitholders may be required to sell their common units at an undesirable time or price and may not receive any return or a negative return on their investment. Unitholders may also incur tax liability upon a sale of their units. Our general partner is not obligated to obtain a fairness opinion regarding the value of the common units to be repurchased by it upon exercise of the limited call right. There is no restriction in our partnership agreement that prevents our general partner from causing us to issue additional common units and then exercising its limited call right.
If our general partner exercised its limited call right, the effect would be to take us private and, if the units were subsequently deregistered, we would no longer be subject to the reporting requirements of the Exchange Act.
The standstill in the Board Representation and Standstill Agreement among us, our general partner and Stonepeak Catarina Holdings LLC will expire on March 31, 2019.
In connection with our October 2015 issuance of Class B Preferred Units to Stonepeak Catarina Holdings LLC (“Stonepeak Catarina”), an affiliate of Stonepeak Infrastructure Partners (“Stonepeak”), we entered into that certain Board Representation and Standstill Agreement (the “Representation and Standstill Agreement”), among us, our general partner and Stonepeak Catarina. The Representation and Standstill Agreement includes a standstill provision pursuant to which Stonepeak Catarina, as the holder of all of our outstanding Class B Preferred Units, agreed that it and its affiliates would refrain from, among other things, (i) acquiring beneficial ownership of additional common units, Class A Preferred Units, Class B Preferred Units or other Partnership Interests (as defined in our partnership agreement); (ii) acquiring any of our debt or assets, or the debt or assets of any of our subsidiaries, (iii) engaging in any hostile takeover activities with respect to us or our general partner, including any merger, consolidation, recapitalization, business combination, joint venture, acquisition or similar transaction involving us or our general partner or any of our respective affiliates or properties
(excluding Sanchez Energy and its subsidiaries and its and their properties), (iv) entering into any transaction the effect of which would be to “short” any of our securities, (v) forming, jointing or participating in any “group” (within the meaning of Section 13(d) of the Exchange Act) with respect to any voting securities of us or our affiliates in respect of any action otherwise prohibited pursuant to the standstill, (vi) calling (or participation in the calling of) a meeting of our partner for the purpose of removing (or approving the removal of) of Sanchez Midstream Partners GP LLC as our general partner and/or electing a successor general partner, (vii) “soliciting” any “proxies” (as such terms are used in the rules and regulation of the SEC) or voting for or in support of (A) the removal of Sanchez Midstream Partners GP LLC as our general partner or (B) the election of any successor general partner, or taking any action the direct effect or purpose of which would be to induce our partners to vote or provide proxies that may be voted in favor of any action contemplated by either of (A) or (B) of this subsection, (viii) issuing, inducing or assisting in the publication of any press release, media report or other publication in connection with the potential or proposed removal of Sanchez Midstream Partners GP LLC as our general partner and/or the election of a successor general partner for the Partnership, and (ix) if Sanchez Midstream Partners GP LLC is removed as our general partner, then the participation in any way in the management, ownership and/or control of the successor general partner or the successor general partner’s operation of us, other than participation by directors designated to the Board by Stonepeak Catarina in connection with the fulfillment of their duties as directors (actions described in the foregoing (i) through (ix), the “Standstill Actions”). Under the terms of the Representation and Standstill Agreement, the prohibition against taking any of the Standstill Actions expires on March 31, 2019. While we are not aware of any current intentions by Stonepeak Catarina or its affiliates to take any of the Standstill Actions, we will no longer be afforded protection from such actions after March 31, 2019. If any of the Standstill Actions occurs it may materially and adversely affect our business, liquidity, cash flows and prospects.
SOG and its affiliates may compete with us.
SOG and its affiliates may compete with us. As a result, SOG and its affiliates have the ability to acquire and operate assets that directly compete with our assets.
Manager may not allocate corporate opportunities to us.
Pursuant to the terms of our partnership agreement, the doctrine of corporate opportunity, or any analogous doctrine, does not apply to our general partner or any of its affiliates, including Manager and its executive officers and directors. Any such person or entity that becomes aware of a potential transaction, agreement, arrangement or other matter that may be an opportunity for us does not have any duty to communicate or offer such opportunity to us. Any such person or entity will not be liable to us or to any limited partner for breach of any fiduciary duty or other duty by reason of the fact that such person or entity pursues or acquires such opportunity for itself, directs such opportunity to another person or entity or does not communicate such opportunity or information to us. This may create actual and potential conflicts of interest between us and affiliates of our general partner and result in less than favorable treatment of us and our common unitholders.
Our partnership agreement permits our general partner to redeem any partnership interests held by a limited partner who is an ineligible holder.
If our general partner, with the advice of counsel, determines that our not being treated as an association taxable as a corporation or otherwise taxable as an entity for U.S. federal income tax purposes, coupled with the tax status (or lack of proof thereof) of one or more of our limited partners, has, or is reasonably likely to have, a material adverse effect on the maximum applicable rates chargeable to customers by us or our subsidiaries, or we become subject to federal, state or local laws or regulations that create a substantial risk of cancellation or forfeiture of any property that we have an interest in because of the nationality, citizenship or other related status of any limited partner, our general partner may redeem the units held by the limited partner at their current market price. In order to avoid any material adverse effect on rates charged or cancellation or forfeiture of property, our general partner may require each limited partner to furnish information about their U.S. federal income tax status or nationality, citizenship or related status. If a limited partner fails to furnish information about their U.S. federal income tax status or nationality, citizenship or other related status after a request for the information or our general partner determines after receipt of the information that the limited partner is not an eligible holder, our general partner may elect to treat the limited partner as an ineligible holder. An ineligible holder assignee does not have the right to direct the voting of their units and may not receive distributions in kind upon our liquidation.
The market price of our common units may fluctuate significantly, and you could lose all or part of your investment.
The market price of our common units may be influenced by many factors, some of which are beyond our control, including:
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the level of our quarterly distributions;
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our quarterly or annual earnings or those of other companies in our industry;
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announcements by us or our competitors of significant contracts or acquisitions;
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changes in accounting standards, policies, guidance, interpretations or principles;
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general economic conditions, including interest rates and governmental policies impacting interest rates;
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the failure of securities analysts to cover our common units or changes in financial estimates by analysts;
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future sales of our common units; and
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other factors described in this proxy statement/prospectus and the documents incorporated herein.
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Our partnership agreement replaces our general partner’s fiduciary duties to holders of our common units with contractual standards governing its duties.
Our partnership agreement contains provisions that eliminate the fiduciary standards to which our general partner would otherwise be held by state fiduciary duty law and replace those duties with several different contractual standards. For example, our partnership agreement permits our general partner to make a number of decisions in its individual capacity, as opposed to in its capacity as our general partner, free of any duties to us and our unitholders other than the implied contractual covenant of good faith and fair dealing, which means that a court will fill gaps under the partnership agreement to enforce the reasonable expectations of the partners, but only where the language in the partnership agreement does not provide for a clear course of action. This provision entitles our general partner to consider only the interests and factors that it desires and relieves it of any duty or obligation to give any consideration to any interest of, or factors affecting, us, our affiliates or our limited partners. Examples of decisions that our general partner may make in its individual capacity include:
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how to allocate business opportunities among us and its other affiliates;
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whether to exercise its limited call right;
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whether to seek approval of the resolution of a conflict of interest by the Conflicts Committee; and
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whether or not to consent to any merger or consolidation of the partnership or amendment to the partnership agreement.
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Our partnership agreement restricts the remedies available to our common unitholders for actions taken by our general partner that might otherwise constitute breaches of fiduciary duty.
The effect of eliminating fiduciary standards in our partnership agreement is that the remedies available to unitholders for actions taken by our general partner that might otherwise constitute breaches of fiduciary duty under state fiduciary duty law will be significantly restricted. For example, our partnership agreement provides that:
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whenever our general partner, the Board or any committee thereof (including the Conflicts Committee) makes a determination or takes, or declines to take, any other action in their respective capacities, our general partner, the Board and any committee thereof (including the Conflicts Committee), as applicable, is required to make such determination, or take or decline to take such other action, in good faith, and under our partnership agreement, a determination, other action or failure to act by our general partner and any committee thereof
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(including the Conflicts Committee) will be deemed to be in good faith unless the general partner, the Board or any committee thereof (including the Conflicts Committee) believed that such determination, other action or failure to act was adverse to the interests of the partnership or, with regard to certain determinations by the Board relating to the conflict transactions described below, the Board did not believe that the specified standards were met, and, except as specifically provided by our partnership agreement, neither our general partner, the Board nor any committee thereof (including the Conflicts Committee) will be subject to any other or different standard imposed by our partnership agreement, Delaware law, or any other law, rule or regulation, or at equity;
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our general partner will not have any liability to us or our unitholders for decisions made in its capacity as a general partner so long as such decisions are made in good faith;
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our general partner and its officers and directors will not be liable for monetary damages to us or our limited partners resulting from any act or omission unless there has been a final and non-appealable judgment entered by a court of competent jurisdiction determining that our general partner or its officers and directors, as the case may be, acted in bad faith or, in the case of a criminal matter, acted with knowledge that the conduct was criminal; and
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our general partner will not be in breach of its obligations under the partnership agreement (including any duties to us or our unitholders) if a transaction with an affiliate or the resolution of a conflict of interest is:
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approved by the Conflicts Committee of the Board, although our general partner is not obligated to seek such approval;
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approved by the vote of a majority of the outstanding common units, excluding any common units owned by our general partner and its affiliates;
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determined by the Board to be on terms no less favorable to us than those generally being provided to or available from unrelated third parties; or
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determined by the Board to be fair and reasonable to us, taking into account the totality of the relationships among the parties involved, including other transactions that may be particularly favorable or advantageous to us.
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In connection with a situation involving a transaction with an affiliate or a conflict of interest, any determination by our general partner or the Conflicts Committee must be made in good faith. If an affiliate transaction or the resolution of a conflict of interest is not approved by our common unitholders or the Conflicts Committee and the Board determine that the resolution or course of action taken with respect to the affiliate transaction or conflict of interest satisfies either of the standards set forth in the third and fourth sub-bullets above, then it will be presumed that, in making its decision, the Board acted in good faith, and in any proceeding brought by or on behalf of any limited partner or the partnership challenging such determination, the person bringing or prosecuting such proceeding will have the burden of overcoming such presumption.
Furthermore, if any limited partner, our general partner or any person holding any beneficial interest in us brings any claims, suits, actions or proceedings (including, but not limited to, those asserting a claim of breach of a fiduciary duty) and such person does not obtain a judgment on the merits that substantially achieves, in substance and amount, the full remedy sought, then such limited partner, our general partner or person holding any beneficial interest in us shall be obligated to reimburse us and our “affiliates,” as defined in Section 1.1 of our partnership agreement (including our general partner, the directors and officers of our general partner, SOG and Manager) for all fees, costs and expenses of every kind and description, including, but not limited to, all reasonable attorney’s fees and other litigation expenses, that the parties may incur in connection with such claim, suit, action or proceeding.
Our partnership agreement includes exclusive forum, venue and jurisdiction provisions and limitations regarding claims, suits, actions or proceedings. By taking ownership of a common unit, a limited partner is irrevocably consenting to these provisions and limitations regarding claims, suits, actions or proceedings and submitting to the exclusive jurisdiction of Delaware courts.
Our partnership agreement is governed by Delaware law. Our partnership agreement includes exclusive forum, venue and jurisdiction provisions designating Delaware courts as the exclusive venue for most claims, suits, actions and proceedings involving us or our officers, directors and employees and limitations regarding claims, suits, actions or proceedings. By taking ownership of a common unit, a limited partner is irrevocably consenting to these provisions and limitations regarding claims, suits, actions or proceedings and submitting to the exclusive jurisdiction of Delaware courts. If a dispute were to arise between a limited partner and us or our officers, directors or employees, the limited partner may be required to pursue its legal remedies in Delaware, which may be an inconvenient or distant location and which is considered to be a more corporate-friendly environment. Furthermore, if any limited partner, our general partner or person holding any beneficial interest in us brings any claims, suits, actions or proceedings (including, but not limited to, those asserting a claim of breach of a fiduciary duty) and such person does not obtain a judgment on the merits that substantially achieves, in substance and amount, the full remedy sought, then such limited partner, our general partner or person holding any beneficial interest in us shall be obligated to reimburse us and our “affiliates,” as defined in Section 1.1 of our partnership agreement (including our general partner, the directors and officers of our general partner, SOG and Manager) for all fees, costs and expenses of every kind and description, including, but not limited to, all reasonable attorneys’ fees and other litigation expenses, that the parties may incur in connection with such claim, suit, action or proceeding. This provision may have the effect of increasing a unitholder’s cost of asserting a claim and therefore, discourage lawsuits against us and our general partner’s directors and officers. Because fee-shifting provisions such as these are relatively new developments in corporate and partnership law, the enforceability of such provisions are uncertain; in addition, future legislation could restrict or limit this provision of our partnership agreement and its effect of saving us and our affiliates from fees, costs and expenses incurred in connection with claims, actions, suits or proceedings.
Holders of our common units will have limited voting rights and will not be entitled to elect our general partner or its directors.
Our common unitholders have limited voting rights on matters affecting our business and, therefore, limited ability to influence management’s and our general partner’s decisions regarding our business. Common unitholders will have no right on an annual or ongoing basis to elect our general partner or the Board. Rather, the Board will be appointed by Manager. Furthermore, if common unitholders are dissatisfied with the performance of our general partner, they will have little ability to remove our general partner. As a result of these limitations, the price at which our common units will trade could be diminished because of the absence or reduction of a takeover premium in the trading price. Our partnership agreement also contains provisions limiting the ability of common unitholders to call meetings or to acquire information about our operations, as well as other provisions limiting our common unitholders’ ability to influence the manner or direction of management.
Our partnership agreement restricts the voting rights of common unitholders owning 20% or more of our common units.
Common unitholders’ voting rights are further restricted by a provision of our partnership agreement providing that any units held by a person that owns 20% or more of any class of units then outstanding, other than our general partner, its affiliates, their transferees and persons who acquired such units with the prior approval of the Board, cannot vote on any matter.
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Our general partner interest or the control of our general partner may be transferred to a third-party without unitholder consent.
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Our general partner is able to transfer its general partner interest to a third party in a merger or in a sale of all or substantially all of any assets it may own without the consent of our common unitholders. Furthermore, there is no restriction in the partnership agreement on the ability of Manager to transfer its membership interest in our general partner to a third party. The new members of our general partner would then be in a position to replace the directors and officers of our general partner in order to control the decisions taken by the Board or such officers.
The incentive distribution rights held by Manager may be transferred to a third party without unitholder consent.
Manager is able to transfer its incentive distribution rights to a third party at any time without the consent of our common unitholders. If Manager transfers its incentive distribution rights to a third party but retains its ownership interest in our general partner, our general partner may not have the same incentive to grow our partnership and increase quarterly distributions to unitholders over time as it would if Manager had retained ownership of the incentive distribution rights. For example, a transfer of incentive distribution rights by Manager could reduce the likelihood of SOG or its affiliates accepting offers made by us relating to assets owned by it or its affiliates, as they would have less of an economic incentive to grow our business, which in turn would impact our ability to grow our asset base.
Following the conversion of the Class B Preferred Units, you may experience dilution of your common units and we may not have sufficient available cash to enable us to maintain or increase the quarterly distribution amount on our common units.
As of March 7, 2019, there were 31,310,896 Class B Preferred Units issued and outstanding which are convertible at any time into not less than 31,310,896 common units (plus additional common units resulting from the issuance of paid-in-kind distributions, if any, on such Class B Preferred Units). Any future conversion of the Class B Preferred Units would dilute the percentage ownership held by our common unitholders. Additionally, any future conversion of Class B Preferred Units will result in the payment of distributions on any additional common units issued as a result of such conversion, and we may not have sufficient available cash to maintain or increase the quarterly distribution amount on our common units following the payment of such distributions.
We are able to issue additional units without common unitholder approval, which would dilute unitholder interests.
Our partnership agreement does not limit the number of additional limited partner interests, including limited partner interests that rank senior to our common units that we may issue at any time without the approval of our common unitholders. The issuance by us of additional common units or other equity securities of equal or senior rank will have the following effects:
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our existing limited partners’ proportionate ownership interest in us will decrease;
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the amount of cash available for distribution on each limited partnership interest may decrease;
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because the amount payable to holders of incentive distribution rights is based on a percentage of the total cash available for distribution, the distributions to holders of incentive distribution rights will increase even if the per unit distribution on common units remains the same;
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the ratio of taxable income to distributions may increase;
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the relative voting strength of each previously outstanding limited partner interest may be diminished; and
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the market price of our common units may decline.
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Our general partner intends to limit its liability regarding our obligations.
Our general partner intends to limit its liability under contractual arrangements so that the counterparties to such arrangements have recourse only against our assets and not against our general partner or its assets. Our general partner may therefore cause us to incur indebtedness or other obligations that are nonrecourse to our general partner. Our partnership agreement permits our general partner to limit its liability, even if we could have obtained more favorable terms without the limitation on liability. In addition, we are obligated to reimburse or indemnify our general partner to the extent that it incurs obligations on our behalf. Any such reimbursement or indemnification payments would reduce the amount of cash otherwise available for distribution to our unitholders.
Manager, or any transferee holding a majority of the incentive distribution rights, may elect to cause us to issue common units to it in connection with a resetting of the minimum quarterly distribution and the target distribution levels related to the incentive distribution rights, without the approval of the Conflicts Committee of our general partner or our unitholders. This election may result in lower distributions to our common unitholders in certain situations.
The holder or holders of a majority of the incentive distribution rights, which is currently Manager, has the right, at any time when such holders have received incentive distributions at the highest level to which they are entitled (35.5%) for each of the prior four consecutive fiscal quarters (and the amount of each such distribution did not exceed adjusted operating surplus for each such quarter), to reset the minimum quarterly distribution and the initial target distribution levels at higher levels based on our cash distribution at the time of the exercise of the reset election. Following a reset election, the minimum quarterly distribution will be reset to an amount equal to the average cash distribution per unit for the two fiscal quarters immediately preceding the reset election (such amount is referred to as the “reset minimum quarterly distribution”), and the target distribution levels will be reset to correspondingly higher levels based on percentage increases above the reset minimum quarterly distribution. Manager has the right to transfer the incentive distribution rights at any time, in whole or in part, and any transferee holding a majority of the incentive distribution rights will have the same rights as Manager with respect to resetting target distributions.
In the event of a reset of the minimum quarterly distribution and the target distribution levels, the holders of the incentive distribution rights will be entitled to receive, in the aggregate, the number of common units equal to that number of common units which would have entitled the holders to an average aggregate quarterly cash distribution in the prior two quarters equal to the distributions on the incentive distribution rights in the prior two quarters. We anticipate that Manager would exercise this reset right in order to facilitate acquisitions or internal growth projects that would not otherwise be sufficiently accretive to cash distributions per common unit. It is possible, however, that Manager or a transferee could exercise this reset election at a time when it is experiencing, or expects to experience, declines in the cash distributions that it receives related to its incentive distribution rights and may therefore desire to be issued common units rather than retain the right to receive incentive distribution payments based on target distribution levels that are less certain to be achieved in the then-current business environment. This risk could be elevated if our incentive distribution rights have been transferred to a third party. As a result, a reset election may cause our common unitholders to experience dilution in the amount of cash distributions that they would have otherwise received had we not issued common units to Manager in connection with resetting the target distribution levels.
Your liability may not be limited if a court finds that unitholder action constitutes control of our business.
A general partner of a partnership generally has unlimited liability for the obligations of the partnership, except for those contractual obligations of the partnership that are expressly made without recourse to the general partner. Our partnership is organized under Delaware law, and we conduct business in and outside of Delaware. The limitations on the liability of holders of limited partner interests for the obligations of a limited partnership have not been clearly established in some of the other states in which we do business. You could be liable for any and all of our obligations as if you were a general partner if a court or government agency were to determine that:
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we were conducting business in a state but had not complied with that particular state’s partnership statute; or
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your right to act with other unitholders to remove or replace our general partner, to approve some amendments to our partnership agreement or to take other actions under our partnership agreement constitute “control” of our business.
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Unitholders may have liability to repay distributions that were wrongfully distributed to them.
Under certain circumstances, unitholders may have to repay amounts wrongfully returned or distributed to them. Under Section 17-607 of the Delaware Revised Uniform Limited Partnership Act (the “Delaware Act”), we may not make a distribution to you if the distribution would cause our liabilities to exceed the fair value of our assets. Delaware law provides that for a period of three years from the date of an impermissible distribution, limited partners who received the distribution and who knew at the time of the distribution that it violated Delaware law will be liable to the limited partnership for the distribution amount. Transferees of common units are liable both for the obligations of the transferor
to make contributions to the partnership that were known to the transferee at the time of transfer and for those obligations that were unknown if the liabilities could have been determined from the partnership agreement. Neither liabilities to partners on account of their partnership interest nor liabilities that are non-recourse to the partnership are counted for purposes of determining whether a distribution is permitted.
The NYSE American does not require a publicly traded limited partnership like us to comply with certain of its corporate governance requirements.
Because we are a publicly traded limited partnership, the NYSE American does not require us to have a majority of independent directors on the Board or to establish a compensation committee or a nominating and corporate governance committee. Accordingly, unitholders will not have the same protections afforded to certain corporations that are subject to all of the NYSE American corporate governance requirements.
Tax Risks
Our tax treatment depends on our status as a partnership for U.S. federal income tax purposes, as well as our not being subject to a material amount of entity-level taxation by states and localities. If the Internal Revenue Service (“IRS”) were to treat us as a corporation for U.S. federal income tax purposes or if we were otherwise subject to a material amount of entity-level taxation, then our cash available for distribution would be substantially reduced.
The anticipated after-tax economic benefit of an investment in our common units depends largely on us being treated as a partnership for U.S. federal income tax purposes. Despite the fact that we are a limited partnership under Delaware law, we will be treated as a corporation for U.S. federal income tax purposes unless we satisfy a “qualifying income” requirement. Based on our current operations, we believe that we satisfy the qualifying income requirement and will continue to be treated as a partnership for U.S. federal income tax purposes. Failure to meet the qualifying income requirement or a change in current law could cause us to be treated as a corporation for U.S. federal income tax purposes or otherwise subject us to taxation as an entity. We have not requested, and do not plan to request, a ruling from the IRS with respect to our treatment as a partnership for U.S. federal income tax purposes.
If we were treated as a corporation for U.S. federal income tax purposes, we would pay U.S. federal income tax on our taxable income at the corporate income tax rate, and we would also likely pay additional state and local income taxes at varying rates. Distributions to unitholders would generally be taxed again as corporate dividends (to the extent of our current and accumulated earnings and profits as determined for U.S. federal income tax purposes), and no income, gains, losses, deductions or credits recognized by us would flow through to the unitholders. Because a tax would be imposed on us as a corporation, our cash available for distribution to our unitholders would be reduced.
At the state level, several states have been evaluating ways to subject partnerships to entity-level taxation through the imposition of state income, franchise and other forms of taxation. Imposition of a material amount of any these taxes in the jurisdictions in which we own assets or conduct business could substantially reduce the cash available for distribution to our unitholders.
If we were treated as a corporation for U.S. federal income tax purposes or otherwise subjected to a material amount of entity-level taxation, there would be a material reduction in the anticipated cash flow and after-tax return to our unitholders likely causing a substantial reduction in the value of our common units.
Our partnership agreement provides that if a law is enacted or existing law is modified or interpreted in a manner that subjects us to taxation as a corporation or otherwise subjects us to entity-level taxation for U.S. federal, state or local income tax purposes, the minimum quarterly distribution and the target distributions may be adjusted to reflect the impact of that law on us.
The tax treatment of publicly traded partnerships or an investment in our common units could be subject to potential legislative, judicial or administrative changes and differing interpretations, possibly on a retroactive basis.
The present U.S. federal income tax treatment of publicly traded partnerships, including us, or an investment in our common units may be modified by administrative or legislative changes or differing judicial interpretation at any time. For example, from time to time members of the U.S. Congress have proposed and considered substantive changes to the existing U.S. federal income tax laws that would affect publicly traded partnerships. We are unable to predict whether any of these changes or other proposals will ultimately be enacted. Any modification to the U.S. federal income tax laws and interpretations thereof may or may not be applied retroactively and could make it more difficult or impossible for us to meet the exception for certain publicly traded partnerships to be treated as a partnership for U.S. federal income tax purposes and could negatively impact the value of an investment in our common units.
Our common unitholders’ share of our income will be taxable to them even if they do not receive any cash distributions from us.
Common unitholders are required to pay U.S. federal income and other taxes and, in some cases, state and local income taxes, on their share of our taxable income, whether or not they receive cash distributions from us. Our common unitholders may not receive cash distributions from us equal to their share of our taxable income or even equal to the actual tax liability due from them with respect to that income.
If the IRS contests the U.S. federal income tax positions we take, the market for our common units may be adversely impacted, and our cash available for distribution to our unitholders might be substantially reduced.
We have not requested a ruling from the IRS with respect to our treatment as a partnership for U.S. federal income tax purposes or any other matter affecting us. The IRS may adopt positions that differ from the positions we take. It may be necessary to resort to administrative or court proceedings to sustain some or all of the positions we take, and a court may disagree with some or all of those positions. Any contest with the IRS may materially and adversely impact the market for our common units and the price at which they trade. In addition, our costs of any contest with the IRS will result in a reduction in cash available for distribution to our unitholders and thus will be borne indirectly by our unitholders.
Pursuant to legislation applicable for partnership tax years beginning after 2017 if the IRS makes audit adjustments to our partnership tax returns, it may assess and collect any taxes (including any applicable penalties or interest) resulting from such audit adjustments directly from us. To the extent possible under these new rules, our general partner may elect to either pay the taxes (including any applicable penalties and interest) directly to the IRS in the year in which the audit is completed, or, if we are eligible, issue a revised information statement to each current and former unitholder with respect to an audited and adjusted partnership tax return. Although our general partner may elect to have our current and former unitholders take such audit adjustment into account and pay any resulting taxes (including applicable penalties or interest) in accordance with their interests in us during the tax year under audit, there can be no assurance that such election will be practical, permissible or effective in all circumstances. If we make payments of taxes and any penalties and interest directly to the IRS in the year in which the audit is completed, our cash available for distribution to our unitholders might be substantially reduced, in which case our current unitholders may bear some or all of the tax liability resulting from such audit adjustment even if the unitholders did not own units in us during the tax year under audit.
Tax gain or loss on the disposition of our common units could be more or less than expected.
If a common unitholder sells common units, the unitholder will recognize gain or loss equal to the difference between the amount realized and its tax basis in those common units. Because distributions in excess of a unitholder’s allocable share of our net taxable income decrease the unitholder’s tax basis in its common units, the amount, if any, of such prior excess distributions with respect to the common units a unitholder sells will, in effect, become taxable income to the unitholder if the unitholder sells such common units at a price greater than its tax basis in those common units, even if the price received is less than its original cost. Furthermore, a substantial portion of the amount realized, whether or not representing gain, may be taxed as ordinary income due to potential recapture items, including depreciation, depletion and intangible drilling cost recapture. In addition, because the amount realized may include a unitholder’s share of our liabilities, a unitholder that sells common units may incur a tax liability in excess of the amount of cash received from the sale.
Unitholders may be subject to limitations on their ability to deduct interest expense we incur.
Our ability to deduct business interest expense is limited for U.S. federal income tax purposes to an amount equal to our business interest income and 30% of our “adjusted taxable income” during the taxable year, computed without regard to any business interest income or expense, and in the case of taxable years beginning before 2022, any deduction allowable for depreciation, amortization, or depletion. Business interest expense that we are not entitled to fully deduct will be allocated to each unitholder as excess business interest and can be carried forward by the unitholder to successive taxable years and used to offset any excess taxable income allocated by us to the unitholder. Any excess business interest expense allocated to a unitholder will reduce the unitholder’s tax basis in its partnership interest in the year of the allocation even if the expense does not give rise to a deduction to the unitholder in that year.
Tax-exempt entities face unique tax issues from owning common units that may result in adverse tax consequences to them.
Investment in common units by tax-exempt entities, including employee benefit plans and individual retirement accounts (known as IRAs), raises issues unique to them. For example, virtually all of our income allocated to organizations exempt from U.S. federal income tax, including IRAs and other retirement plans, will be unrelated business taxable income and will be taxable to them. Tax-exempt entities with multiple unrelated trades or businesses cannot aggregate losses from one unrelated trade or business to offset income from another to reduce total unrelated business taxable income.
As a result, it may not be possible for tax-exempt entities to utilize losses from an investment in us to offset unrelated business taxable income from another unrelated trade or business and vice versa. Tax-exempt entities should consult a tax advisor before investing in our common units.
Non-U.S. unitholders will be subject to U.S. federal income taxes and withholding with respect to income and gain from owning our common units.
Non-U.S. persons are generally taxed and subject to U.S. federal income tax filing requirements on income effectively connected with a U.S. trade or business. Income allocated to our unitholders and any gain from the sale of our units will generally be considered to be “effectively connected” with a U.S. trade or business. As a result, distributions to a non-U.S. unitholder will be subject to withholding at the highest applicable effective tax rate and a non-U.S. unitholder who sells or otherwise disposes of a common unit will also be subject to U.S. federal income tax on the gain realized from the sale or disposition of that unit.
The Internal Revenue Code also imposes a U.S. federal income tax withholding obligation of 10% of the amount realized upon a non-U.S. person’s sale or exchange of an interest in a partnership that is engaged in a U.S. trade or business. However, application of this withholding rule to dispositions of publicly traded partnership interests has been temporarily suspended by the IRS until regulations or other guidance have been issued. It is not clear when or if such regulations or guidance will be issued. Non-U.S. persons should consult a tax advisor before investing in our common units.
We treat each purchaser of our common units as having the same tax benefits without regard to the common units purchased. The IRS may challenge this treatment, which could adversely affect the value of our common units.
Because we cannot match transferors and transferees of common units, we have adopted depletion, depreciation and amortization positions that may not conform with all aspects of existing U.S. Treasury regulations. A successful IRS challenge to those positions could adversely affect the amount of tax benefits available to our unitholders. Our counsel is unable to opine as to the validity of such filing positions. A successful IRS challenge also could affect the timing of these tax benefits or the amount of gain on the sale of common units and could have a negative impact on the value of our common units or result in audits of and adjustments to our unitholders’ tax returns.
We prorate our items of income, gain, loss and deduction between transferors and transferees of common units each month based upon the ownership of our common units on the first day of each month, instead of on the basis of the date a particular common unit is transferred. The IRS may challenge this treatment, which could change the allocation of items of income, gain, loss and deduction among our unitholders.
We prorate our items of income, gain, loss and deduction between transferors and transferees of common units each month based upon the ownership of our common units on the first day of each month, instead of on the basis of the date a particular common unit is transferred. Although Treasury regulations allow publicly traded partnerships to use a similar monthly simplifying convention, such tax items must be prorated on a daily basis and these regulations do not specifically authorize all aspects of our proration method. Accordingly, our counsel is unable to opine as to the validity of this method. If the IRS were to successfully challenge our proration method, we may be required to change the allocation of items of income, gain, loss and deduction among our unitholders.
A unitholder whose common units are the subject of a securities loan (e.g., a loan to a “short seller” to cover a short sale of common units) may be considered as having disposed of those common units. If so, the unitholder would no longer be treated for U.S. federal income tax purposes as a partner with respect to those common units during the period of the loan and may recognize gain or loss from the disposition.
Because a unitholder whose common units are loaned to a “short seller” to cover a short sale of common units may be considered as having disposed of the loaned common units, the unitholder may no longer be treated for U.S. federal income tax purposes as a partner with respect to those common units during the period of the loan to the short seller, and the unitholder may recognize gain or loss from such disposition. Moreover, during the period of the loan to the short seller, any of our income, gain, loss or deduction with respect to those common units may not be reportable by the unitholder and any distributions received by the unitholder as to those common units could be fully taxable as ordinary income. Our counsel has not rendered an opinion regarding the treatment of a unitholder whose common units are loaned to a short seller to effect a short sale of common units; therefore, our unitholders desiring to assure their status as partners and avoid the risk of gain recognition from a loan to a short seller are urged to consult with their tax advisor about whether it is advisable to modify any applicable brokerage account agreements to prohibit their brokers from borrowing their common units.
We have adopted certain valuation methodologies in determining a unitholder’s allocations of income, gain, loss and deduction. The IRS may challenge these methodologies or the resulting allocations, and such a challenge could adversely affect the value of our common units.
In determining the items of income, gain, loss and deduction allocable to our unitholders, we must routinely determine the fair market value of our assets. Although we may from time to time consult with professional appraisers regarding valuation matters, we make many fair market value estimates ourselves using a methodology based on the market value of our common units as a means to determine the fair market value of our assets. The IRS may challenge these valuation methods and the resulting allocations of income, gain, loss and deduction.
A successful IRS challenge to these methods or allocations could adversely affect the timing, character or amount of taxable income or loss being allocated to our unitholders. It also could affect the amount of gain from our unitholders’ sale of common units and could have a negative impact on the value of our common units or result in audit adjustments to our unitholders’ tax returns without the benefit of additional deductions.
As a result of investing in our common units, our unitholders may become subject to state and local taxes and return filing requirements in jurisdictions where we operate or own or acquire properties.
In addition to U.S. federal income taxes, our unitholders will likely be subject to other taxes, including state and local income taxes, unincorporated business taxes and estate, inheritance or intangible taxes that are imposed by the various jurisdictions in which we do business or own property now or in the future, even if they do not reside in any of those jurisdictions. Our unitholders will likely be required to file state and local income tax returns and pay state and local income taxes in some or all of these various jurisdictions. Furthermore, our unitholders may be subject to penalties for failure to comply with those requirements. It is the responsibility of each unitholder to file all U.S. federal, state and local tax returns that may be required of such unitholder. Our counsel has not rendered an opinion on the state or local tax consequences of an investment in our common units.
Item 1B. Unresolved
Staff Comments
None.
Item 2. Properties
A description of our properties is included in “Part I, Item 1. Business,” and is incorporated herein by reference.
The obligations under our Credit Agreement are secured by mortgages on substantially all of our assets. See “Part II, Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations—Liquidity and Capital Resources—Credit Agreement,” in this Form 10-K for additional information concerning our Credit Agreement.
Item 3. Legal Proceedings
We are the subject of legal proceedings and claims arising in the ordinary course of business from time to time. Management cannot predict the ultimate outcome of such legal proceedings and claims. While the legal proceedings and claims are asserted for amounts that may be material should an unfavorable outcome be the result, management does not currently expect that these matters will have a material adverse effect on our financial position or results of operations.
Item 4. Mine Safet
y Disclosures
Not applicable.