MarkWest Energy Partners, LP 10-Q 2008
Washington, D.C. 20549
x QUARTERLY REPORT PURSUANT TO SECTION 13 or 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended March 31, 2008
¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from to
Commission File Number 001-31239
MARKWEST ENERGY PARTNERS, L.P.
(Exact name of registrant as specified in its charter)
1515 Arapahoe Street, Tower 2, Suite 700, Denver, Colorado 80202-2126
(Address of principal executive offices)
Registrants telephone number, including area code: 303-925-9200
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definitions of large accelerated filer, accelerated filer, and smaller reporting company in Rule 12b-2 of the Exchange Act. (Check one):
Indicate by check mark whether the registrant is a shell company (as defined in Exchange Act Rule 12b-2 of the Exchange Act) Yes o No x
The number of the registrants Common Units outstanding at May 9, 2008, were 56,626,295.
Throughout this document we make statements that are classified as forward-looking. Please refer to the Forward-Looking Statements included in Part I, Item 2 for an explanation of these types of assertions. Also, in this document, unless the context requires otherwise, references to we, us, our, MarkWest Energy or the Partnership are intended to mean MarkWest Energy Partners, L.P., and its consolidated subsidiaries.
As explained further in Item 1, Notes to the Condensed Consolidated Financial Statements, Note 1. Basis of Presentation, on February 21, 2008, MarkWest Energy Partners, L.P. completed its plan of redemption and merger (the Merger) with MarkWest Hydrocarbon, Inc. (the Corporation) and MWEP, L.L.C., a wholly-owned subsidiary of the Partnership, pursuant to which the Corporation was merged into the Partnership. The Merger was considered a downstream merger whereby the Corporation was viewed as the surviving consolidated entity for accounting purposes rather than the Partnership, which is the surviving consolidated entity for legal purposes. As such, the Merger was accounted for in the Corporations condensed consolidated financial statements as an acquisition of non-controlling interest using the purchase method of accounting. As a result, the historical and comparative condensed consolidated financial statements of the surviving legal entity are those of the Corporation, the accounting acquirer, rather than those of the Partnership, the legal acquirer. Under the Merger, the shareholders of the Corporation exchanged each share of Corporation common stock for consideration equal to 1.9051 Partnership common units (the Exchange Ratio). All historical unit and per unit data has been adjusted to reflect the Exchange Ratio to give the effect of the Merger.
Glossary of Terms
MARKWEST ENERGY PARTNERS, L.P.
(unaudited, in thousands)
The accompanying notes are an integral part of these condensed consolidated financial statements.
MARKWEST ENERGY PARTNERS, L.P.
(unaudited, in thousands, except per unit amounts)
(1) All unit and per unit data has been adjusted to reflect the 1.9051 Exchange Ratio to give the effect to the redemption and merger between MarkWest Hydrocarbon, Inc. and MarkWest Energy Partners, L.P. on February 21, 2008 (see Note 3). The Partnership declared a distribution of $0.60 per common unit on April 24, 2008 for the period ended March 31, 2008 (see Note 15).
The accompanying notes are an integral part of these condensed consolidated financial statements.
MARKWEST ENERGY PARTNERS, L.P.
(unaudited, in thousands)
(1) All unit and per unit data has been adjusted to reflect the 1.9051 Exchange Ratio to give the effect to the redemption and merger between MarkWest Hydrocarbon, Inc. and MarkWest Energy Partners, L.P. on February 21, 2008 (see Note 3).
The accompanying notes are an integral part of these condensed consolidated financial statements.
MARKWEST ENERGY PARTNERS, L.P.
(unaudited, in thousands)
The accompanying notes are an integral part of these condensed consolidated financial statements.
MarkWest Energy Partners, L.P. (the Partnership) was formed on January 25, 2002, as a Delaware limited partnership. The Partnership is engaged in the gathering, transportation and processing of natural gas, the transportation, fractionation, marketing and storage of natural gas liquids, or NGLs, and the gathering and transportation of crude oil. The Partnership has extensive natural gas gathering, processing and transmission operations in the southwestern and Gulf Coast regions of the United States and is the largest natural gas processor in the Appalachian region.
On February 21, 2008, the Partnership completed the transactions contemplated by its plan of redemption and merger (the Merger) with MarkWest Hydrocarbon, Inc. (the Corporation) and MWEP, L.L.C., a wholly-owned subsidiary of the Partnership. As a result of the Merger, MarkWest Hydrocarbon is now a wholly-owned subsidiary of the Partnership (see Note 3). Unless otherwise indicated or the context otherwise requires, all references in this report to MarkWest Energy Partners, the Partnership, us, our or we are to MarkWest Energy Partners, L.P. Except as otherwise specified, references to MarkWest Hydrocarbon or the Corporation are to MarkWest Hydrocarbon, Inc.
The Merger was accounted for in accordance with SFAS No. 141, Business Combinations (SFAS 141) and related interpretations. The Merger was considered a downstream merger, whereby the Corporation was viewed as the surviving consolidated entity for accounting purposes rather than the Partnership, which is the surviving consolidated entity for legal purposes. As such, the Merger was accounted for in the Corporations condensed consolidated financial statements as an acquisition of non-controlling interest using the purchase method of accounting. Under this accounting method, the Partnerships accounts, including goodwill, were adjusted to proportionately step up the book value of certain assets and liabilities. As a result, the historical and comparative condensed consolidated financial statements of the surviving legal entity are those of the Corporation, the accounting acquirer, rather than those of the Partnership, the legal acquirer.
The Partnerships unaudited condensed consolidated financial statements include the accounts of all majority-owned or majority-controlled subsidiaries. Equity investments in which the Partnership exercises significant influence but does not control, and is not the primary beneficiary, are accounted for using the equity method. These condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (GAAP) for interim financial reporting. Accordingly, certain information and footnote disclosures normally included in financial statements prepared in accordance with GAAP have been condensed or omitted. In managements opinion, the Partnership has made all adjustments necessary for a fair presentation of its results of operations, financial position and cash flows for the periods shown. These adjustments are of a normal recurring nature. In addition to reviewing these condensed consolidated financial statements and accompanying notes, you should also consult the audited financial statements and accompanying notes included in the Partnerships December 31, 2007 Annual Report on Form 10-K and its Current Report filed on Form 8-K/A on March 14, 2008. Finally, consider that results for the three months ended March 31, 2008, are not necessarily indicative of results for the full year 2008, or any other future period.
As a result of the Merger, goodwill was recorded on the Partnerships balance sheet. The carrying value of goodwill was $37.7 million at March 31, 2008. Goodwill will be reviewed for impairment annually at November 30 or more frequently when events and circumstances occur indicating that the recorded goodwill may not be recoverable. If the carrying value of goodwill exceeds the implied fair value, an impairment loss is recorded in an amount equal to that excess.
In September 2006 the FASB issued SFAS No. 157, Fair Value Measurements (SFAS 157). SFAS 157 clarifies the principle that fair value should be based on the assumptions market participants would use when pricing an asset or liability and establishes a fair value hierarchy that prioritizes the information used to develop those assumptions.
The Partnership adopted SFAS 157 on January 1, 2008 (see Note 4). On February 12, 2008 the FASB issued FASB Staff Position No. FAS 157-2 that defers the effective date of SFAS 157 for non-financial assets and liabilities, except for items that are recognized or disclosed at fair value in the financial statements on a reoccurring basis (at least annually) until fiscal years beginning after November 15, 2008. The Partnership deferred recognition of items including:
· Nonfinancial assets and liabilities initially measured at fair value in a business combination or other new basis event, but not measured at fair value in subsequent periods (nonrecurring fair value measurements).
· Reporting units measured at fair value in the first and second steps of a goodwill impairment test as described in paragraphs 19 to 21 of SFAS No. 142, Goodwill and Other Intangible Assets (SFAS 142).
· Indefinite lived intangible assets measured at fair value for impairment assessment under SFAS 142.
· Long-lived assets measured as fair value for impairment assessment under SFAS No. 144, Accounting for Impairment or Disposal of Long Lived Assets (SFAS 144).
· Asset retirement obligations initially measured at fair value under SFAS No. 143, Accounting for Asset Retirement Obligations.
· Liabilities for exit or disposal activities initially measured at fair value under SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities (SFAS 146).
The adoption of SFAS 157 had an effect of a $1.1 million decrease to fair value of derivative instruments liability, a decrease to Revenue - derivative loss of $0.4 million and an increase to derivative gain related to purchase product costs of $0.7 million.
In February 2007 the FASB issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities (SFAS 159), which permits an entity to measure certain financial assets and financial liabilities at fair value. The statements objective is to improve financial reporting by allowing entities to mitigate volatility in reported earnings caused by the measurement of related assets and liabilities using different attributes, without having to apply complex hedge accounting provisions. Under SFAS 159, entities that elect the fair value option will report unrealized gains and losses in earnings at each subsequent reporting date. The fair value option may be elected on an instrument-by-instrument basis, with a few exceptions, as long as it is applied to the instrument in its entirety. The fair value option election is irrevocable, unless a new election date occurs. SFAS 159 establishes presentation and disclosure requirements to help financial statement users understand the effect of the entitys election on its earnings, but does not eliminate disclosure requirements of other accounting standards. Assets and liabilities that are measured at fair value must be displayed on the face of the balance sheet. SFAS 159 is effective for the Partnership as of January 1, 2008. The adoption of SFAS 159 did not impact the Partnerships condensed consolidated financial statements since the Partnership did not elect the fair value option.
In December 2007 the FASB issued SFAS No. 141 (revised 2007), Business Combinations (SFAS 141R). This statement replaces SFAS 141, Business Combinations. The statement provides for how the acquirer recognizes and measures the identifiable assets acquired, liabilities assumed and any non-controlling interest in the acquiree. SFAS 141R provides for how the acquirer recognizes and measures the goodwill acquired in the business combination or a gain from a bargain purchase. The statement determines what information to disclose to enable users to evaluate the nature and financial effects of the business combination. The provisions of SFAS 141R are effective for the Partnership as of January 1, 2009 and do not allow early adoption. The Partnership is currently evaluating the impact of adopting SFAS 141R.
In December 2007 the FASB issued SFAS No. 160, Noncontrolling Interests in Consolidated Financial Statementsan amendment of ARB No. 51 (SFAS 160). This statement provides that noncontrolling interests in subsidiaries held by parties other than the parent be identified, labeled and presented in the statement of financial position within equity, but separate from the parents equity. SFAS 160 states that the amount of consolidated net income attributable to the parent and to the noncontrolling interest be clearly identified on the consolidated statement of income. The statement provides for consistency regarding changes in parent ownership including when a subsidiary is
deconsolidated. Any retained noncontrolling equity investment in the former subsidiary will be initially measured at fair value. The provisions of SFAS 160 are effective for the Partnership as of January 1, 2009 and do not allow early adoption. The Partnership is currently evaluating the impact of adopting SFAS 160.
In March 2008 the FASB issued SFAS No. 161, Disclosures about Derivative Instruments and Hedging Activities (SFAS No. 161). SFAS No. 161 amends and expands the disclosure requirements of SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, and requires entities to provide enhanced qualitative disclosures about objectives and strategies for using derivatives, quantitative disclosures about fair values and amounts of gains and losses on derivative contracts, and disclosures about credit-risk-related contingent features in derivative agreements. SFAS No. 161 will be effective for the Partnerships fiscal 2009 interim and annual consolidated financial statements. The adoption of SFAS 161 is not expected to have a material impact on the Partnerships condensed consolidated financial statements.
3. Redemption and Merger
On February 21, 2008, the Partnership completed the transactions contemplated by its plan of redemption and merger with the Corporation and MWEP, L.L.C., a wholly-owned subsidiary of the Partnership. Under the Merger, the shareholders of the Corporation exchanged each share of Corporation common stock for consideration equal to 1.9051 Partnership common units (Exchange Ratio). This Exchange Ratio was computed based on the stated consideration of 1.285 Partnership common units plus $20 in cash, or equivalent value. In accordance with the merger agreement, the equivalent value was based on a Partnership common unit price of $32.25, which equals the average market price of Partnership common units for the ten day period ending three days prior to the closing date. Therefore, the $20.00 in cash is equivalent to 0.6201 Partnership common units which results in a total Exchange Ratio of 1.9051 when combined with the other 1.285 units included in the stated consideration. Subject to pro ration, the shareholders elected to receive this consideration either entirely in cash in the redemption, entirely in Partnership common units in the Merger, or in any combination of cash and Partnership common units with equivalent value. The Corporation redeemed for $240.5 million in cash those shares of Corporation common stock electing to receive cash. Immediately after the redemption, the Partnership acquired the Corporation through a merger of MWEP, L.L.C. with and into the Corporation, pursuant to which all remaining shares of the Corporations common stock were converted into approximately 15.5 million Partnership common units. As a result of the Merger, the Corporation is a wholly owned subsidiary of the Partnership. In connection with the Merger, the incentive distribution rights in the Partnership, the 2% economic interest in the Partnership held by MarkWest Energy GP, L.L.C. (the General Partner) and the Partnership common units owned by the Corporation were exchanged for Partnership Class A Units. Contemporaneously with the closing of the transactions contemplated by the Merger, the Partnership separately acquired 100% of the Class B membership interests in the General Partner that had been held by current and former management and certain directors of the Corporation and the General Partner. Additionally, as a result of the merger and redemption, the Partnership assumed the 2006 Hydrocarbon Stock Incentive Plan and the 1996 Hydrocarbon Stock Incentive Plan (see Note 12).
Using the Exchange Ratio, the number of Corporation shares outstanding as of December 31, 2007 and activity through February 21, 2008 has been adjusted to the equivalent number of Partnership common units in the accompanying Condensed Consolidated Financial Statements. The following table illustrates these conversions (shares and units in thousands):
Class A units represent limited partner interests in the Partnership and have identical rights and obligations of the Partnership common units except that Class A units (a) do not have the right to vote on, approve or disapprove, or
otherwise consent to or not consent to any matter (including mergers, share exchanges and similar statutory authorizations) except as otherwise required by any non-waivable provision of law and (b) do not share in any cash and cash equivalents on hand, income, gains, losses, deductions and credits that are derived from or attributable to the Partnerships ownership of, or sale or disposition of, the shares of MarkWest Hydrocarbon common stock. Pursuant to Accounting Research Bulletin No. 51, Consolidated Financial Statements, the Class A units held by the Corporation and the General Partner are not treated as outstanding common units in the Condensed Consolidated Balance Sheet.
The total fair value of the non-controlling interest acquired was the number of non-controlling interest units outstanding on the date the Merger closed valued at the then current per unit market price of the Partnership common units of $31.79. The following table shows the calculation of the purchase price of the Partnership ($ in thousands):
Significant fair value estimates were required for the following assets and liabilities:
· Property, plant, and equipment- The fair value estimates for property, plant and equipment were based primarily on the cost approach, which considers both historical cost and replacement cost. Additionally, the Partnership estimated the remaining useful lives of the property, plant and equipment to ensure that the useful lives used for depreciation subsequent to the Merger are reasonable and consistent with the Partnerships accounting policy.
· Intangible assets- The fair value estimates for customer relationships were based on a version of the income approach. The income approach involves estimating future cash flows from existing customer relationships and making provisions for a fair return on other recognized contributory assets. Key assumptions in the valuation include contract renewals, economic incentives to retain customers, historic volumes, current and future capacity in the gathering system, pricing volatility and the discount rate. The estimated useful life of the intangible assets was determined by assessing the estimated useful life of the other assets to which the contracts and relationships relate, likelihood of renewals, projected reserves, competitive factors, regulatory or legal provisions, and maintenance and renewal costs.
· Long-term debt- The fair value of the Partnerships Senior Notes was estimated using a high yield market price at which our debt was trading as of the date the Merger closed.
· Deferred finance costs- The deferred finance costs of the Partnership have no fair market value as of the date the Merger closed. Therefore 85.7% of these costs are written-off under the purchase method of accounting.
The remaining purchase price in excess of the fair values of the assets and liabilities acquired was recorded as goodwill. The values of certain assets and liabilities are preliminary, and are subject to adjustment as additional information is obtained. When the purchase price allocation is finalized, material adjustments to goodwill or intangibles may result which could impact depreciation and amortization expense.
The following table shows the preliminary purchase price allocation as of February 21, 2008 (in thousands):
n/aAmounts represent the recognition of deferred tax liabilities related to temporary tax differences that are expected to reverse in future periods related to the proportional step-up of fair value due to the Merger. No deferred tax liabilities related to goodwill were recognized as goodwill is not deductible for tax purposes.
4. Fair Value
Fair Value Measurement
The Partnership adopted SFAS 157 on January 1, 2008. SFAS 157 clarifies the principle that fair value should be based on the assumptions market participants would use when pricing an asset or liability and establishes a fair value hierarchy that prioritizes the information used to develop those assumptions. SFAS 157 applies to all fair value measurements however the FASB deferred the effective date for certain nonfinancial assets and liabilities until January 1, 2009 (Note 2). SFAS 157 applies principally to the Partnerships derivative positions and trading securities at March 31, 2008. Additional key provisions of the statement include:
· Defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date, and establishes a framework for measuring fair value;
· Establishes a three-level hierarchy for fair value measurements based upon the transparency of inputs to the valuation of an asset or liability as of the measurement date;
· Nullifies the guidance in Emerging Issues Task Force Issue No. 02-3, Issues Involved in Accounting for Derivative Contracts Held for Trading Purposes and Involved in Energy Trading and Risk Management Activities, which required the deferral of profit at inception of a transaction involving a derivative financial instrument in the absence of observable data supporting the valuation technique;
· Eliminates large position discounts for financial instruments quoted in active markets and requires consideration of the Firms creditworthiness when valuing liabilities; and
· Expands disclosures about instruments measured at fair value.
SFAS 157 establishes a three-level valuation hierarchy for disclosure of fair value measurements. The valuation hierarchy is based upon the transparency of inputs to the valuation of an asset or liability as of the measurement date. The three levels are defined as follows:
· Level 1 inputs to the valuation methodology are quoted prices (unadjusted) for identical assets or liabilities in active markets.
· Level 2 inputs to the valuation methodology include quoted prices for similar assets and liabilities in active markets, and inputs that are observable for the asset or liability, either directly or indirectly, for substantially the full term of the financial instrument.
· Level 3 inputs to the valuation methodology are unobservable and significant to the fair value measurement.
A financial instruments categorization within the valuation hierarchy is based upon the lowest level of input that is significant to the fair value measurement. Following is a description of the valuation methodologies the Partnership used for instruments measured at fair value, as well as the general classification of such instruments pursuant to the valuation hierarchy.
Commodity Derivative Transactions
The Partnership utilizes a combination of fixed-price forward contracts, fixed-for-floating price swaps and options available in the over-the-counter (OTC) market, and futures contracts. The Partnerships derivative positions are valued using corroborated market data and internally developed models when observable market data is not available. Commodity transactions based on crude oil and natural gas are considered Level 2 transactions as the pricing methodology include quoted prices for similar assets and liabilities and the Partnership can determine the prices are observable and do not contain Level 3 inputs that are significant to the measurement. Natural gas liquid positions have significant unobservable market parameters and are normally traded less actively or have trade activity that is one way, and therefore are classified within Level 3 of the valuation hierarchy.
Trading securities consist exclusively of auction rate securities as of March 31, 2008. Quoted market prices are not available and these securities fair values are estimated by using pricing models, quoted prices of securities with similar characteristics, or discounted cash flows. Considering observable market activity is not available for these securities, the securities are classified within Level 3 of the valuation hierarchy.
The methods described above may produce a fair value calculation that may not be indicative of net realizable value or reflective of future fair values. Furthermore, while the Partnership believes its valuation methods are appropriate and consistent with other market participants, the use of different methodologies or assumptions to determine the fair value of certain financial instruments could result in a different estimate of fair value at March 31, 2008.
The following table presents the financial instruments carried at fair value as of March 31, 2008, by caption on the condensed consolidated balance sheet and by SFAS 157 valuation hierarchy (as described above, in thousands):
Changes in Level 3 fair value measurements
The tables below include a rollforward of the balance sheet amounts for the three months ended March 31, 2008 (including the change in fair value) for financial instruments classified by the Partnership within Level 3 of the valuation hierarchy. When a determination is made to classify a financial instrument within Level 3 of the valuation hierarchy, the determination is based upon the significance of the unobservable factors to the overall fair value measurement. However,
Level 3 financial instruments typically include, in addition to the unobservable or Level 3 components, observable components (that is, components that are actively quoted and can be validated to external sources); accordingly, the gains and losses in the table below include changes in fair value due in part to observable factors that are part of the valuation methodology.
(a) Gains and losses are recorded in derivative (loss) gain in revenue, purchased product costs or facility expenses.
(b) Gains and losses recorded in miscellaneous expense.
Assets and liabilities measured at fair value on a nonrecurring basis
Certain assets and liabilities are measured at fair value on a nonrecurring basis; that is, the instruments are not measured at fair value on an ongoing basis but are subject to fair value adjustments in certain circumstances. As of March 31, 2008, there were not any assets or liabilities to be measured at fair value on a nonrecurring basis.
The following are the components of marketable securities (in thousands):
For the quarter ended March 31, 2008, the Partnership recognized an other than temporary loss of approximately $0.1 million on its trading securities.
During the quarter ended March 31, 2008, the Partnership sold its available-for-sale securities and recognized a $1.2 million gain on sale, which has been recorded as part of miscellaneous expense in the accompanying Condensed Consolidated Statements of Operations.
6. Current Assets
Receivables consist of the following (in thousands):
Other current assets consist of the following (in thousands):
The Partnerships intangible assets at March 31, 2008 and December 31, 2007, are comprised of customer contracts and relationships, as follows (in thousands):
Amortization expense related to the intangible assets was $6.8 million and $4.2 million for the three months ended March 31, 2008 and 2007, respectively.
The purchase price in excess of the fair value of the minority interest in the net assets and liabilities of the Partnership at the time of the Merger between MarkWest Energy Partners and MarkWest Hydrocarbon is recorded as goodwill. In accordance with SFAS 142, goodwill is not amortized but instead tested annually for impairment. As of March 31, 2008 goodwill was $37.7 million. The Partnership did not have goodwill recorded prior to the Merger.
On March 1, 2008, the Partnership acquired a 20% interest in Centrahoma Processing, LLC (Centrahoma) for $11.6 million, which is accounted for under the equity method, with a right to acquire an additional 20% interest under certain circumstances (see Note 18). Centrahoma will own certain processing plants in the Arkoma basin. In addition, the Partnership signed agreements to dedicate certain acreage in the Woodford Shale play to Centrahoma through March 1, 2018. The Partnerships share of Centrahomas income was near zero for the three months ended March 31, 2008.
The Partnership applies the equity method of accounting for its 50% non-operating interest in Starfish Pipeline Company, L.L.C. (Starfish). Differences between the Partnerships investment and its proportionate share of Starfishs reported equity are amortized based upon the respective useful lives of the assets to which the differences relate. Summarized financial information for 100% of Starfish is as follows (unaudited, in thousands):
The following is a reconciliation of the changes in the asset retirement obligation from December 31, 2007 to March 31, 2008 (in thousands):
At March 31, 2008, and December 31, 2007, there were no assets legally restricted for purposes of settling asset retirement obligations. The asset retirement obligation has been recorded as part of other long-term liabilities in the accompanying Condensed Consolidated Balance Sheets.
10. Long-Term Debt
Debt is summarized below (in thousands):
On February 20, 2008, the Partnership entered into a new credit agreement (Partnership Credit Agreement). The Partnership Credit Agreement provides for a maximum lending limit of $575.0 million through February 2013. The Partnership Credit Agreement includes a senior secured revolving facility of $350.0 million (that under certain circumstances can be increased to $550.0 million) and a $225.0 million term loan, both of which can be repaid at any time without penalty. The Partnership retired the term loan in April 2008 (see Note 18). The credit facility is guaranteed and collateralized by substantially all of the Partnerships assets and those of its wholly-owned subsidiaries. Initial borrowings under the revolving facility portion of Partnership Credit Agreement were used to finance other payments under the Merger and outstanding amounts due on the old partnership credit facility revolver of $67.0 million. The Partnership
Credit Agreement required the payment of $10.5 million in deferred financing costs. As of March 31, 2008, the Partnership had approximately $217.0 million of available borrowings under the credit facility, including outstanding letters of credit. The Partnership completed a public equity offering and a private placement of senior notes in April 2008 and used a portion of the proceeds to retire the term loan and pay-down the revolving portion of the Partnership Credit Agreement. As of May 9, 2008, the Partnership had available borrowings under the credit facility of $295.0 million, including outstanding letters of credit of $55.0 million (see Note 18).
The borrowings under the Partnership Credit Agreement bear interest at a variable interest rate, plus basis points. The variable interest rate typically is based on the London Inter Bank Offering Rate (LIBOR); however, in certain borrowing circumstances the rate would be based on the higher of a) the Federal Funds Rate plus 0.5-1%, and b) a rate set by the Partnership Credit Agreements administrative agent, based on the U.S. prime rate. The basis points correspond to the ratio of the Partnerships Consolidated Funded Debt (as defined in the Partnership Credit Agreement) to Adjusted Consolidated EBITDA (as defined in the Partnership Credit Agreement), ranging from 0.50% to 1.25% for Base Rate loans, and 1.50% to 2.25% for LIBOR loans. The basis points will increase by 0.50% during any period (not to exceed 270 days) where the Partnership makes an acquisition for a purchase price in excess of $50.0 million. The Partnership will incur a commitment fee on the unused portion of the credit facility at a rate between 30.0 and 50.0 basis points based upon the ratio of consolidated senior debt (as defined in the Partnership Credit Agreement) to consolidated EBITDA (as defined in the Partnership Credit Agreement). As of March 31, 2008, the interest rate for borrowings under the Partnership Credit Agreement was LIBOR plus 1.50%. For the three months ended March 31, 2008, the weighted average interest rate on the Partnership Credit Agreement was 5.52%.
At March 31, 2008, the Partnership and its wholly-owned subsidiary, MarkWest Energy Finance Corporation (MarkWest Finance), have two series of senior notes outstanding; $225.0 million principal at a fixed rate of 6.875% due in November 2014 (the 2014 Notes), recorded at $214.1 million, net of unamortized discount of $10.9 million, and $ 275.0 million, recorded at $274.0, net of unamortized discount of $1.0 million, at a fixed rate of 8.5% due in July 2016 (the 2016 Notes and together the Senior Notes). The estimated fair value of the Senior Notes was approximately $489.7 million and $499.8 million at March 31, 2008 and December 31, 2007, respectively, based on quoted market prices.
The Partnership has no independent operating assets or operations. All wholly-owned subsidiaries guarantee the Senior Notes jointly and severally and fully and unconditionally. The notes are senior unsecured obligations equal in right of payment with all of the Partnerships existing and future senior debt. These notes are senior in right of payment to all of the Partnerships future subordinated debt but effectively junior in right of payment to its secured debt to the extent of the assets securing the debt, including the Partnerships obligations in respect of the Partnership Credit Agreement.
The indentures governing the Senior Notes limit the activity of the Partnership and its restricted subsidiaries. Subject to compliance with certain covenants, the Partnership may issue additional notes from time to time under the indentures pursuant to Rule 144A and Regulation S under the Securities Act of 1933.
11. Income Taxes
The Partnership is not a taxable entity for federal income tax purposes. As such, the Partnership does not directly pay federal income tax. The Partnerships taxable income or loss, which may vary substantially from the net income or loss reported in the Condensed Consolidated Statements of Operations, is includable in the federal income tax returns of each partner. The Partnership is, however, a taxable entity under certain state jurisdictions. Pursuant to the Merger, the Partnership owns 100% of the Corporation, which is a tax paying entity for both federal and state purposes.
The Partnership and the Corporation account for income taxes under the asset and liability method pursuant to SFAS 109, Accounting for Income Taxes (SFAS 109). Under SFAS 109, deferred income taxes are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax basis and net operating loss and credit carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect of any tax rate change on deferred taxes is recognized in the period that includes the enactment date of the tax rate change. Realizability of deferred tax assets is assessed and, if not more likely than not, a valuation allowance is recorded to write down the deferred tax assets to their net realizable value.
The Partnership and the Corporation base the effective tax rate for interim periods on the estimated annual effective tax rate. The Corporation pays tax on its share of the Partnerships income or loss as a result of its ownership of Class A units. As a result, the Corporation will have a tax provision related to the ownership of the Class A units without having recognized any book income from those units.
The income tax provision totaled $23.4 million for the three months ended March 31, 2008, resulting in an effective tax rate of 55.04%. The 2008 estimated annual effective income tax rate varies from the statutory rate mostly due to treatment of the Class A units as discussed above and the write-off of certain deferred tax assets that as an indirect result of the Merger will no longer be realized.
A reconciliation of the provision for income tax expense and the amount computed by applying the federal statutory rate of 35% to the income before income taxes for the three-month ended March 31, 2008 is as follows (in thousands):
As of March 31, 2008, the Partnership had four share-based compensation plans which are administered by the Compensation Committee of the General Partners board of directors (Compensation Committee). Compensation expense is recognized under SFAS No. 123R, Share-Based Payment (SFAS 123R).
Total compensation expense for share-based pay arrangements was as follows (in thousands):
A distribution equivalent right is a right, granted in tandem with a specific phantom unit, to receive an amount in cash equal to, and at the same time as, the cash distributions made by the Partnership with respect to a unit during the period such phantom unit is outstanding.
Compensation expense under the share-based compensation plans has been recorded as either Selling, general and administrative expenses or Facility expenses in the accompanying Consolidated Statements of Operations.
As of March 31, 2008, total compensation expense not yet recognized related to the unvested awards under the 2008 LTIP, 2006 Hydrocarbon Plan and 1996 Hydrocarbon Plan was approximately $26.4 million, with a weighted average remaining vesting period of approximately 1.8 years. Total compensation expense not yet recognized related to unvested awards under the 2002 LTIP was approximately $2.9 million, with a weighted-average remaining vesting period of approximately 1.6 years. The actual compensation expense recognized for awards under the 2002 LTIP may differ as they qualify as liability awards under SFAS 123R, which are affected by changes in fair value.
The 2008 LTIP was approved by unitholders on February 21, 2008. The 2008 LTIP provides 2.5 million common units for issuance to the Corporationss employees and affiliates as share-based payment awards. The 2008 LTIP was created to attract and retain highly qualified officers, directors, and other key individuals and to motivate them to serve the General Partner and to expend maximum effort to improve the business results and earnings of the Partnership and its affiliates. Awards authorized under the 2008 LTIP include unrestricted units, restricted units, phantom units, distribution equivalent rights, and performance awards to be granted in any combination.
Upon the closing of the Merger, 765,000 phantom units were granted to senior executives and other key employees under the 2008 LTIP. The phantom units vest on a time-based and performance-based schedule over a three year period. Forty percent, or 306,000 phantom units, of the total individual grant is based on continuing employment over the three-year vesting period, and sixty percent, or 459,000 phantom units, of the total individual grant is performance-based. As of March 31, 2008, there were 459,000 phantom units outstanding, with a grant date fair value of $14.6 million, containing performance vesting criteria (performance units). Vesting of these units occurs if the Partnership achieves established performance goals determined by the Compensation Committee. In accordance with the provisions of SFAS 123R, Management will conduct a quantitative analysis on an ongoing basis to assess the probability of meeting the established performance goals. Based on a quantitative analysis conducted during the first quarter, approximately $0.4 million of the grant date fair value was included in phantom unit compensation expense for the performance units expected to vest.
2006 Hydrocarbon Plan and 1996 Hydrocarbon Plan
On February 21, 2008, the 25,897 outstanding shares of restricted stock held by 43 employees granted under the 2006 Hydrocarbon Plan and 1996 Hydrocarbon Plan were converted to 49,354 phantom units, pursuant to the terms of the redemption and merger agreement. The conversion qualified as a modification in accordance with SFAS 123R, requiring the Partnership to compare the grant date fair value of the original awards with the converted awards. As a result of the comparison, the Partnership determined that the fair value of the awards had increased by $0.5 million. Approximately $0.4 million of the fair value was expensed in the first quarter; the remaining $0.1 million will be amortized as compensation expense over the remaining vesting period. The converted phantom unit awards will remain outstanding under the terms of the 2006 Hydrocarbon Plan and 1996 Hydrocarbon Plan until their respective settlement dates.
Summary of Equity Awards
Under SFAS 123R, awards under the 2008 LTIP, 2006 Hydrocarbon Plan and 1996 Hydrocarbon Plan qualify as equity awards. Accordingly, the fair value is measured at the grant date and is based on the market price of the Partnerships common units. The associated compensation expense related to service-based awards is recognized over the requisite service period, reduced for an estimate of expected forfeitures. Compensation expense related to performance units is recognized when probability of vesting is established as discussed above. The phantom units, with exception of performance based awards, generally vest equally over a three year period. A phantom unit entitles an employee to receive a common unit upon vesting. The Partnership generally issues new common units upon the vesting of a phantom unit. During the quarters ended March 31, 2008 and 2007, the Partnership received no proceeds for issuing phantom units, and there were no cash settlements.
The following is a summary of phantom unit activity under the 2008 LTIP, 2006 Hydrocarbon Plan and 1996 Hydrocarbon Plan:
(1) Includes 49,354 restricted shares converted to phantom units pursuant to the terms of the redemption and merger agreement.
As of March 31, 2008, there were 148,743 phantom units outstanding under the 2002 LTIP; no additional awards will be made under the plan. The phantom units awarded under the 2002 LTIP are classified as liability awards under SFAS 123R. Accordingly, the fair value of the outstanding awards is remeasured at the end of each reporting period based on the market price of the Partnerships common units. The fair value of the phantom units awarded is amortized into earnings as compensation expense over the vesting period, which is generally three years. A phantom unit entitles an employee to receive a common unit upon vesting, or at the discretion of the Compensation Committee, cash equivalent to the value of a common unit. The Partnership generally issues new common units upon the vesting of a phantom unit. During the quarters ended March 31, 2008 and 2007, the Partnership received no proceeds (other than the contributions by the General Partner to maintain its 2% ownership interest) for issuing phantom units. None of the phantom units that vested were redeemed by the Partnership for cash.
The following is a summary of phantom unit activity under the 2002 LTIP:
The interests in the Partnerships General Partner sold by the Corporation to certain directors and employees were referred to as the Participation Plan. The Participation Plan was considered a compensatory arrangement and under SFAS 123R, the General Partner interests were classified as liability awards. As a result, the Corporation was required to calculate the fair value of the General Partner interests at the end of each period. As of March 31, 2008 and December 31, 2007, the Participation Plan liability was $0.0 and $47.0 million, respectively, and was recorded in Other long-term liabilities in the accompanying Condensed Consolidated Balance Sheets.
On February 21, 2008, all of the outstanding interests in the General Partner were exchanged for a combination of 0.9 million common units with a fair value of approximately $30.1 million and approximately $21.2 million in cash. The exchange was accounted for as the settlement of a share based payment liability under SFAS 123R.
Hydrocarbon Stock Options
On or before February 21, 2008, the remaining 51,509 Hydrocarbon stock options outstanding were exercised or deemed exercised with a weighted average exercise price of $7.21. The Corporation received proceeds of approximately $0.4 million from the exercise of all the remaining options. The intrinsic value of the options exercised during the period was approximately $2.9 million. There were no options outstanding as of March 31, 2008. Of the 51,509 options exercised during the quarter ended March 31, 2008, 50,392 options were exercised and issued for cash, compared to 1,117 exercised and 1,079 issued using a broker-assisted cashless exercise.
During the quarter ended March 31, 2007, 679 options were exercised with a weighted average exercise price of $6.79. The intrinsic value of the options exercised during the period was $35,425. The Corporation received proceeds of approximately $0.1 million for the exercise of these options. Of the 679 options exercised during the quarter ended March 31, 2007, 679 were exercised and issued for cash.
At the adoption of SFAS 123R, the Partnership elected to adopt the simplified method to establish the beginning balance of the additional paid-in capital pool (APIC Pool) related to the tax effects of employee share-based compensation, and to determine the subsequent impact on the APIC Pool and condensed consolidated statements of cash flows of the tax effects of share-based compensation awards that were outstanding upon adoption of SFAS 123R. APIC is reported as Common Units in the accompanying Condensed Consolidated Balance Sheets as a result of the Merger.
SFAS 123R requires that cash flows resulting from tax deductions in excess of the cumulative compensation cost recognized for options exercised be classified as financing cash flows. Previously, all tax benefits from stock options had been reported as an operating activity. The company recognized $0.7 million and less than $0.1 million, for the three months ended March 31, 2008 and 2007, respectively, related to excess tax benefits realized from the exercise of stock options.
13. Derivative Financial Instruments
The Partnerships primary risk management objective is to reduce downside volatility in its cash flows arising from changes in commodity prices related to future sales or purchases of natural gas, NGLs and crude oil. Swaps and futures contracts may allow the Partnership to reduce downside volatility in its realized margins as realized losses or gains on the derivative instruments generally are offset by corresponding gains or losses in the Partnerships sales or purchases of physical product. While management largely expects realized derivative gains and losses to be offset by increases or decreases in the value of physical sales and purchases, the Partnership will experience volatility in reported earnings due to the recording of unrealized gains and losses on derivative positions that will have no offset. The Partnerships non-trading commodity derivative instruments are recorded at fair value in the Condensed Consolidated Balance Sheets and Condensed Consolidated Statements of Operations. Accordingly, the volatility in any given period related to unrealized gains or losses can be significant to the overall financial results of the Partnership; however, management ultimately expects those gains and losses to be offset when they become realized. The Partnership does not have any trading derivative financial instruments.
Because of the strong historical correlation between NGL prices and crude oil prices and limited liquidity in the NGL financial market, the Partnership uses crude oil derivative instruments to manage NGL price risk. As a result of these transactions, the Partnership has mitigated a significant portion of its expected commodity price risk with agreements expiring at various times through the fourth quarter of 2011. The margins earned from condensate sales are directly correlated with crude oil prices. The Partnership has a committee comprised of the senior management team that oversees all of the risk management activity and continually monitors the risk management program and expects to continue to adjust its financial positions as conditions warrant.
To manage its commodity price risk, the Partnership utilizes a combination of fixed-price forward contracts, fixed-for-floating price swaps, options available in the over-the-counter (OTC) market, and futures contracts. The Partnership enters into OTC swaps with financial institutions and other energy company counterparties. Management conducts a standard credit review on counterparties and has agreements containing collateral requirements where deemed necessary. The Partnership uses standardized agreements that allow for offset of positive and negative exposures. Due to the timing of purchases and sales, direct exposure to price volatility may result because there is no longer an offsetting purchase or sale that remains exposed to market pricing. Through marketing and derivative activities, direct price exposure may occur naturally or the Partnership may choose direct exposure when it is favorable as compared to the frac spread risk.
The use of derivative instruments may create exposure to the risk of financial loss in certain circumstances, including instances when (i) NGLs do not trade at historical levels relative to crude oil, (ii) sales volumes are less than expected, requiring market purchases to meet commitments, or (iii) OTC counterparties fail to purchase or deliver the contracted quantities of natural gas, NGLs or crude oil or otherwise fail to perform. To the extent that the Partnership engages in derivative activities, it may be prevented from realizing the benefits of favorable price changes in the physical market; however, it may be similarly insulated against unfavorable changes in such prices.
The Partnership values its derivative instruments and estimates fair value as discussed in Note 4. The impact of the Partnerships commodity derivative instruments on financial position are summarized below (in thousands):
The Partnership has recorded premium payments relating to certain derivative option contracts. The premiums allowed the Partnership to secure specific pricing on those contracts. The payment is recorded as an asset and is amortized as a reduction to revenue as the puts expire or are exercised.
The Partnership accounts for the impact of its commodity derivative instruments as either a component of revenue or purchased product costs. The Partnership has a contract which creates a floor on the frac spread which can be realized on a specific volume purchased. Gains and losses from this contract are recorded as a component of purchased product costs. The Partnership also has a contract allowing it to fix a component of the price of electricity at one of its plant locations. Gains and losses from the contract are recognized as a component of facility expenses.
The impact of the Partnerships commodity derivative instruments on the results of operations reported in the accompanying Condensed Consolidated Statements of Operations are summarized below (in thousands):
Basic and diluted income per common unit is computed in accordance with SFAS 128, Earnings per Share. Basic income per common unit is computed by dividing net income attributable to common unit holders by the weighted average number of common units outstanding.
All unit and per unit data has been adjusted to reflect the Exchange Ratio to give the effect to the Merger (see Note 3). The following is a reconciliation of the Corporation common stock adjusted to reflect comparable units as a result of the Merger (in thousands):