The clock is ticking now for upstream MLPs. In truth it was ticking all along, only now the ticks have gotten louder.

The partnerships are used to touting their oil hedges as protection against a worst-case scenario. Now that the crash in crude prices is at hand, minds have been focused on a possibility that’s even worse: that of a slump that outlasts the hedges and takes a big bite out of cash flow.

Does that have to happen? Of course not. Oil’s collapse in 2008/9 and the implosion of natural gas prices in 2012 proved to be relatively short-lived anomalies, and if the latest drop ends up the same the MLPs can rehedge in a year or two once prices recover.

But without a rebound many distributions will need to be cut once the hedges expire, and the fact that current payouts not indefinitely sustainable under current market conditions is what’s been keeping investors up nights, and has turned some  limited partners into eager sellers.

The unit prices have been devastated. Atlas Resource Partners (NYSE: ARP), which gets 60% of its revenue from natural gas, has nevertheless depreciated more than 40% just since Nov. 21. (Through Dec. 12, as is the case for all the numbers in this story.) Linn Energy (NASDAQ: LINE) is down 59% since Sept. 30; Mid-Con Energy Partners (NASDAQ: MCEP) a whopping 70% over the same span.

HOOK AND SINKER

Bondholders who get to recoup their money in a liquidation scenario before unitholders see a dime are also having serious second thoughts. Memorial Production Partners (NASDAQ: MEMP) eight-year senior notes expiring in 2021 traded nearly 6% above face value as recently as Sept. 5. Now they’re changing hands at 77 cents on the dollar, for an effective yield of 13.2%.

Quite aside from the threat of lower commodity prices to future cash flows, the spike in the cost of debt and equity capital imperils the acquisition-fueled growth that has been the hallmark of upstream MLPs. They need the acquisitions to maintain production levels and, more importantly, to continue generating the depletion write-offs underpinning their high tax-deferred distribution yields.

Without acquisitions, less of each year’s per-unit distribution would be tax-deferred. That forces partnerships to keep shopping at all times, including recently when oil prices where unsustainably high. Now that the price has crashed would be a better time to buy, but of course by now the cost of additional capital needed to finance such acquisitions would be prohibitive even if anyone were willing to offer it.

I’ve been asked repeatedly to explain my skepticism of upstream MLPs, as evidenced by the decisions to stop recommending Linn last year and to drop MCEP and Legacy Reserves (NASDAQ: LGCY) from the portfolios in April. As I pointed out at the time, my two main problems with upstream MLPs were their overvaluation relative to comparable C-corp drillers and the low quality of their distributable cash flow.

It’s true that depreciation, depletion and amortization is a non-cash cost that doesn’t affect cash flow; but it’s nevertheless a real cost of producing a portion of a partnership’s proved reserves. Replacing those reserves, whether by acquisition or development, would cost real money.

Here’s Warren Buffet discussing depreciation in Berkshire Hathaway’s 2002 annual report, and everything he says is equally applicable to depletion charges reported by an energy producer:

Trumpeting EBITDA (earnings before interest, taxes, depreciation and amortization) is a particularly pernicious practice. Doing so implies that depreciation is not truly an expense, given that it is a “non-cash” charge. That’s nonsense. In truth, depreciation is a particularly unattractive expense because the cash outlay it represents is paid up front, before the asset acquired has delivered any benefits to the business. Imagine, if you will, that at the beginning of this year a company paid all of its employees for the next 10 years of their service (in the way they would lay out cash for a fixed asset to be useful for ten years). In the following nine years, compensation would be a “non-cash” expense – a reduction of a prepaid compensation asset established this year. Would anyone care to argue that the recording of the expense in years two through ten would be simply a bookkeeping formality? 

We make frequent references to EBITDA here because so do the MLPs we cover, and doing so allows us to compare their leverage, for example. But we’ve never lost sight of the fact that cash flow, be it from operations, investing or financing, matters more. And the cash flow statements from upstream MLPs generally make clear their inferiority to corporate energy producers.

Over the first nine months of 2014, Atlas Resource Partners had revenue of $495 million against operating costs of $480 million, including a depreciation, depletion and amortization (DD&A) expense of $171 million. After further deductions for interest and preferred dividend costs, the net loss attributable to limited partners was $51 million. In fact, ARP hasn’t posted an annual net gain since 2011.

Now compare those metrics to that of C-corp gas driller EQT (NYSE: EQT) over the same period. During the first nine months of this year, EQT posted revenue of $1.8 billion against $991 million of costs, for an operating margin of 44%, vs. ARP’s 3%. EQT also had directly attributable net income of $402 million after subtracting $485 million in DD&A.

So EQT converted 23% of revenue into net income even after paying nearly 14% of revenue in income taxes. Despite passing all income tax liabilities to its partners, ARP could only manage a net loss.

And while ARP paid out $162 million in distributions during the first nine months of the year, it also added $338 million in net debt and sold $426 million worth of units during the same time period.

All of this to post a net loss and record a slender $70 million in cash flow from operations. Where will the partnership get the cash for next year’s distributions and acquisitions if the debt and equity markets remain effectively shut to it? There are workarounds like buying properties for a share of future profits, but of course these may not be seen as sustainable either.

Upstream MLPs could use a rebound in oil prices for sure. But what they need more than anything is a recovery in bond and unit prices that would restore their access to capital markets. A drilling MLP without access to fresh capital is like Pacific salmon after its upstream run: living on borrowed time.