| MARKWEST HYDROCARBON INC ITEM 1A RISK FACTORS In addition to the other information set forth elsewhere in this Form 10-K, you should carefully consider the following factors when evaluating MarkWest Hydrocarbon |
| Risks Inherent in Our Business We are highly dependent upon the earnings and distributions of MarkWest Energy Partners |
| A significant decline in MarkWest Energy Partners’ earnings and/or cash distributions would have a corresponding negative impact on us |
| For more information on these earnings and cash distributions, please see MarkWest Energy Partners’ 2005 Annual Report on Form 10-K If we are unable to successfully integrate the Partnership’s recent or future acquisitions, our future financial performance may be negatively impacted |
| Our future growth will depend in part on our ability to integrate the Partnership’s recent acquisitions, as well as its ability to acquire additional assets and businesses at competitive prices |
| The Partnership recently completed the Starfish and Javelina acquisitions, which geographically expanded its operations into offshore and onshore Gulf of Mexico operations |
| We cannot assure you that the Partnership will successfully integrate these or any other acquisitions into its operations, or that the Partnership will achieve the desired profitability from such acquisitions |
| Failure to do so could adversely affect our financial condition and results of operations |
| The integration of acquisitions with our existing business involves numerous risks, including: • operating a significantly larger combined organization and integrating additional midstream operations to our existing operations; • difficulties in the assimilation of the assets and operations of the acquired businesses, especially if the assets acquired are in a new business segment or geographical area; • the loss of customers or key employees from the acquired businesses; • the diversion of management’s attention from other business concerns; • the failure to realize expected synergies and cost savings; • coordinating geographically disparate organizations, systems and facilities; • integrating personnel from diverse business backgrounds and organizational cultures; and • consolidating corporate and administrative functions |
| Further, unexpected costs and challenges may arise whenever businesses with different operations or management are combined, and we may experience unanticipated delays in realizing the benefits of an acquisition |
| Following an acquisition, the Partnership may discover previously unknown liabilities subject to the same stringent environmental laws and regulations relating to releases of pollutants into the environment and environmental protection as the Partnership’s existing plants, pipelines and facilities |
| If so, the Partnership’s operation of these new assets could cause us to incur increased costs to attain or maintain compliance with such requirements |
| If the Partnership consummates any future acquisition, its capitalization and results of operation may change significantly, and you will not have the opportunity to evaluate the economic, financial and other relevant information that we will consider in determining the application of these funds and other resources |
| The Partnership’s acquisition strategy is based, in part, on our expectation of ongoing divestitures of assets within the midstream petroleum and natural gas industry |
| A material decrease in such divestitures could limit the Partnership’s opportunities for future acquisitions, and could adversely affect its operations and cash flows available for distribution to its unitholders |
| 15 ______________________________________________________________________ Our commodity derivative activities may reduce our earnings, profitability and cash flows |
| Our operations expose us to fluctuations in commodity prices |
| We utilize derivative financial instruments related to the future price of natural gas and certain NGLs with the intent of reducing volatility in our cash flows due to fluctuations in commodity prices |
| We account for derivative instruments in accordance with the provisions of Statement of Financial Accounting Standards (SFAS) Nodtta 133, Accounting for Derivative Instruments and Hedging Activities |
| The extent of our commodity price exposure is related largely to the effectiveness and scope of our hedging activities |
| We have a policy to enter into derivative transactions related to only a portion of the volume of our expected production or fuel requirements and, as a result, we will continue to have direct commodity price exposure to the unhedged portion |
| Please read “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Quantitative and Qualitative Disclosures about Market Risk |
| ” Our actual future production or fuel requirements may be significantly higher or lower than we estimate at the time we enter into derivative transactions for such period |
| If the actual amount is lower than the 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 flow from our sale or purchase of the underlying physical commodity |
| 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 risks that a counterparty may not perform its obligation under the applicable derivative instrument, the terms of the derivative instruments are imperfect, and our hedging policies and procedures are not properly followed |
| It is possible that the steps we take to monitor our derivative financial instruments may not detect and prevent violations of our risk management policies and procedures, particularly if deception or other intentional misconduct is involved |
| Our management has discretion in conducting our risk management activities and may not accurately predict future price fluctuations and therefore expose us to financial risks and reduce our opportunity to benefit from price increases |
| We evaluate our exposure to commodity price risk from an overall portfolio basis |
| Our management has discretion in determining whether and how to manage the commodity price risk associated with our physical and derivative positions |
| To the extent that we do not manage the commodity price risk relating to a position that is subject to commodity price risk, and commodity prices move adversely, we could suffer losses |
| Such losses could be substantial, and could adversely affect our financial condition and results of operations |
| Changes in commodity prices subject us to margin calls, which may adversely affect our liquidity |
| Unfavorable commodity price changes may subject us to margin calls that require us to provide cash collateral to our counterparties in amounts that may be material |
| Such funding requirements could exceed our ability to access our credit line or other sources of capital |
| If we are unable to meet these margin calls with borrowings or cash on hand, we would be forced to sell product to meet the margin calls, or to terminate the corresponding futures contracts |
| If we are forced to sell product to meet margin calls, we may have to sell product at prices that are not advantageous, which could adversely affect our financial condition, results of operations and cash flows |
| The Partnership’s substantial debt and other financial obligations could impair our financial condition, results of operations and cash flows and our ability to fulfill our debt obligations |
| The Partnership has substantial indebtedness and other financial obligations |
| Subject to the restrictions governing the Partnership’s indebtedness and other financial obligations, and the indenture governing our existing debt, the Partnership may incur significant additional indebtedness and other financial obligations, which may be secured and/or structurally senior to its existing debt |
| The Partnership’s substantial indebtedness and other financial obligations could have important consequences |
| For example, they could: • make it more difficult for the Partnership to satisfy its obligations with respect to its existing debt; • impair the Partnership’s ability to obtain additional financings in the future for working capital, capital expenditures, acquisitions, general corporate purposes or other purposes; • have a material adverse effect on the Partnership if it fails to comply with financial and restrictive covenants in the Partnership’s debt agreements and an event of default occurs as a result of that failure that is not cured or 16 ______________________________________________________________________ waived; • require the Partnership to dedicate a substantial portion of its cash flow to payments on its indebtedness and other financial obligations, thereby reducing the availability of the Partnership’s cash flow to fund working capital, capital expenditures, distributions and other general partnership requirements; • limit the Partnership’s flexibility in planning for, or reacting to, changes in its business and the industry in which it operates; and • place the Partnership at a competitive disadvantage compared to its competitors that have proportionately less debt |
| These restrictions could limit the Partnership’s ability, and the ability of its subsidiaries, to obtain future financings, make needed capital expenditures, withstand a future downturn in its business or the economy in general, conduct operations or otherwise take advantage of business opportunities that may arise |
| The Partnership’s existing credit facility contains covenants requiring it to maintain specified financial ratios and satisfy other financial conditions |
| The Partnership may be unable to meet those ratios and conditions |
| Any future breach of any of these covenants or the Partnership’s failure to meet any of these ratios or conditions could result in a default under the terms of the Partnership’s credit facility, which could result in acceleration of its debt and other financial obligations |
| If the Partnership were unable to repay those amounts, the lenders could initiate a bankruptcy proceeding or liquidation proceeding or proceed against the collateral |
| A significant decrease in natural gas and refinery off-gas supplies in the Partnership’s areas of operation due to the decline in production from existing wells, refinery operations, depressed commodity prices, reduced drilling activities or other factors otherwise could adversely affect our revenues and operating income and cash flow |
| Our profitability is influenced by the volume of natural gas the Partnership gathers, transmits and processes, and NGLs the Partnership transports and fractionates at its facilities |
| A decrease in natural gas or refinery off-gas supplies in the Partnership’s areas of operation would result in a decline in the volume of natural gas delivered to its pipelines and facilities for gathering, transporting and processing and NGLs delivered to its pipelines and facilities for fractionation, storage, transportation and sales |
| This would reduce the Partnership’s revenue and operating income |
| Fluctuations in energy prices can greatly affect production rates and investments by third parties in the development of new oil and natural gas reserves |
| Drilling activity generally decreases as oil and natural gas prices decrease |
| We have no control over the level of drilling activity in the areas of operations, the amount of reserves underlying the wells and the “decline rate,” or the rate at which production from a well declines |
| In addition, we have no control over producers or their production decisions, which are affected by, among other things, prevailing and projected energy prices, demand for hydrocarbons, the level of reserves, geological considerations, governmental regulation and the availability and cost of capital |
| Failure to connect new wells to the Partnership’s gathering systems would, therefore, result in a reduction of the amount of natural gas it gathers, transmits and processes and the amount of NGLs the Partnership transports and fractionates |
| Over time upon exhaustion of the current wells, this could cause the Partnership to abandon its gathering systems and, possibly, cease gathering operations |
| We are exposed to the credit risk of our customers and counterparties, and a general increase in the nonpayment and nonperformance by our customers could reduce our revenues and cash flow |
| We are diligent in attempting to ensure that we issue credit to only credit-worthy customers |
| Even if our credit review and analysis mechanisms work properly, however, we may experience losses in dealing with operators and other parties |
| Any increase in the nonpayment and nonperformance by our customers could reduce our revenues and cash flow |
| The Partnership may not be able to retain existing customers or acquire new customers, which would reduce its revenues and limit its future profitability |
| The renewal or replacement of existing contracts with the Partnership’s customers at rates sufficient to maintain current revenues and cash flows depends on a number of factors beyond its control, including competition from other gatherers, processors, pipelines, fractionators, and the price of, and demand for, natural gas, NGLs and crude oil in the markets we serve |
| The Partnership’s competitors include large oil, natural gas, refining and petrochemical companies, some of which have greater financial resources, more numerous or greater capacity pipelines, processing and other facilities, and greater access to natural gas and NGL supplies than the Partnership does |
| Additionally, the Partnership’s customers that gather gas through facilities that are not otherwise dedicated to the Partnership may develop their own processing and fractionation facilities in lieu of using the Partnership’s services |
| Certain of the Partnership’s competitors may also have advantages in competing for acquisitions, or other new business opportunities, because of their financial resources and synergies in operations |
| As a consequence of the increase in competition in the industry, and the volatility of natural gas prices, end-users 17 ______________________________________________________________________ and utilities are reluctant to enter into long-term purchase contracts |
| Many end-users purchase natural gas from more than one natural gas company and have the ability to change providers at any time |
| Some of these end-users also have the ability to switch between gas and alternative fuels in response to relative price fluctuations in the market |
| Because there are numerous companies of greatly varying size and financial capacity that compete with the Partnership in the marketing of natural gas, the Partnership often competes in the end-user and utilities markets primarily on the basis of price |
| The inability of the Partnership’s management to renew or replace its current contracts as they expire and to respond appropriately to changing market conditions could affect its profitability |
| Relative changes in NGL product and natural gas prices may adversely impact our results due to frac spread, natural gas and liquids exposure |
| We are exposed to frac spread risk |
| Under our keep-whole arrangements, our principal cost is delivering dry gas of an equivalent Btu content to replace Btus extracted from the gas stream in the form of NGLs, or consumed as fuel during processing |
| The spread between the NGL product sales price and the purchase price of natural gas with an equivalent Btu content is called the “frac spread |
| ” Generally, the frac spread and, consequently, the net operating margins are positive under these contracts |
| In the event natural gas becomes more expensive on a Btu equivalent basis than NGL products, the cost of keeping the producer “whole” results in operating losses |
| Through our marketing and derivatives activity, direct exposure may occur naturally or we may choose direct exposure to either gas or liquids when we favor that exposure over frac spread risk |
| Given that we have positions, adverse movement in prices to the positions we have taken will negatively impact our results |
| Through our interest in the Partnership, our profitability is affected by the volatility of NGL product and natural gas prices |
| Crude oil, NGL products and natural gas prices have been volatile in recent years in response to relatively minor changes in the supply and demand for NGL products and natural gas, market uncertainty, and a variety of additional factors that are beyond our control, including: • the level of domestic oil, natural gas and NGL production; • imports of crude oil, natural gas and NGLs; • seasonality; • the condition of the US economy; • political conditions in other oil-producing and natural gas-producing countries; and • domestic government regulation, legislation and policies |
| The net operating margins of the Partnership under its various types of commodity-based contracts are directly affected by changes in NGL product prices and natural gas prices, and thus are more sensitive to volatility in commodity prices than its fee-based contracts |
| Additionally, its purchase and resale of gas in the ordinary course of business exposes it to significant risk with volatility in gas prices due to the potential difference in the time of the purchases and sales, and the existence of a difference in the gas price associated with each transaction |
| The Partnership’s Javelina processing agreements are also potentially affected by the profitability of the NGLs and other products relative to the fuel value of the refinery off-gas stream |
| Finally, changes in natural gas prices may indirectly affect the Partnership’s profitability, since prices can influence drilling activity and well operations and, thus, the volume of gas it gathers and processes |
| In the past, the prices of natural gas and NGLs have been extremely volatile, and we believe this volatility may continue |
| We have found material weaknesses in our internal controls that require remediation and concluded, pursuant to Section 404 of the Sarbanes-Oxley Act of 2002, that our internal controls over financial reporting at December 31, 2005, were not effective |
| As we discuss in our Management’s Report on Internal Control over Financial Reporting in Part II, Item 9A, “Controls and Procedures,” of this Form 10-K, we have discovered deficiencies, including material weaknesses, in our internal controls over financial reporting as of December 31, 2005 |
| In particular, we identified, and Deloitte & Touche’s audit report on management’s assessment of the effectiveness of internal control over financial reporting and the effectiveness of internal control over financial reporting as of December 31, 2005 confirmed the presence of, the following material weaknesses: 18 ______________________________________________________________________ • Ineffective control environment; and • Risk management and accounting for derivative financial instruments |
| We are fully committed to remediating the material weaknesses described above, and we believe that we are taking the steps that will properly address these issues |
| Further, our Audit Committee has been and expects to remain actively involved in the remediation planning and implementation |
| However, the remediation of the design of the deficient controls and the associated testing efforts are not complete, and further remediation may be required |
| While we are taking immediate steps and dedicating substantial resources to correct these material weaknesses, they will not be considered remediated until the new and improved internal controls operate for a period of time, are tested and are found to be operating effectively |
| Pending the successful completion of such testing and the hiring of additional personnel, we will perform mitigating procedures |
| If we fail to remediate any material weaknesses, we could be unable to provide timely and reliable financial information, which could have a material adverse effect on our business, results of operations or financial condition |
| We are subject to operating and litigation risks that may not be covered by insurance |
| Our industry is subject to numerous operating hazards and risks incidental to processing, transporting, fractionating and storing natural gas and NGLs and to transporting and storing crude oil |
| These include: • damage to pipelines, plants, related equipment and surrounding properties caused by floods and other natural disasters; • inadvertent damage from construction and farm equipment; • leakage of crude oil, natural gas, NGLs and other hydrocarbons; • fires and explosions; and • other hazards, including those associated with high-sulfur content, or sour gas that could also result in personal injury and loss of life, pollution and suspension of operations |
| As a result, we may be the defendants in various legal proceedings and litigation arising from our operations |
| We may not be able to maintain or obtain insurance of the type and amount we desire at reasonable rates |
| Market conditions could cause certain insurance premiums and deductibles to become unavailable, or available only for reduced amounts of coverage |
| For example, insurance carriers now require broad exclusions for losses due to war risk and terrorist acts |
| If we were to incur a significant liability for which we were not fully insured, it could have a material adverse effect on our financial position |
| Transportation on certain of the Partnership’s pipelines may be subject to federal or state rate and service regulation, and the imposition and/or cost of compliance with such regulation could adversely affect our profitability |
| Some of the Partnership’s gas, liquids and crude oil transmission operations may be subject to rate and service regulations under FERC, or various state regulatory bodies, depending upon jurisdiction |
| FERC generally regulates the transportation of natural gas and oil in interstate commerce, and FERC’s regulatory authority includes: facilities construction, acquisition, extension or abandonment of services or facilities; accounts and records; and depreciation and amortization policies |
| Intrastate natural gas pipeline operations are generally not subject to regulation by FERC, and the Natural Gas Act (“NGA”) specifically exempts some gathering systems |
| The applicable statutes and regulations generally require that our rates and terms and conditions of service provide no more than a fair return on the aggregate value of the facilities used to render services |
| FERC rate cases can involve complex and expensive proceedings |
| The Partnership is indemnified for liabilities arising from an ongoing remediation of property on which its facilities are located and its results of operation and its ability to make payments of principal and interest on its debt could be adversely affected if the indemnifying party fails to perform its indemnification obligation |
| Columbia Gas is the previous or current owner of the property on which the Partnership’s Kenova, Boldman, Cobb and Kermit facilities are located, and is the previous operator of its Boldman and Cobb facilities |
| Columbia Gas has been, or is currently, involved in investigatory or remedial activities with respect to the real property underlying the Boldman and Cobb facilities, pursuant to an “Administrative Order by Consent for Removal Actions” entered into by Columbia Gas and the US Environmental Protection Agency and, in the case of the Boldman facility, an “Agreed Order” with the Kentucky Natural Resources and Environmental Protection Cabinet |
| 19 ______________________________________________________________________ Columbia Gas has agreed to retain sole liability and responsibility for, and to indemnify MarkWest Hydrocarbon against, any environmental liabilities associated with these regulatory orders or the real property underlying these facilities to the extent such liabilities arose prior to the effective date of the agreements pursuant to which such properties were acquired or leased from Columbia Gas |
| At the closing of our initial public offering, MarkWest Hydrocarbon assigned us the benefit of its indemnity from Columbia Gas with respect to the Cobb, Boldman and Kermit facilities |
| While the Partnership is not a party to the agreement under which Columbia Gas agreed to indemnify MarkWest Hydrocarbon with respect to the Kenova facility, MarkWest Hydrocarbon has agreed to provide to the benefit of its indemnity, as well as any other third party environmental indemnity of which it is a beneficiary |
| MarkWest Hydrocarbon has also agreed to provide an additional environmental indemnity pursuant to the terms of the Omnibus Agreement |
| The Company’s results of operation and ability to make cash distributions could be adversely affected if, in the future, Columbia Gas fails to perform under the indemnification provisions of which the Company is the beneficiary |
| Our business is subject to federal, state and local laws and regulations with respect to environmental, safety and other regulatory matters, and the violation of or the cost of compliance with such laws and regulations could adversely affect our profitability |
| Numerous governmental agencies enforce complex and stringent laws and regulations on a wide range of environmental, safety and other regulatory matters |
| We could be adversely affected by increased costs due to stricter pollution-control requirements or liabilities resulting from non-compliance with operating or other regulatory permits |
| New environmental laws and regulations might adversely influence our products and activities |
| Federal, state and local agencies also could impose additional safety requirements, any of which could affect our profitability |
| In addition, we face the risk of accidental releases or spills associated with our operations |
| These could result in material costs and liabilities, including those relating to claims for damages to property and persons |
| Our failure to comply with environmental or safety-related laws and regulations could result in administrative, civil and criminal penalties, the imposition of investigatory and remedial obligations and even injunctions that restrict or prohibit our operations |
| For more information regarding the environmental, safety and other regulatory matters that could affect our business, please see Item 1, Regulatory Matters and Environmental Matters |
| MarkWest Energy Partners may not be able to successfully execute its business plan and may not be able to grow its business, which could adversely affect the value of our investment in the limited partner units and the general partnership interests in MarkWest Energy Partners |
| MarkWest Energy Partners’ ability to successfully operate its business, generate sufficient cash to pay the minimum quarterly cash distributions to its unitholders, and to allow for growth, is subject to a number of risks and uncertainty |
| Similarly, MarkWest Energy Partners may not be able to successfully expand its business through acquiring or growing its assets, because of various factors, including economic and competitive factors beyond its control |
| If MarkWest Energy Partners is unable to grow its business, or execute on its business plan, the market price of the common units is likely to decline, causing the limited partner units and the general partner interest we hold in MarkWest Energy Partners to also decline in value |
| Our cash flow would be adversely affected if operations at any of the Partnership’s facilities were interrupted |
| The Partnership’s operations depend upon the infrastructure that it has developed, including processing and fractionation plants, storage facilities, and various means of transportation |
| Any significant interruption at these facilities or pipelines, or the Partnership’s inability to transmit natural gas or NGLs, or transport crude oil to or from these facilities or pipelines for any reason, would adversely affect our results of operations and cash flows |
| Operations at the Partnership’s facilities could be partially or completely shut down, temporarily or permanently, as the result of circumstances not within its control, such as: • unscheduled turnarounds or catastrophic events at our physical plants; • labor difficulties that result in a work stoppage or slowdown; or • a disruption in the supply of crude oil to the Partnership’s crude oil pipeline, natural gas to its processing plants or gathering pipelines, or a disruption in the supply of NGLs to the Partnership’s transportation pipeline and fractionation facility |
| Due to the Partnership’s lack of asset diversification, adverse developments in the Partnership’s gathering, processing, transportation, transmission, fractionation and storage businesses would reduce the Partnership’s ability to make distributions to its unitholders |
| 20 ______________________________________________________________________ We rely on the revenues generated from the Partnership’s gathering, processing, transportation, transmission, fractionation and storage businesses |
| An adverse development in one of these businesses would have a significantly greater impact on our financial condition and results of operations than if we maintained more diverse assets |
| The tax treatment of MarkWest Energy Partners depends upon its status as a partnership for federal income tax purposes, as well as it not being subject to entity-level taxation by states |
| If the Internal Revenue Service were to treat MarkWest Energy Partners as a corporation, or if it were to become subject to entity-level taxation for state tax purposes, then its cash available for distribution would be significantly reduced |
| We own limited partner units representing approximately 19prca of the limited partnership interests in MarkWest Energy Partners, in addition to a 2prca general partnership interest |
| The anticipated after-tax benefit of an investment in the limited partner units of MarkWest Energy Partners depends largely on MarkWest Energy Partners being treated as a partnership for federal income tax purposes |
| If MarkWest Energy Partners were treated as a corporation for federal income tax purposes, it would pay federal income tax on its income at the corporate tax rate, which is currently a maximum of 35prca |
| Cash distributions to the holders of limited partnership interests, including the subordinated units we hold and the common units held by the public, would generally be taxed again as corporate distributions, and no income, gains, losses, deductions or credits would flow through to the holders of the limited partnership interests to shelter a substantial portion of such distributions from state and federal income taxes |
| Because a tax would be imposed upon MarkWest Energy Partners as a corporation, its cash available for distribution to limited partners would be significantly reduced |
| Thus, treatment of MarkWest Energy Partners as a corporation would result in a material reduction in the anticipated cash flow and after-tax return to its owners, including us, as a holder of the limited partner units, likely causing a significant reduction in the value of the market price of the common units |
| A shortage of skilled labor may make it difficult for us to maintain labor productivity, and competitive costs and could adversely affect our profitability |
| The Partnership’s operations require skilled and experienced laborers with proficiency in multiple tasks |
| In recent years, a shortage of workers trained in various skills associated with the midstream energy business has caused us to conduct certain operations without full staff, which decreases our productivity and increases our costs |
| This shortage of trained workers is the result of the previous generation’s experienced workers reaching the age for retirement, combined with the difficulty of attracting new laborers to the midstream energy industry |
| Thus, this shortage of skilled labor could continue over an extended period |
| If the shortage of experienced labor continues or worsens, it could have an adverse impact on our labor productivity and costs and our ability to expand production in the event there is an increase in the demand for our products and services, which could adversely affect our profitability |