Current Events That Highlight The Energy Sector For Income Investors

by: Michael J. Ray

In the world of income investing there is never a shortage of financial instruments that are competing for the investor's dollar. That being the case, picking the right investments for one's income portfolio can be a daunting task. Inspiration for new ideas can often come from very interesting, if not unique places. The latest events that have come into play revolve around the latest tragedies named Hurricane Sandy, as well as the latest round of fighting in the Middle East.

The devastation that Sandy left in its wake is truly terrible, and no words can describe the loss that the victims are experiencing. Leaving that aside, it was interesting to watch the aftermath of the storm. Story after story was splashed across the media where individuals lined up for hours to get their chance to acquire fuel. They waited in their cars or held gas cans in lines that stretched for many city blocks. It was even reported that one motorist pointed a pistol at another motorist after he tried to cut in line at a gas station. The issue was not a shortage of the fuel, but a shortage of electricity to power the pumps. Regardless of the issue, it situation highlighted America's way of life is very dependent on oil and energy, and any disruption in the supply can have a profoundly negative effect. It is obvious that the demand is every present, and growing.

Next comes the latest news of fighting out of the Middle East between the nation of Israel and Hamas. Though there is a cease fire in place, both sides continue the strike at each other. As this uneasy peace holds, there is still always the threat of a serious escalation of the conflict outside the current borders into the oil producing areas of the region. Needless to say, this would make a bad situation that much worse.

As these events play out, income investors once again turn their attention the energy names. Let's take a look at three possible names that income investor should consider in these troubling times.

Linn Energy (LINE)/Linn Co, LLC (LNCO)

Anyone who reads my articles knows that I sound like a broken record when it comes to Linn Energy. When it comes to income and the energy sector, LINE just cannot be beat. LINE is an independent company that engages in the acquisition and development of oil and gas properties. The company's properties are primarily located in the Mid-Continent, the Permian Basin, Michigan, California, and the Williston Basin in the U.S. Linn is a top-10 U.S. independent oil and natural gas company. The company focuses on the development and acquisition of long-life properties that complement its asset profile.

The question is what makes Linn so compelling for income investors? Currently energy prices are in a state of flux, and many companies are suffering through the price volatility. Linn is not one of those companies. LINE is sitting behind an impressive wall of hedging that is absorbing much of the pain that is crushing other companies. LINE is approximately 100% hedged on expected natural gas production for six years through 2017. The oil production is 100% hedged for five years through 2016. For 2012, the company is hedged at a weighted average oil price of $97.26 per Bbl and a weighted average natural gas price of $5.28 per Mcf. Needless to say, this hedging goes a long way to keep the company's and investor's minds at easy.

In more recent news, we find Linn energy launching their new IPO with shares of Linn Co, LLC . Each shares of this new entity represents one common unit of Linn, and it will have no assets or operations. LNCO will own 13.2% of LINE. This is an interesting move by management. They have stated that one reason for the launch was to structure Linn Co as a corporation in the hopes to attract institutional investors and pension funds that are often unable to buy into partnerships. The final result was that Linn was able get approximate $1.3 billion from the initial public offering , which is going to be used to repay indebtedness that is outstanding under the company's revolving credit facility.

LINE's recent third quarter 2012 results also show many positives for the company. LINE has increased its average daily production 106% to 782 MMcfe/d, compared to 379 MMcfe/d for the third-quarter 2011. The partnership was also able to increase its adjusted EBITDA 65% to $402 million, compared to $243 million for the third-quarter 2011. Finally LINE reported that it has achieved a distribution coverage ratio of 1.40x, which was positively impacted by acquisitions, NGL prices and recent drilling results.

LINE, and now LNCO, is firing on cylinders. With a 7.5% yield, LINE is an investment that might prove to be a step in the right direction for an income investor.

SeaDrill Limited (NYSE:SDRL)

SDRL is another energy name that income investor should consider for their portfolio. Seadrill is an offshore deep water drilling company. The company operates a versatile fleet of 67 units that comprises drill ships, jack-up rigs, semi-submersible rigs and tender rigs for operations in shallow to ultra-deep water areas in harsh and benign environments. The focus of the company is on modern state-of-the-art offshore drilling units with the main focus on deep water operations.

SDRL's third quarter financial statements were just released, so to follow the trend one must make note of the second quarter financial reports. In the second quarter of 2012 Seadrill reported net income of US $554 million and earnings per share of US$1.12. In the third quarter, Seadrill reported net income of US $216 million and earnings per share of US$0.40. The company continues to note the continued strong operational performance within the sector. This was highlighted when SDRL secured new contracts and commitments totaling US$7.6 billion since their first quarter reports. Subsequent to the filing of their second quarter 2012 report, SDRL has entered into the new contracts and received commitments with a total estimated revenue potential of US $2 billion. The company estimates that the total order backlog as of November 23, 2012, is approximately US$21.3 billion.

Digging deeper into the numbers, SDRL also reports operating revenues of US $3,264 million, operating income of US $1,351 million and a net income of US$1,207 for the nine months ended September 30, 2012. This compares to operating revenues of US$3,133 million, operating income of US$1,340 million and a net income of US$1,589 for the nine months ended September 30, 2011.

Even though quarter to quarter financial numbers vary, looking out into the future SDRL continues to see success for their business model. The company expects to see a continued increase in their development drilling activities. Rig availability in 2013 is going to be limited and demand is outpacing the supply. For 2013 most of SDRL's assets are spoken for and that trend is forecasted to continue into 2014 with strong demand coming from the Middle East and Southeast Asia. SDRL is currently paying an 8.5% yield.

With SDRL's successful business model, it was interesting to watch the company introduce Seadrill Partners LLC (NYSE:SDLP) which operates as a subsidiary of SeaDrill Limited. This new entity was created to own, operate, and acquire offshore drilling rigs, and intends to acquire interests in three drilling rigs and one drill ship. The company was founded in 2012 and is based in London, United Kingdom. In October of 2012 the company announced that it priced the initial public offering of 8,750,000 common units at a price of $22.00 per unit. It was estimated that Seadrill Partners would use the net proceeds from the offering to acquire interest in Seadrill Operating LP and Seadrill Capricorn Holdings LLC.

The listing of SDLP is a first as it is the first offshore drilling MLP in history. SDLP raised US $207 million net of transaction fees. SDRL will receive the funds raised in the offering and 75.7% ownership in SDLP in return for selling ownership stakes in four offshore drilling units. Basically this boils down to a large chunk of new funds that will roll into SDRL's coffers while shedding some of the risks and potential liability that goes along with deep water drilling. Seadrill Partners is expected to pay total distributions of $1.62 in 2013, and with a current share price of $26.54 that makes for a yield of 6.1%.

BreitBurn Energy Partners L.P. (BBEP)

BBEP is a name that does not get much attention but it is a very dynamic investment option. BBEP is independent oil and gas limited partnership, focused on the acquisition, exploitation and development of oil and gas properties for the purpose of generating cash flow to make distributions to its unit holders. The partnership's assets consist primarily of producing and non-producing crude oil and natural gas reserves located in the Los Angeles Basin in California, the Wind River and Big Horn Basins in central Wyoming, the Powder River Basin in eastern Wyoming, the Evanston and Green River Basins in southwestern Wyoming, the Sunniland Trend in Florida, the Permian Basin in Texas, the Antrim Shale in Michigan, and the New Albany Shale in Indiana and Kentucky.

BBEP has a balanced production mix which is 50% oil to 50% natural gas. It has estimated proved reserves of 151.1 MMboe on the books. BBEP recently increased its 2012 capital spending to approximately $137 million, and those funds will be focused on oil projects in legacy assets and developing newly acquired assets in Texas and Wyoming. The partnership is targeting a 21% year-over-year production growth in 2012. This basically boils down to more income for the unit holders. BBEP is targeting approximately a 5% annual distribution growth rate supported by ongoing acquisition activity, and has increased distributions for nine consecutive quarters. A strong second half of 2012 has been positive for investors as the coverage ratio guidance range has been calculated to be 1.2x to 1.3x.

To stabilize and protect their cash flow BBEP does use a good deal of hedging. Those hedges currently push out well beyond 2015 and provide income investor with a sense of security. Below is the latest company presentation on their positions.

(Click to enlarge)

BBEP is one of those income investment opportunities that do not come around too often. The partnership is very well run and management is very aware of its commitment to investors as it pays a 10.2% distribution. Those looking for an income holding in the energy sector should definitely take a closer look at BBEP.

In conclusion, energy will always be in demand. The most recent events only highlight this fact and point investors in the right direction. The real trick is finding companies that best represent their sectors. My picks above should help point to some of the best that are available.

Disclosure: I am long LINE. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.