Atlas Pipeline: Call Option on Oil

Natural gas transport and processing company Atlas Pipeline Partners (APL) has been hit hard by falling oil prices. Or at least its stock price has. At the time I write this APL stock is trading at 2 times the annual dividend. It is apparent that there is a strong belief that APL will be unable to continue distributions at the current rate.

Atlas Pipeline Partners is dependent for a majority of its revenues on the processing and sale of natural gas liquids (NGL’s). NGL’s are used in the chemical and petroleum industries and their prices are strongly correlated with the price of oil. Those who provide analysis of APL stock believe that the company needs oil prices to be in the $70 to $80 range to be able to maintain its distribution levels. As oil prices have fallen, the market has hammered the value of APL stock. Last week, Jim Cramer added APL to is “Sell Block” when oil dropped below $50 per barrel.

First, we have to remember that oil prices dropped below $70 all of oh…3 weeks ago. Three months ago oil was in the $115 range. Six months ago everyone thought oil was headed for $200. Who really can forecast where oil prices will be in the next 3 to 6 months. I am not uncomfortable with the idea of oil recovering to over $70 in the very near future.

Last week I wrote an article on how Mexico has hedged its entire 2009 oil production to earn at least $70. How many other state owned or controlled oil agencies “need” oil to sell for more than $70 and have taken hedge positions to insure they get the required revenues? How many traders are out there trying to skin these agencies of the premiums they have paid for their hedges? This is entirely conjecture on my part, but I think a not unlikely scenario.

My point is that if oil does rebound above $70 in the next few months, APL is a $25 stock. Owning the stock gives you an open call option on $70+ oil. In the meantime you may (even probably) collect some level of distribution in February. The last distribution was 96¢. When oil was $70ish in 2006-2007 they were paying 75¢ to 85¢ per share. I think the distribution could be cut to 40¢ for the 4th quarter if oil does not rally rapidly. But 40¢ is 5% of the current share price!

I have written several articles recently about the Atlas family of companies. APL and Atlas Pipeline Holdings (AHD) have become the most speculative of the bunch. If you believe that oil prices will rally above current levels I believe I have made a case for these stocks.

Disclosure: APL is a component of my site’s hypothetical Income Portfolio.

Comments

[whisperonth...:]

I've got time, I'll hold on for a while.

2008 Nov 26 06:03 AM

[Toeser:]

Oil prices could stay low for a year or so. However, if APL can hang in there (they have high debt levels), oil above $70 is a no brainer two or more years out. This stock is very much like an option. It could expire worthless, or be a huge winner. While I acknowledge the risks, I opt for the latter.

2008 Nov 26 07:06 AM

[doublebogey:]

We will have raging inflation and a crashing dollar sooner or later. That in itself will raise the price of crude even ignoring any recovery in the world economy and hence oil demand and pricing. Pretty much a no brainer over the next couple of years I think. The biggest risk maybe some slight of hand by the Cohen's. Some law firm then will make a pile on one of these stockholder suits, but the stockholders never get much out of these things. Barring that kind of problem APL is a long term slam dunk as is just about any other energy/commodity stock at current levels. That billion people in Chindia that have a shot at moving up the income/consumption scale a notch or two have not given up the fight. The genie is out of the bottle for those people. The commodity bull market will resume, perhaps a lot quicker than a lot of people think. I have made my bets and now just waiting while I get 10%+ distributions from MLP's like APL.

2008 Nov 26 11:03 AM

[Skip Olinger:]

Tim,
I think you have missed a key point. I spoke with the company a week ago to try to understand how they do, in fact, generate revenues. It is more complex than it looks. You are right, they do make most of their GP on the sale of NGL's.

However, the key point is that the correlation between the price of NGL's and the price of oil has broken down. The company got in trouble a few months ago as a result. They hedged their NGL's using crude oil as a proxy. However, oil went up (remember?) and NGL's did not so the company was underwater, had to break the hedges right at the peak oil price and raise $200M to pay off the hedges.

As I understand it, NGL prices remain low as a result of 2 things: 1) the hurricanes badly damaged several gulf coast refineries so they are unable take NGL's. This has driven down the price substantially. 2) there has been a general drop in the demand for the refinery products made with NGL's due to the economy. So even when the refineries get fixed there is no guaranty that demand for NGL's will pick up.

The next point is that one should understand that NGL's are hard to hedge out much past 6-9 months. So the company remains exposed to price fluctuations on NGL's gong forward.

My final point is that I have to admit I screwed up here big time buying this company. I bought the stock (not a big position) and I did not fully understand how the company generates its GPM or revenues and what the risks were. My Bad! It is VERY complicated to figure that out with APL. You have to know how much NGL's they generate from the gas they buy and/or transport. You have to know the price of NG as they have to buy NG in some contracts to offset the amount of NGL's they strip out. You have to know how much volume they transport for each of the 3 types of contracts they use. You have to know the price of NGL's. Lastly, you have to know how much they have hedged, at what price and what contracts they apply to. It is a very complex algorithm.

In conclusion, APL is not a proxy for oil price increases at all. It is a proxy for NGL's. It is also a proxy for NG pricing as they make more money when NG prices are high. They get a % of the proceeds. And, it is a proxy for how well they have hedged. If I were doing it again, I would buy Energy Transfer, a big pipeline that makes its money from tolls fees, not the sale of NGL's or I would buy E&P MLP's that produce oil, gas and to a lesser extent NGL's and just sell them. No complex stripping out NGL's and replacing with NG.

2008 Nov 26 11:18 AM

[dan-d:]

I think petro is in a real bind at this juncture due to the worldwide recessionary pressure and the fact that to much upward movement in petro will seal the deal so to speak in many countries for the push on green alt energy sources. This is not to say reasonable pricing with some stability can not be achieved. But given the political climate and generational changes in thinking regarding energy sourcing any more "oil crisis " situations will contribute to the ultimate demise of pricing. Upward movement yes, to a degree, high volitily no. NG as has been mentioned is tied to oil so I would not look for a big spike there either. Inflationary pressure that increase petro would exert is not a good thing at all in the long run.

2008 Nov 26 12:56 PM

[Tim Plaehn:]

Skip in CA, I do think your analysis is correct. APL is a complicated company that has a lot of moving parts. I still believe that increasing energy prices will bail them out. The stock price has a lot of upside if the scenario works out. If energy prices stay low I think they will struggle.

2008 Nov 26 01:03 PM

[Jack Walker:]

Tim,

APL does indeed seem like an interesting situation with the stock selling at $7.25. With a trailing four quarters distribution rate of $3.82 the ROI, if it can be maintained is 52%. However, the question is how soon and how much will the distribution rate will be cut?

Assuming it is cut 2/3 that would bring it down to .32 quarterly or at an annual rate of $1.28 it would then be running at a 17.7% rate.

We then suggest going one step further and adding an options collar to protect the downside for the long stock position.

For example, if we look at the May options, which would be about right for the seasonal recovery in crude prices, we find the May 5 put is selling at an indicated mid price between the bid and ask of 1.325 and the May 10 call is selling at 1.175.

The collar trade is to buy 100 shares of stock at 7.25
Buy the May 5 put APLQA 1.325
Sell the May 10 call APLEB 1.175

Based upon the mid price the debit cost of the collar is .15. However, the options are thinly traded so it will cost more, as we will have to sell our call for something less and pay something more for the put. As example, if we paid something between .30 and .45 it would be about right.

Now we would be long 100 shares of stock at 7.25. Assuming we paid .45 for the collar and assuming the next distribution was .32 we will have almost covered the cost of the collar on the next distribution expected in early February and will have exceeded its cost on the May distribution before the options expire.

Now that we have protected the downside let’s look at the upside. If you are right and crude oil prices are back toward the $70 level and APL is trading above $10 then our stock will be called away at $10. Using the assumption above our basis in the stock would now be $7.06. That’s $7.25 for the purchase, plus .45 for the collar, less .64 for the two distributions. The ROI on this hedged position with our stock called away would be 41.6%.

If the stock recovers sooner and is called away before we have received our distributions then we will still have a gain, but not quite as much in a shorter period of time.

If by then there was a good defined uptrend we could do another hedged trade at a higher price.

Jack

2008 Nov 26 02:23 PM

[Skip Olinger:]

Big picture you are correct. However, oil/gas may move up but NGL's stay low due to lack of refinery and feedstock demand. My point is that there are better ways to play increasing energy prices. LINE and LGCY are direct plays on oil/gas and much less complex. I think the reason to invest in pipelines is that it is you are buying a tolling business and get paid on throughput, not to speculate on energy prices.

I should have listened to my own good advice. And, I am holding as you get paid a very big yield and it looks like they won't go bust.

Did you look at the GP (AHD)? I think you can get a bigger bang on dividend increases owning that rather than the LP. But again, it is difficult to analyze.


On Nov 26 01:03 PM Tim Plaehn wrote:

> Skip in CA, I do think your analysis is correct. APL is a complicated
> company that has a lot of moving parts. I still believe that increasing
> energy prices will bail them out. The stock price has a lot of upside
> if the scenario works out. If energy prices stay low I think they
> will struggle.

2008 Nov 26 06:33 PM

[zoebird126:]

Wouldn't be better to buy NS or NSH where the distributions currently yield over 11% with more certain growth potential in yield and price? I don't see the risk as with APL. Zoe

2008 Nov 26 10:02 PM

[sr9web:]

SkipinCA, I think your caution is well advised here. For oil proxy holdings, I'd look at PWE and PGH before this. Also DPM is looking interesting.


On Nov 26 11:18 AM SkipinCA wrote:

> Tim,
> I think you have missed a key point. I spoke with the company a week
> ago to try to understand how they do, in fact, generate revenues.
> It is more complex than it looks. You are right, they do make most
> of their GP on the sale of NGL's....

2008 Dec 01 11:26 AM