Co-written by Patrick Kirts
By now the cat is out of the bag on Linn Energy, LLC (LINE). This was a top holding of Seth Klarman, from whom I ripped off the idea (I do mean that in a good way!). Warren Buffett has always supported copying the great investors. On May 5th I read some commentary by Sham Gad on RealMoney on Oil & Gas MLPs that reminded me why I own them.
While we hold both LINE and Tortoise Energy Infrastructure Corp. (TYP) (a closed end fund that owns a bunch of MLPs), we do so for different reasons and for different clients. At the end of the day it comes down to concentrating risk (and getting paid for it), versus diluting your risk (along with return).
Below we will get into the finer points, but remember this is not a competition between the two; break down the two different strategies so you can come to your own conclusions.
It would seem that any investor must be able to answer two questions about any security one wishes to purchase: How does the common shareholder make money? What are the risks involved? The following chart offers basic information on two stocks of energy-related master limited partnerships (MLPs).
LINE (yr 12/31/2008) | TYG (yr 11/30/2008) | |
Closing Price 6/17/2009 | $18.85 | $26.15 |
52 wk range* | $10.81 - $25.84 | $7.49 - $32.95 |
% from top, bottom | (38.7%), 46.4% | (29.9%), 208.5% |
Div./Yield | $2.52 / 16.50% | $2.16 / 8.90% |
Market cap | $1.81B | $540.10M |
3 mo average volume | 954m | 84m |
Since market highs around May 2007, LINE has tracked about 20-30% below the S&P 500, while TYG has been about 10-15% below it, except for sharp spikes in early October and late November 2008, which explains its current price 209% above its year lows. Since January TYG has tracked the S&P almost exactly.
Tortoise Energy Infrastructure Corp. (TYP) is a publicly traded closed end fund managed by Tortoise Capital Advisors, LLC, which exclusively manages funds investing in energy infrastructure (pipelines) MLPs, none of which comprise more than 9% of a given portfolio.
50% of TYG's investments are in crude/refined products pipelines, 32% natural gas and NGLs pipelines, and 11% natural gas gathering/processing. TYG collects distributions (dividends that pay all available cash at quarter’s end, usually) from its MLP holdings. It then distributes more than 60% of received distributions to shareholders; another way of thinking about this is to look at the net assets applicable to common shares.
The following chart summarizes its total and net assets, distributions paid and received, total leverage and the two greatest expenses, leverage costs and advisory fees:
TYG (yr end 11/30) | 2007 | 2008 | Comparison |
Total assets end of period | $1,261,638 | $691,183 | 45% decline |
Net assets end of period* | $618,412 | $407,031 | 34% decline |
Net assets/total assets | 50.0% | 58.9% | |
Distributions received (DR) | $64,255 | $72,930 | 11.9% gain |
Percent of total assets | 5.09% | 7.63% | |
Distributions paid common stock (DP) | $40,702 | $48,536 | 16.1% gain |
Percent of net assets | 6.58% | 11.9% | |
DP/DR | 63.3% | 66.6% | 12.2% gain |
Distributable cash flow (DCF) | $40,884 | $45,940 | |
DP/DCF (payout percentage) | 99.6% | 105.7% | |
Net realized gain (loss) | $26,631 | ($7,847) | |
Leverage** | $458,050 | $280,000 | 38.9% decline |
Percent of total assets | 36.3% | 40.5% | |
Leverage costs | $22,110 | $27,416 | |
Leverage costs/DR | 34.4% | 37.6% | |
Advisory fees | $10,571 | $9,532 | |
Advisory fees/DR | 16.5% | 13.1% | |
Net asset value per share | $32.96 | $17.36 | |
Market value per share | $32.46 | $17.11 |
Dollars in thousands except per share data.
*Net assets are assets applicable to common shares = total investments + other assets and liabilities – long-term debt – preferred shares at redemption value.
**Long –term debt obligations, preferred stock and short-term borrowings
Both total and net assets declined precipitously in 2008, almost entirely during the fourth quarter, but because of deleveraging, a greater share of total assets became applicable to common shares.
We see that, because TYG itself collects distributions (and not, say, sales of oil and gas), its distributions can rise even when the market value of its assets shrinks; the yields it collects are also increasing. The company functions like an index for collection of dividends.
While the quarterly distribution has since been cut from $0.56 to $0.54, it is heartening that its cash flow value has increased as a result of the market decline—Wall Street prices it according to net assets per share, but its extremely high yield, if indeed it is safe, almost certainly means it is undervalued.
We see the potential danger for TYG most clearly in the DP/DCF ratio. Over the long term, this should be almost, but probably just under, 100%—all cash net of fees, taxes, and operating expenses must be paid to shareholders. 2007 looks just right, but 2008 is almost 106%.
TYG technically lost money in 2008--$7.8M, almost all Q4—due to the asset depreciation, but did not cut the distribution until the new year. This seems okay, as long as it doesn’t become a habit. Let’s compare Q1 2009 to Q4 2008:
TYG (yr end 11/30) | Q4 2008 | Q1 2009 |
Total assets | $692,183 | $719,479 |
Net assets | $407,031 | $433,698 |
DR | $20,104 | $19,137 |
DP | $13,128 | $12,659 |
DCF | $12,665 | $13,444 |
DP/DCF | 103.7% | 94.2% |
Net realized gain (loss) | ($13,412) | ($7,777) |
Leverage | $280,000 | $260,250 |
Leverage costs | $4,968 | $3,962 |
Leverage costs/DR | 24.7% | 20.7% |
Advisory fees | $1,764 | $1,413 |
Advisory fees/DR | 8.77% | 7.38% |
Dollars in thousands.
The first quarter looks good. While distributions, both received and paid, declined slightly, this was to be expected; in our view, management is successful if they can be kept from falling in proportion to the market value of the assets. It’s not surprising that assets increased slightly; so has the overall market.
What is important is the continuing reduction in leverage costs and advisory fees, trends for three and five quarters, respectively. TYG still lost money in the first quarter, but by slightly cutting the distribution, deleveraging and cost-cutting, we see that management is not charting an unsustainable course; DP/DCF affirms this.
Linn Energy, LLC (LINE) is an MLP focused on the acquisition and development of long term (25+ years) oil and natural gas properties, with a large derivatives hedging strategy against commodity price volatility. It directly invests in fields and extraction--87% of total reserves are in the Texas panhandle, Oklahoma, and Kansas, and 13% in the Brea Olinda Field of the Los Angeles Basin. Like TYG, it pays a quarterly distribution of all available cash (and it yields almost twice as much right now), but its revenues are due to oil and gas sales and derivative instruments, in about equal proportions.
The first chart below summarizes its sales activities, and their relationship to distributions—this data is most comparable to TYG’s:
LINE (yr end 12/10) | 2007 | 2008 | Comparison |
Net oil and gas properties | $3,386,061 | $3,552,378 | 4.9% gain |
Sales | $255,927 | $755,644 | 195% gain |
Daily production | 87 MMcfe/d | 212 MMcfe/d | 247% gain |
Sales/assets | 7.56% | 21.1% | |
DP | $154,963 | $289,915 | 87% gain |
DP/Sales | 60.5% | 38.4% | |
Units | 114,080 | 113,816 | |
Unitholder’s capital (UC) | $2,109,089 | $2,374,660 | 12.6% gain |
UC/net properties | 62.3% | 66.9% | |
DP/UC | 7.35% | 12.2% |
Dollars in thousands.
Treating net properties as comparable to TYG’s total assets, UC to net assets, and sales to DR, we see similar performance between the two companies. UC/total properties and DP/UC are basically identical to TYG’s net/total assets and DP/net assets. Only sales/total properties markedly exceeds TYG’s.
This last is easily explained by the rise in productivity; LINE is responsible for the actual development of its holdings. Will overall results differ significantly from TYG’s? An extension of the chart should direct us to answers:
LINE (yr end 12/10) | 2007 | 2008 | |
Net current derivatives* | $19,952 | $321,946 | |
Net noncurrent derivatives* | ($63,813) | $454,355 | |
Derivatives gain (loss) | ($345,537) | $662,782 | |
Income continuing operations | ($356,194) | $825,625 | |
Per share (diluted) | ($5.17) | $7.23 | |
Income discontinued | ($8,155) | $173,959 | |
Net income | ($364,349) | $999,616 | |
Expenses | $205,246 | $437,769 | |
Credit facility | $1,443,000 | $1,403,393 | |
Senior notes | -- | $250,175 | |
Current liabilities | $242,727 | $237,830 |
Dollars in thousands.
*Assets – liabilities.
We see immediately the drastic effect that LINE’s commodity hedging can have on the bottom line; it can both destroy it and double it. But LINE must hedge, because its revenues are exposed to energy price fluctuations in a way that TYG, which invests in pipelines that charge according to volume transported, does not.
Nevertheless, it’s clear that the hedging strategy is not fool proof, and carries considerable risk in itself.
Fortunately 2008’s gains considerably offset 2007’s losses—these disparities are explained by the short-lived oil bubble preceding the recession. LINE can also turn profits by selling real properties, streamlining its portfolio. Neither of these activities are comparable to anything being done by TYG, but that is not necessarily a good thing, and they may be of far greater benefit to management than to investors.
Moreover, expenses are rising, and it is only by issuing $250M new debt—almost equal to DP—that the company stayed in the black in 2008. The lion’s share of LINE’s leverage is also purchased at a variable rate expiring in June; rising rates could seriously undermine its earnings potential. At a 16.50% yield, investors stand to make almost twice as much money on LINE as on TYG’s 8.90%.
The question is which company’s distribution is actually safer? Fluctuations in demand for oil and gas have a much greater effect on LINE, regardless of its hedging, and it would be foolish to expect its productivity to continue advancing as it did between 2007 and 2008, when it brought many of its properties on-line. TYG, however, has had the market value of its assets cut almost in half, and while it continues to extract distributions of nearly the same size from its investments, it is unclear how long this trend will continue. If the sector as a whole begins to cut its distributions, it could be disastrous for TYG’s yield.
We think the cuts are on the decline or would not be in the sector. The bottom line is that you need to figure out what kind of investor you are, the risk you are willing to take. Just try to avoid empty wells!
Disclosure: Long TYG at time of writing.
