I've been a long-term investor in upstream (E&P) MLPs, having bought my first units of Linn Energy (LINE) in 2006 and invested in many of the others after that. Over that time, I've met with the management from each of the companies in the sector several times, so I've followed the recent imbroglio over LINE with great interest.
I will leave the fairly complicated accounting issues to another time. Instead, I want to focus on the more basic "blowdown" valuation of these companies, particularly since some folks are making claims of overvaluation by outrageous 3X and 4X multiples. Most of these folks are failing to back up these claims with real numbers. So let's take a look at the real numbers. We'll throw in a couple of the best bargain conventional E&Ps for comparison purposes.
|Company||Yield||EV/EBITDA||Price/DCF||EV/Std. Measure||EV/Flowing BOE|
|EV Energy (EVEP)||8.9%||8.6||9.8||1.6||82,757|
|Legacy Reserves (LGCY)||9.0%||7.3||8.2||1.3||96,745|
|Linn Energy||12.5%||8.1||6.6||1.9 (1.48)||87,293|
|Pioneer Southwest (PSE)||5.8%||12.3||16.4||2.3||170,982|
|QR Energy (QRE)||12.9%||6.7||6.8||1.1||98,807|
|Vanguard Natural Resources (VNR)||9.5%||6.6||6.9||1.3||59,522|
Note that EVEP's valuation metrics do not credit it for its expansive Utica acreage.
So just taking these numbers at face value, most of the MLPs aren't as wildly overvalued as some have claimed (we'll talk about Pioneer Southwest (PSE) in a moment). When we start to look behind the numbers, the massive overvaluation claims start to look a little silly.
Let's start with the Standardized Measure (PV-10) ratio. This metric gives no credit for the extensive hedges that assure the MLPs' revenue stream even when oil and gas prices drop. LINE actually provides an adjustment that includes the hedges. Using that, LINE's ratio drops from 1.9 to 1.48. That puts it on par with Apache and well below Devon. The other MLPs don't provide these adjustments, but we can guesstimate that they lower the EV/Std Measure ratios substantially, albeit somewhat less than LINE's adjustment does. That suggests that all of the MLPs (except PSE, and possibly EVEP) are cheaper than Devon (DVN) and Apache (APA) on an EV/reserves basis. Some, like QR (QRE), are trading below their likely blowdown values.
The BOE in "EV/Flowing BOE," is a Barrel of Oil Equivalent. That's calculated on a 6:1 BTU equivalency between crude and natural gas. The snag is that the actual price ratio of crude to natural gas is more like 30:1. So a company like Devon, whose production is only about 25% oil looks a whole lot cheaper than it really is. A company like Legacy (LGCY), which produces roughly 70% oil looks comparatively more expensive than it really is.
Underlying all of this is the fact that the nature of the MLP production is vastly different from that of most E&P companies. The MLPs have focused on buying mature (old) producing properties. Old wells sound like a bad thing. But they're actually a really good thing when it comes to generating income, because well production curves often have asymptotic shapes. The production from a shale gas well can decline as much as 80%, just in the first year. Conventional E&P companies have a lot of wells like that. By contrast, mature wells like the 90-year old wells in the Brea Olinda field, decline under 3% a year. That's where MLPs like LINE and Breitburn Energy Partners (BBEP) own acreage. You decide what kind of flowing barrel is better for income: the kind that's declining 80% or the kind that's declining 3%.
But there's more. One barrel of oil or Mcf of gas is not the same as another. Apache and Devon both have substantial production in Canada. Oil and gas sell for nearly 15% less in Canada than in the U.S. And if the sales price is 15% lower, we can expect the margin will lower by at least that much. In a nutshell, the value of a Canadian flowing BOE is a lot less than a U.S. BOE. So again, the MLPs are comparatively better off than the numbers in the table reflect.
We also need to discuss risk. The upstream MLPs' production is entirely based in the continental U.S. on terra firma (with the possible exception of BBEP, which has some oil wells in Florida swamps). By contrast, 27% of APA's production is in Egypt (that's right, the place where another fitna is starting). And then there's the production in Argentina. Does anybody remember what happened to YPF Repsol in Argentina? Oh, and then there's Devon's offshore production. A big drilling accident on land can certainly be expensive. But a big drilling accident off-shore just might just spell the end of your company.
Don't get me wrong: I actually think Devon and Apache are pretty good buys at current levels. But I think the MLPs are better buys, with less geo-political and accident risk. The MLPs have survived a tough commodity cycle, while many E&Ps (e.g. GMX Resources) have gone belly up. Most of the MLPs could survive $50 oil and $2 gas for the next couple of years. That may not be the case for many E&P companies.
The Bottom Line: PSE
With all the fuss about LINE and accounting, many have forgotten that we have a good benchmark on what a savvy buyer is willing to pay for an upstream MLP. PSE is being bought out by its parent, Pioneer Natural Resources (PXD). You would think that if there were any problem with valuation, the parent company would know it. And the parent is paying roughly double what other upstream MLPs are valued at right now.
What's an MLP?
A BBEP executive once told me a great story about an investing genius whose out-of-print book sells for $2000 on Amazon. A few years ago, when BBEP was a bit lower than it is now, the genius visited BBEP management. He reviewed their capitalization, debt, production, and reserves, and determined BBEP was a great bargain. After committing to buying many millions of units, he quietly asked as he was about to leave: "By the way, what's an MLP?"
A year ago, analysts were trying to "one-up" each other, assigning higher and higher price targets to Apple (AAPL). Now pundits are trying to beat each other out in assigning the lowest possible targets to upstream MLPs. As a result, I think a number of these companies may be approaching a genius moment again. The MLP structure and accounting imbroglio are noise that is obscuring some pretty attractive values.