Seeking Alpha
Dividend investing, dividend growth investing, master limited partnerships, oil & gas
Profile| Send Message| ()  

Lately it seems as if nearly every upstream MLP has shifted over to monthly distributions. The early pioneer here was Vanguard Natural Resources (VNR), which started paying monthly distributions in September 2012. Then in April 2013, Linn Energy (LINE) announced that it would start paying monthly distributions, though they only started paying them in June due to complications related to its merger with Berry Petroleum (BRY). A few months later on November 6, BreitBurn Energy Partners (BBEP) announced a conversion over to monthly distributions. Finally, on December 3, QR Energy (QRE) announced a shift towards a monthly distribution policy.

Income investors prefer monthly payments

Clearly something is up. Why would so many companies in the same industry shift towards monthly distribution payments if the vast majority of other companies, be them MLPs or not, pay quarterly? The answer to this question is quite simple: They know who their shareholders are.

Frankly, the vast majority of investors in these stocks are there for the income provided. Yes, other MLPs in the energy sector, such as the midstreams, offer income, but the upstream MLPs yields are unmatched.

Below are the forward yields for the upstream MLPs mentioned in the intro:

(click to enlarge)

As can be seen, these stocks offer well above average yields. In fact, even other MLPs offer only about half the yield these names have. Of the stocks that do have similar yields, such as some BDCs and mREITs, most are found in the financial sector and carry arguably much greater risk due to higher leverage.

Another factor in play here is that monthly income is more highly valued by investors than quarterly income as it allows for faster compounding and reinvestment. A high initial yield also multiples this compounding effect. Indeed, the yield offered by upstream MLPs is likely the primary method investors will see returns as essentially all excess cash flow is paid out.

Monthly payments allow for smaller, fractional dividend increases

While this may seem obvious, the upstream MLPs typically aim to pay out nearly 100% of their distributable cash flow, or DCF. As these companies see increases in DCF, many times a result of acquisitions or internal production growth, it often leads to increases for their distributions. A benefit of having monthly payouts is that it allows companies to push out these distribution increases at a faster pace compared to quarterly payments.

Monthly distributions add stability due to smaller ex-dividend declines

The last and arguably most important reason the upstream MLPs may be shifting to monthly payouts is that it will likely reduce sector wide volatility. As investors in the sector are aware of, the stock prices for these companies have been ravaged multiple times this year. This volatility has sometimes been caused by short sellers. By having monthly payouts, it will likely increase the cost of being short these stocks as the short seller would have to pay the distribution on the borrowed units.

However, another less obvious benefit would be lower ex-dividend related declines. These stocks often runup right before the ex-dividend date and then sell off shortly after. A common tactic for traders is to short high yield stocks right after the ex-dividend date. This tactic works due to the stock price declining much more sharply than the dividend amount.

Below are a few examples of the ex-dividend decline greatly effecting several upstream MLPs. Do note that I used Vanguard Natural Resources as the comparison due to it paying monthly dividends for all of 2013 as well as for its relatively stable share price.

(click to enlarge)(click to enlarge)

As can be seen, both of these stocks saw massive increases right before and massive declines shortly after their ex-dividend dates. From the peak to the through, the declines ranged from 5% to 15%, with the average being closer to 10%. By comparison, Vanguard Natural Resources' stock price was extremely stable during this timeframe exhibiting few of the large price swings. The only real difference between these stocks is that Vanguard Natural Resources pays monthly distributions while the others pay quarterly.

Best pick among the upstream MLPs: Vanguard Natural Resources

While this may sound somewhat controversial, there are clearly some laggards in the sector. First of all, I would avoid Linn Energy until its merger with Berry is finally resolved. The company was forced to raise its exchange ratio to 1.68 shares of Linn Co (LNCO) for each share of Berry share, up from 1.25 shares, essentially paying $600M more. While the merger now seems more likely than not to go through, the stock may get crushed if shareholders vote to nix the transaction.

Of the other stocks, I think the case can be made that Vanguard Natural Resources offers the most attractive risk/reward ratio. Among its peers, the company has the longest track record in paying monthly distributions. Vanguard Natural Resources' payout ratio has also remained healthy all year, averaging about 1.05X YTD. In addition, the company has raised lots of capital recently and is ready to deal. Any such transaction will likely be accretive and boost its DCF per unit.

This is not to say that I am bearish on QR Energy or BreitBurn Energy Partners. However, each of these other names each have issues which make them a tad more risky.

For QR Energy, the issue would be its IDR payments to its GP. The investor reaction to the last IDR payment was very negative. Every December, the general partner can take up to 80% of this payment and convert it into new subordinate units. A good explanation on this issue from MLP Protocol's Philip Trinder can be found here.

For BreitBurn Energy Partners, a compelling bullish case can be made. However, the company recently completed a very large acquisition of upstream assets from Whiting Petroleum on July 15 for $846M. The transaction basically made the company 50% larger. BreitBurn Energy Partners only started operating the properties on November 1. BreitBurn Energy Partners has since been issuing equity to lower its debt and leverage from the transaction. I would wait until the company has fully "digested" these assets. I would like to see where its coverage ratio settles with the increase in units as well as see how the company manages the production.

Conclusion

It is my opinion that these upstream MLPs are making the right choice in shifting over to monthly distributions. By doing so, they should make life much easier for their income oriented shareholders. As anyone with bills can tell you, they are due every month, not quarterly. In addition, this move is likely to greatly reduce the quarter to quarter price volatility related to the ex-dividend date and make it more expensive to be short the stock.

Disclaimer: The opinions in this article are for informational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned. Please do your own due diligence before making any investment decision.

Source: Why Are Upstream MLPs Moving Towards Monthly Dividends?