Out of the 100-plus energy master limited partnership companies, the highest distributions yields as a group are paid by the upstream focused companies. This group can also be found as a part of the larger exploration and production - E&P - portion of the energy sector in the stock market. The way a partnership functions and the realities of E&P energy production put these high-yield investments into an "acquire or die" situation that require an understanding of both the potential and risks for investors.
Note: Master limited partnerships are not corporations, so investors in an MLP own units and not shares. Income payments made to investors are distributions and not corporate dividends. However, to keep things moving along and not become repetitive, the words shares and dividends may be used in this article with an understanding that the use is not technically correct.
The Limited Partnership E&P Business Model
Exploration and production energy companies set up as corporations tend to focus much of their operations on the drilling of wells in new locations in an attempt to find new sources of crude oil and natural gas. The revenues and profits of these companies depend on their drilling success and the market prices of the oil and gas they bring out of the ground. E&P limited partnerships, on the other hand, focus more on the "P"roduction side of the equation. These companies buy producing assets, use hedging tools to lock in the prices of the projected oil and/or gas production, and spend a limited amount on drilling new wells to enhance the production of the acquired production assets.
As a generality, corporate type E&P companies use capital spending to find new sources of oil and gas. The partnership E&P companies use most of their capital spending to acquire producing assets. There can be a symbiotic relationship between the corporate drillers who need capital to continue their operations and the partnerships who need producing wells that can be turned into cash flow to pay dividends to investors.
For regular readers here on Seeking Alpha, the most popular E&P partnerships are Linn Energy LLC (LINE), Vanguard Natural Resources LLC (VNR), BreitBurn Energy Partners LP (BBEP), and Legacy Reserves LP (LGCY). The current distribution yields for these MLPs range from 8.2% up to almost 10%.
Replacing Depleting Assets
Since the upstream MLP companies buy existing production assets and are not focused on finding new sources of oil and/or gas, these companies face the challenge of the natural output reduction over time from producing oil and gas wells. To counter the falling production, an upstream company must either drill more wells or buy more producing assets. As a result, the upstream MLP companies have historically made acquisitions of production assets to keep the level of distributable cash flow high enough to maintain the current distribution level and, hopefully, increase distributions over time.
For an MLP, an acquisition will typically be funded with a combination of new debt and the sale of additional shares into the market. To illustrate, Vanguard Natural Resources - with a market cap of $2.36 billion - announced 13 acquisitions valued at $2.1 billion over the last three years. During that period, the company's debt grew from $410 million at the end of 2010 to $957 million as of Q3 of 2013. The number of LP units outstanding grew from 22 million to 78 million over the same time period.
Business Model Has Been Good for Investors
With all of the debt, share dilution, and spending to buy production assets the major E&P MLPs have been successful at their goal of increasing the payout to investors. Vanguard Natural Resources increased the annual distribution rate from $2.20 to $2.49 - a 13% increase - over the three year period. For the other upstream MLPs listed above, the LINE dividend has been increased by 10%, BBEP distributions have increased by 25.5% and the LGCY payout has grown by 11.5%. Along with the distribution growth, the current yields on these MLPs are:
- BBEP: 9.71%
- LINE: 8.84%
- LGCY: 8.76%
- VNR: 8.22%
Dangers Lurk for Continued Performance
These high-yield MLPs are dependent on several factors to be able to continue to meet the goal of providing a growing stream of distributions to investors. Here is a list of things that must go right for the business model to continue to work.
- Production assets must continue to be available for purchase at prices that allow the cash flow from acquisitions to be accretive to unit-holders after the share issuance dilution and increased borrowing costs.
- Share prices must remain high enough and attractive enough for these companies to be able to go into the stock market with significant amounts of equity offerings.
- Borrowing costs - interest rates - must be at a level to keep interest expense at an acceptable level compared to the cash flow produced by acquisitions.
These factors may affect results in spite of effective management practices to select acquisitions and control production expenses. For example, the widely reported troubles experienced by Linn Energy during 2013 forced the company to increase the share exchange ratio to fund the Berry Petroleum acquisition by 34%, diluting any accretion in cash flow that will result from the merger.
Keep An Eye Out for Danger Signals
A meaningful reduction in distributable cash flow could lead one of these companies into a death spiral of lower yield produces lower unit values which would make it more difficult to maintain, let alone grow through acquisitions - which are necessary to support the distributions. More than a single quarter of cash flow problems for one of these companies would be reason to dump shares and avoid further losses.
On the positive side, these companies have thrived through an extended period of low natural gas prices. If the frigid winter of 2013-2014 leads to higher gas values in general, it would be a long-term positive for the E&P MLPs.