Estimated distributions for the next twelve months ranging from 6.8 to 10.4% are attracting investor interest in six oil-oriented Bottom Line Cash Payers and Top Line Cash Payers. Ultimately the level of income depends on oil price which is proving to be an appealing alternative for investors unhappy to see no interest on savings and actual losses from inflation.
There is also a volume bonus in old oil fields where new drilling with advanced techniques is amply profitable again. McDep Ratios above 1.0 suggest some restraint in making new investments though it does not take much commitment to make a difference in the income of a diversified energy portfolio. McDep Ratios may look higher partly because they are predicated on a long-term oil price of $75 a barrel that looks too low compared to current futures price for delivery over the next six years of $92.
Recent acquisitions may also help boost value for actively managed Freehold Royalty Trust (FRHLF.PK), Legacy Reserves L.P. (LGCY), Encore Energy Partners (ENP) and Linn Energy (LINE). The downside is that oil economics sour quickly below $50 a barrel. For partial protection from possible volatility, the actively managed partnerships generally hedge oil price, while the unmanaged trusts have no debt. Meanwhile, the oil price trend is up compared to the 40-week average and drilling economics are positive.
Add Legacy Reserves L.P. to Research Coverage
Newly added to our coverage, the units of Legacy Reserves L.P. offer competitive value among oil-concentrated peers. Legacy is a master limited partnership (MLP) formed by long-time owners of Permian Basin oil properties in West Texas. Partnership unitholders prize a steady quarterly distribution that implies annual income of 8.7%. LGCY attempts to build value by acquiring new reserves at a price below that of the public units. By its analysis, Legacy paid 6.6 times cash flow estimated late last year for a recent acquisition of Wyoming properties. In contrast, our analysis indicates that investors pay 9 times unhedged cash flow (EV/Ebitda) by current assumptions for Legacy’s equity and debt. Cash flow and reserve life justify estimated Net Present Value (NPV). Oil price and acquisitions contribute to cash flow growth.
Raise NPV for Linn to $21 a Unit from $17
Since former Burlington Resources executive Mark Ellis joined Linn in 2006, the income stock has performed better than our expectations. A recent equity offering at a premium to NPV helps boost NPV as do recent, timely, oil-oriented acquisitions. A slide in Linn’s presentation at the Independent Petroleum Association of America meeting in New York last week illustrates the company’s dominant size in the growing category of oil and gas production MLPs/LLC.
Top Line and Bottom Line Oil Income
Sabine Royalty Trust (SBR), Permian Basin Royalty Trust (PBT) and Freehold Royalty Trust have the less common but desirable characteristic of paying all or some of distributions from cash flow before production expenses. The high quality securities, which we call Top Line Cash Payers, essentially get a free ride on the budding boom in drilling in old oil areas. Highlighted in a Revenue Royalty column, SBR pays 100% from the top line, FRHLF about 71% and PBT about 32%.
Formed in just the past few years, the two MLPs LGCY and ENP, along with the LLC (Limited Liability Company) LINE, are meeting a demand for oil income once met by Canadian Income Trusts before the Canadian government changed the rules effective next year. Because LGCY, ENP and LINE pay distributions from cash flow after operating expenses, we classify them as Bottom Line Cash Payers.
We also like the idea that none of the production stocks in our coverage has incentive distribution rights. Widely used in downstream partnerships, IDRs can give the managing party up to half of cash flow for no capital outlay.
Originally published on April 23, 2010.