Dorchester Minerals: Under-Appreciated Energy and Income MLP

| About: Dorchester Minerals, (DMLP)

Dorchester Minerals Limited Partnership (DMLP - $26.65) is an under-appreciated mainly natural gas MLP firm that thinks it’s a royalty company. Revenues are generated from royalties or net profit interests (NPI) from producing oil and gas wells on its land holdings of 300,000 gross acres in 25 states. Some mineral rights date back over a 100 years. Often discarded during income investor’s research due to its size and variable distributions, DMLP is worthy of inclusion in either an energy portfolio or an income portfolio.

Dorchester Minerals offers exposure to the potential of a multi-year rising natural gas market, with a substantial portion of increased operating cash flow being returned to investors through higher cash distributions. Dorchester Minerals is not followed by Wall Street and institutions own only 14% of outstanding shares. DMLP flies under most investor’s radar. By the looks of their website, its how management likes it.

There are several aspects that set DMLP apart from other “royalty” firms. Dorchester Minerals is forbidden by its bylaws from committing to any long-term debt, and as an MLP, DMLP generates its NPI after the driller recoups the producing well’s capital expenditures. DMLP has no exposure to exploration, development, or production costs and risks, and should not run afoul of MLP non-related business income thresholds.

The cash distribution is set each quarter based on operating cash flow of NPI and royalty income. Management typically pays out around 87% of operating cash flow. However, with the volatility of natural gas pricing, distributions will fluctuate quarter to quarter.

For some income investors, this payout variance may be unattractive on the surface. Nevertheless, DMLP offers an adequate 7.0% current yield with the opportunity to increase the distribution over time. Due to its mostly unhedged exposure to the price of natural gas, during low prices, such as current market conditions, payouts decline. However, the opposite is true in rising price environments.

The anticipated 2010 annual payout is $1.77, down from $2.83 in 2008 and up from $1.28 last year.

Some of Dorchester Minerals “headline play” land holdings can be grouped as:

  • Fayetteville Shale: 23,300/11,600 gross/net acres, 252 wells permitted and 235 completed;
  • Barnett Shale: 1,800 net acres, 30 wells completed;
  • Horizontal Bakken, Williston Basin: 70,400/7,600 acres gross/net, 109 wells permitted, 79 wells completed;
  • Appalachian Basin 31,000/22,000 acres gross/net, under restriction by NY State, no reported wells completed.

Even in the poor natural gas environment over the past 12 months, management has generated a 23% return on equity and, since it has no debt, a 23% return on capital. Five-year average return on capital is 28.7%. EBITDA over the trailing 12 months, ending Sept 2010, was $52.7 million, or about $1.75 per share.

For the first 9 months, oil production increase by 8.4% and natural gas production increased by 17.0% y-o-y. Most of the added production volume is credited from the two acquisitions made earlier this year, the Barnett Shale addition and the Maecenas Minerals acquisition. Through the 3rd qtr, DMLP has added or permitted 98 new royalty wells and elected to participate in 22 new NPI wells.

Operating revenues for the first three quarters increased 58% to $46 million and net cash from operations increased 53% to $43 million, y-o-y. Higher production and a 30% improvement in market prices were the catalysts for better performance.

Management makes an occasional acquisition using cash on hand or issuing additional shares. For example, the two acquisitions made this year increased share count by 6% to 30.4 million and added significant production volume growth along with higher proven reserves.

Distribution and share price growth will be fueled by a combination of market price and production increases, with the majority of gains coming from market price improvements. Through Sept, DMLP’s realized market price for natural gas was a weighted average of $4.44 for royalty income and NPI combined. This was up 30% from the $3.41 realized last year.

In order to maintain a higher distribution, 2010 total payout to operating cash flow ratio could be above average at 94%. At a $4.67 natural gas market price, 5% higher production, and an 87% payout ratio, distributions could be slightly higher at $1.87. At a $5.10 natural gas market price and 5% higher production, distributions could be $2.04. At a $5.55 natural gas market price and 5% higher production, distributions could be $2.20. At a $5.85 natural gas market price and 5% higher production, distributions could be $2.31.At a $6.00 natural gas market price and 5% higher production, distributions could be $2.37.

At $6.00 natural gas pricing and $2.37 in distributions, a 7% yield would equate to a stock price of $34. Investors buying in a today stock price could realize an 8.8% cash yield on invested capital and a 28% capital gain. Investor returns, both cash income and capital gain, should continue to improve as commodity pricing climbs above $6.00.

The downside to DMLP comes from three directions. Current share price should not be considered undervalued and overall market weakness will probably depress DMLP stock prices. Some natural gas price deck projections call for average pricing of $4.60 to $4.75 in 2011, $5.00 to $5.15 in 2012, and $5.50 to $5.75 in 2013. These projections would produce lower distribution and capital gains growth, but is offset by an above average current yield. There is also the risk commodity pricing will deteriorate substantially, reducing investor distributions.

If you are bullish on natural gas rebounding to 2006 and early 2007 levels of commodity pricing and demand, DMLP should be on your research list. Year-end financials should be available around Feb 25, 2011.

As always, investors should conduct their own due diligence, should develop their own understanding of these potential opportunities, and should determine how it may fit their current financial situation.

Disclosure: I am long DMLP and have been a shareholder since 2007.