Outrageous Opportunities in Upstream MLPs

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 |  Includes: BBEPQ, EVEP, KMP, LINEQ, OKS, SPP
by: MLP Trader

Publicly traded Master Limited Partnerships (MLPs) are great income vehicles which avoid both federal and state corporate income taxes by passing through expenses and income to the investor. Depending on the MLP, quarterly distributions may be either partially, or entirely, tax-deferred. There are some limitations to holding them in tax-deferred accounts, such as IRAs, so consult a tax advisor before you buy.

The MLP structure requires a steady and dependable revenue stream. For this reason, MLPs have traditionally been oil and gas pipeline companies, such as Kinder Morgan Partners (NYSE:KMP) and Oneok Pipelines Partners (NYSE:OKS). However, in recent years, a number of upstream Oil and Gas producing MLPs have come to market. These companies use extensive hedging to assure a steady revenue stream from an otherwise unpredictable commodity market.

Valuation

All MLPs have been pummeled by the credit crunch and hedge-fund deleveraging, but many upstream MLPs have also suffered from the release of previously locked-up Private Investment in Public Equity (PIPE) shares. The PIPE shares enabled the MLPs to quickly complete reserve acquisitions, but resulted in a substantial overhang -- more than half the float in some cases. To make things worse, the hedges these companies used to lock in their revenue, have shown enormous paper losses as oil and gas prices have skyrocketed. This has helped drive down prices, to the point that valuations are now extremely attractive.

The companies publish "Standardized Measure" statistics, which provide the present value of their proven oil and gas reserves after costs. For some of these companies, the Standardized Measure of proven reserves exceeds the market capitalization, even after accounting for debt. Following are figures for Breitburn Energy Partners (BBEP), Enervest Energy Partners (NASDAQ:EVEP), and Linn Energy (LINE):

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What is the Market Missing?

Many of the MLPs trade below the present value of their proven reserves. All their other assets, including probable reserves, are just icing on the cake. If you bought a popular Canadian Royalty stock such as Pengrowth (NYSE:PGH), you would pay almost twice as much for each barrel of proved reserves. Moreover these proved reserves figures are extremely conservative and don't include many spectacular possibilities, such as the Linn Energy's considerable Marcellus shale play acreage.

The paper losses from derivative hedging has made the income statements of upstream MLPs look abominable. But the paper losses are just that: paper that doesn't affect the distributable cash flow. The hedges are doing their job securing future income for years out; any losses will be offset as these companies realize big gains from selling production on the spot market. Without the hedges, these companies could not operate as MLPs. While the hedges limit some of the upside from rapidly increasing oil and gas prices, many of these companies also have some unhedged production. Linn Energy and some others have conducted part of their hedging with Puts, which also allows for upside.

Upstream MLPs are a widely misunderstood sector that has been brutally beaten down. Some of these stocks are down over 50% from their peaks. Between their high distribution yields and their valuable reserve assets, they represent outrageous opportunites for investors who take the time to understand their structure and hedging strategies.

Disclosure: Author holds positions in the stocks mentioned