Outrageous Opportunities in Upstream MLPs

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 (KMP) and Oneok Pipelines Partners (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 (EVEP), and Linn Energy (LINE):

click to enlarge image

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 (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

Comments

[Energy]

There are so many problems with this article...I don't even know where to begin...and is sadly becoming the norm for Seeking Alpha.

If Mr. Heycke really thinks anyone in their right mind would buy a E&P company at PV-10 shows an extreme lack of understanding of basic oil & gas analysis, which he further compounds by forgetting the simple fact that non-cash FAS 133 hedge accounting is not including in DCF making it completely irrelevant.

At least the author was correct about the PIPE issue, because that is one of the issues. In addition the markets overriding concern that E&P MLPs not having adequate access to either equity or debt markets to fund development drilling on a go forward basis...but that is not worth mentioning...right?

[steve Ward]

I have never been happy with MLP's. The GP is always capable of selling off assets, reducing the return and takes excessive compensation. The Canadian Trusts in many cases were and still are paying out dividends in excess of EBITDA. I think this explains Penn West's negative total return last year even though it's paying a whopping dividend.

The royalty trust model is better as Kurt Wolfe points out in his McDep website. The investor must still put up with the vagries of cost and commodity pricing.

[cato]

Energy:
If you look at the prices used for the PV-10 calculations of most of these companies, you'll find that they are significantly below the hedge prices. So, if anything, they underestimate the value. Not to mention that 10 is pretty generous discount rate, even in today's environment.

While equity financing is clearly closed to these companies for now, debt is still available, as evidenced by debt-financed acquisitions by CEP and LINE made this year.

[galeth]

Could Energy explain in more detail the problems he has with the valuation measures used by the writer of the article...if not PV-10 then what? Will the negatives of debt financed acquisitions versus equity financed make a big difference in valuation of these companies? Are they able to get debt financing?

[zayt trader]

"which he further compounds by forgetting the simple fact that non-cash FAS 133 hedge accounting is not including in DCF "

Huh? I thought that was precisely the author's point.

[jjason]

Sorry but this article gives a very poor analysis of MLP's. Also, do not get an MLP confused with Canadian Income Trusts.

I am long pwe and with an eleven year reserve life and a 14% yield, I am a satisfied unitholder. Kurt Wolfe has recommended pwe and forbes has an article on pwe that is well written.

Anyone who is interested in MLP's like Bpl, Tclp, oke, oks can go to yahoo.com and do some research on gas pipelines.

[cato]

jjason,

I suggest you read the 10Ks of your Canroy stocks very carefully. You will find that many of these companies are taking on debt to finance their distributions. Not a good thing!

Also check out Morningstar's detailed reports on these stocks.

[misterchan]

All of you sound very intelligent, so maybe you could give me an opinion about a CanRoy, symbol HTE. I am long a sizeable number of shares which produce more than 16% income + I have capital appreciation (except once in awhile, down a very small amount) and concluded when I bought them that HTE was the best one of all, except for PWI with which I did very well.However, it isn't available anymore, having been bought out. I did very well with that one and chose HTE as the best one available. So I would appreciate any opinions from all of you. Will check back. Thanx.

[steve Ward]

Misterchan, I'll take a stab at it in brief since I follow mostly Canadian and Western European oil stocks.

In brief: This is Harvest Energy Trust, the only upstream and downstream CanRoy in existence. HTE b0ught a refinery in Newfoundland a year or so ago. Upstream she produces about 80,000 BOED if memory serves me correct. She has more oil than gas by about 3 to 1. HTE is unable to fully realize the integration of her refinery with her uppstream refinery due to a lack of a pipeline.
HTE' has large amounts of original oil in place (2 billion boe) and uses mostly secondary and tertiary recovery technologies. HTE also has 1 billion in heavy oil.

Her refinery is capacity at 115,000 BOED. It sells to eastern US and Western Europe. The feedstock comes from the world over, but none from Canada.

She made a profit last year and recorded a loss for the 3rd quarter. HTE has reduced the payout over the last 6 months, it is now 89 percent of cash flow.

HTE has a complex financial structure with 7 different convertible debentures, each with their own redemption provisions.

HTE is now dependent on the refinery increasing the crack spread to make any money. Whatever she makes on oil in the upstream she throws out the window when she has to buy oil from Russia, Venezuela and other countries. She can't refine her own crude and that hurts.

HTE will have to pour more money into the refinery just to keep it running at its current condition and capacity and if expansion or environmental changes occur it will be more money.

Somewhere HTE in the future, I feel, must reduce her dividend again, if the crack spreads don't widen.

When I started writing articles for Seeking Alpha I made a decision not to knock a company or analysts if I disagreed with their efforts and views. If I didn't have anything good to say I wouldn'y say anything at all. But you asked. I would not be a holder of the trust. There are better things out there. Don't strtch just for yield. As the refining business goes so goes HTE.

[Georealist]

Cato is full of more crap than a Canadian goose..PWE is an unbelivably solid investment by alomost any standard. THE CRITICAL number is reserve life and replacement..these are the engines that fuel distribution growth in the future..and PWE has it in spades..ALMOST 14 YEARS OF RESERVE LIFE...
The issue concerning share dilution or debt financing depends on the particulars of either...PWE has enormous cash flow in both directions...
As for Energy..his post sounds like the Delphic Oracle..really meaningless gibberish...Linn Energy (LINE) is very likely THE cheapest buy of the year..it's hard to imagine a domestic producer that has locked up more oil/gas flow at a more reasinable multiple..Their distribution is safe and will prove a bonanza in years to come...

[misterchan]

Steve, thanks so much for the illuminating info. I read it twice. And I'm going to save it for awhile. When I read something like what you wrote, I realize that I'm no genius. You wrote some very intelligent stuff and now I am left to consider HTE from a different angle. Of course, I'm not selling it on Mon., but I will be on the alert. The div. is good for the next two months . About the teaser - I am wondering where are the "better things" you mentioned. If you feel like giving a few hints, because that would be saying something "good" about a company, and would keep your principles intact, it would be very helpful, as was your well-written info. Thanks again.

[steve Ward]

Wow. Look at the firestorm I started with a slight comment on PWE's EIBTDA to dividend payout ratio.
I have been hesitant to do an article on PWE for two reasons.
1. I am not hankering to take on Kurt Wolfe who recommends PWE.
2. To make a valid comparison you need to sight CanRoyTrust performance with trusts thaT TRADE MOSTLY ON THE tORONTO eXCHANGE and SA is reluctant to run articles citing "Foreign Stocks".

Yes, PWE is a great story for the future. But if you had bought at 30 plus you are wondering when it gets back to equal for your portfolio. Reserve life is damn important. I just wrote an article for SA on Endeavour and I cited a short current asset reserve life, yet I still advocated its purchase for its future prospects. Clearly, PWE has great reserves and great prospects.. BUT, last year you had a nefgative total return of 7%. You still lost money even with PWE's high dividend.
Clearly, PWE at 23 and change was a steal, now at 28 more fairly priced. PWE needs cashfor future developments that all require secondary and tertiary recovery methods, at least for her oil deposits.
If the dividend constitutes 126% to 129% of EBITDA, which it does, then where does she get the cash? Borrowing, dilution of share base or a miraculous increase in production without investment that borders on the divine. If Pwe slashed their dividend to yield 9 t0 11 % at current unit price of 28 and change; the stock price of the trust units would soar 10 to 15%, netting the investor at 28 a positive total return exceeding the 1/3 loss in the dividend and a 10% yield.


Yes, hold your PWE, defend it with gusto and misterchan, PWE is a better trust for you than Harvest. Why? Murray Edwards, that's why.

Mr. Edwards, co-founder of CNRL, is the largest individual human being shareholder in PWE. Murray got most of his shares lower than 28, so he don't care too much where the unit price goes.He likes that dividend and PWE will keep paying that dividend as long as Murray and company want it that high.

PWE is smart, they bought a bunch of new properties and production in other trusts. PWE got them cheap. The managements threw in the towel too soon in fear of the new law ending oil and gas trusts and they got greedy, they want that high in the sky dividend too. So they sold their shareholders on it as well. Who in their right mind turns down 12 to 15 % PWE is smart, boy are they smart and so is Murray Edwards. PWE will keep that high dividend as long as there are trusts to be bought and they can buy them cheap by the management and the boards of the prospective trusts how much money they can make on that dividend. Heck with the price of the units, look at the dividend and by the way PWE will tell these Can Roy trusts, "We have enogh tax credits to not pay any income taxes for 2 to 3 years, so heck with the new law", " you can still get your sky high dividend for another couple of years". And Mr. Murray won't say a thing until it is time for CNRL to buy Penn West. Got it. Let's just hope Penn West gets a better premium than PWE paid out to the purchased trusts that hjas made PWE so large. Its got nothing to do with accounting or valuations, that high dividend enables PWE to buyout trusts on the cheap and you the shareholder get to pay for it.
Hello all you future CNRL shareholders, did you like the ride?

[steve Ward]

My sincere apologies to Mr. Kurt Wulff for the mis-spelling of his name in my above comments.

[steve Ward]

To misterchan:
Contact SA via their email link. Tell them to forward to me the email address you wish for me to contact you by. I need to know more about your risk tolerance, age etc. before offering any investment advice. DO NOT put any personal ibfo on the website.

[misterchan]

Steve, thanks. I'll consider PWE. We all did quite a lot of posting tonite. Have a great weekend.

[paultaut]

What a bunch of...

Where do you think oil will be in the next 5 years.....there's so much that it will drop to $50...over Opecs dead body....All I hear is a bunch of garbage about yields...nice while you wait but if they were treated as Oil Companies pure and simple, with extensive acreage and reserves in the 10 plus year range...they would be bought hand over fist...

Take Harvest.....what crack spread....its a 110+ brl/day refiner...but not just any refiner...its a state of the art sour/heavy crude refiner and Harvest is expanding its capacity...Try to buy one in todays market...no one will sell it to you.

Unless Canada gets it act together, most of the CanRoys will be bought or MLP'd in the next 5 yrs.

They all have exposure to massive potential oil reserves of some sort or other, Oil/Oil Sands/Nat. Gas... try to find similar exposure elsewhere.

[paultaut]

That's a 110,000 brl/day refiner

[Energy]

Cato - You are wrong on all three counts and keep proving you really don't understand this stuff. Sorry to be pajorative...trully not the intention.

First PV-10 prices are NOT lower than current hedged prices. Where did you get that information? Have you looked at hedging lately? The curve is in backwardation and no dealer will make a market at those prices.

Second, 10% is a generous rate? Are you kidding me ? The typical oil & gas company can not earn a return greater than 12-15% IRR (which I am certain none of you will not believe and that is a good thing for me), so how can 10% be acceptable? I am sure you been one of the poor saps on the other side of my hedge fund's trades and am glad you are out there for my liquidity.

Third, the debt markets aren't open. Those acquistions you cite were done on bank revolvers and can not be termed out in the debt market...pick up a copy of the WSJ one of these days.

For full disclosure - I am currently short only a few of upstream MLPS at this time...been have been mostly short the refiners and long corn, soy, and silver. Cheers and hope this info has helped somebody.

[zayt trader]

Energy,

Who knows their stuff? Well, I'm glad you finally had the honesty to declare your motivation. How are those shorts working out for you lately?

I'll just throw out one example (I'm not going to do your work for you): CEP uses a blended price of $6.70 for their PV-10 calculation. Amazing that you would take up a short position and harangue other people on a website without bothering to do a modicum of research first.