In an April article ("Upstream MLPs and Canadian Royalty Trusts: High Return, High Risk?"), I wrote:
Lehman Brothers owns substantial stakes in nearly every upstream MLP -- more than 10% in several cases. If circumstances force Lehman to dump those units, it might present great buying opportunities for holders with new money and a long term perspective, but really stressful times for current unitholders.
This was sadly prescient. Lehman and hedge funds liquidated these stocks with wild abandon. This has been compounded by the mis-perception that when commodity prices soared, the mark-to-market, paper losses on these companies’ hedges were real losses. A recent AP headline read "EV Energy Partners swings to 2nd-qtr loss on bad hedges.
In fact, it wasn't a real loss at all; the decline in the hedge value was more than offset by the increased value of production and reserves in the ground. It's just that the hedges get marked down, but the reserves don't get marked up. The hedges weren't "bad" -- they were doing what they were supposed to do: exchanging some upside in order to ensure a future income stream.
Of course, with the massive decline in oil and gas prices, we will now see massive gains in mark-to-market hedge values for Q3. For example, Linn Energy's (LINE) gain will probably approach $1 Billion.
The upstream MLP sector now features extremely compelling valuations. Even using a $6.75-natural gas, $80-oil price deck, the group is trading at an approximate 30% discount to the net value of their proved reserves (accounting for hedges and projected production costs). The average yield for the group is an unreal 21%. Distributable Cash Flow (DCF) is a key metric for evaluating Master Limited Partnerships.
Following are last quarter's annualized DCF expressed as a percentage of share price:
- Atlas Energy Resources (ATN)........19.1%
- Breitburn Energy Partners (BBEP)....26.1%
- EV Energy Partners LP (NASDAQ:EVEP)........34.2%
- Legacy Reserves Lp (NASDAQ:LGCY)...........27.0%
- Linn Energy, LLC (LINE).............32.3%
- Pioneer Southwest Energy (PSE)......23.5%
- Vanguard Natural Resources (NASDAQ:VNR)....29.6%
In other words, if EVEP chose to distribute all of its free cash flow after maintenance CapEx, it would return over a third of its share price on an annualized basis! As things stand, it's paying a 21% distribution, with the rest retained as a cushion. Most of the upstream MLPs have hedged 70%-100% of their production for 4 or 5 years, which will help insulate their NAVs and EBITDA from further oil and gas price declines.
My top picks in this group are BBEP and EVEP. These companies are run by the most capable, seasoned managers in the group. The COOs from both companies have many decades of experience, including heading up U.S. E&P for Anadarko and Occidental, respectively. EVEP and BBEP insiders have bought more of their companies' stock than any others in the sector. The co-CEO of BBEP alone spent $1.5 million of his own money buying shares in the last 6 months. EVEP's CEO culminated a long buying spree with a $300,000 purchase just yesterday. Other execs at these companies are backing up the truck too.
The best scenario for companies in this sector is to hedge high and produce/sell in a low-price environment. That way their revenue is high and their production taxes and expenses are low. That’s where these companies are today. EVEP, for example, has some oil collars with floors of $110. As CHK and others cut back on drilling programs, we're likely to see a retreat in oilfield expenses. Neither EVEP nor BBEP has retracted intentions to raise distributions in upcoming quarters -- an indication of their continuing succesful execution.
I outlined risks in my earlier article. Now that these companies' hedges are mostly in-the-money, there is also a counterparty risk. For BBEP, EVEP, and LINE at least, I think that risk is acceptable. The hedging counterparties are the lenders on their credit facilities. Wells Fargo (NYSE:WFC) is a key lender for EVEP and BBEP. In general, the lender lists comprise names like BNP Paribas (BNP), Barclays (NYSE:BCS), and Deutsche Bank (NYSE:DB). The prudent investor will check each company's list before buying. MLPs do have special tax considerations, which you should research with an accountant before you buy.
Disclosure: Author holds positions in the above-mentioned securities.