An Upstream MLP Forward-Looking Model

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Includes: BBEPQ, EROC, LNCOQ, LNGG, NSLPQ, QRE, VNR
by: nstollon

Summary

A forward-looking model compares hedging of 6 different Upstream MLPs over the next several years.

A projection of some (worst-case) scenarios for hedged oil and gas revenues.

Upstream MLP distributions reasonably well protected for next 2 years; further out has more risk if energy prices stay low.

Upstream MLP prices have taken a significant hit with every drop in oil prices over the last month. The level of upstream MLP response to oil prices has been surprising, since MLPs are supposed to be buffered from price drops more than other energy producers due to hedging. Hedging has been implicit in the MLP distribution coverage business model as a means for ensuring MLP revenue despite fluctuations in oil pricing. However, even extensive hedging will not protect an MLP from extended periods of lower energy prices and their resulting impact on distributions. This article looks at hedges in place for different upstream MLPs and how well they support a distribution model over the next three years. Three years is typically the limit that MLPs provide information on hedges. In particular, the article looks at 6 MLPs: Breitburn Energy Partners (BBEP), QRE (NYSE:QRE), Linn (LINE) (LNCO), Vanguard Nature Resource (NYSE:VNR), New Source Energy Partners (NSLP), and Eagle Rock (NASDAQ:EROC), of which I own shares.

Upstream MLPs have different profiles, based on their relative focus on oil and gas production; some being more gassy, some more oily. However, all MLPs have some mix of oil and gas production. Upstream MLP profiles also vary on their hedging strategies. MLPs vary significantly on not only the levels of hedging, but also the drop-off level of hedging over time of their hedges, which has a large impact in the case of sustained lower energy pricing. As an example, LINE has stated that they have hedged virtually 100% their natural gas [NG] production out to 2017, while maintaining a much lower level of hedging on their oil production in the same timeframes. The following chart shows the hedging and pricing models for Upstream MLPs. Information is based on presentations published by the MLP in 3Q14. Each MLP has 6 rows of data, modeling oil and gas hedging for years 2015-2017.

  1. The first row (Product Mix) shows MLP 2014 percentages of oil and gas production. Note in most cases, this does not add up to 100%, typically due to gas [NGL] liquid products. NGL hedging data is usually not provided by MLPs. For simplicity, product mix is assumed to stay constant for all years.
  2. Row 2 is the percent of oil or hedged for years 2015-2017, as of 3Q14.
  3. Row 3 is the hedged oil or gas price for the year. This is obviously an aggregate number, since a company will have many hedges active for a given year.
  4. Row 4 calculates an overall (oil and NG) percent of hedged product for different years, weighted by the product mix.
  5. Row 5 gives a nominal worst price for sum of hedged (oil and NG) product with remaining product at spot prices at $70/brl oil and $3.00/mcf gas
  6. Row 6 gives a 1-x distribution crossover for sum of hedged (oil and NG) product with remaining product at spot prices at $75/brl oil and $3.50/mcf gas

BBEP and QRE MLPs are modeled as a combined BBEP/QRE MLP, assuming completion of the QRE/BBEP merger in early 2015. The BBEP/QRE model is based on individual BBEP and QRE information, with the hedge and price projections weighted by a 67% BBEP/23% QRE factor (based on their relative revenues).

As in all models, there are certain assumptions made. I was interested in the impact of sustained low oil and gas pricing over the next three years. I assumed worst case prices will not go below $70/ brl for oil or $3.00/mcf for NG for any appreciable time, which is a worst case break-even point for idling wells. If well were idled, revenue and distribution assumptions are broken. The $75/ brl for oil/ $3.50/mcf for NG case is one likely to be crossed over the next year. $75/ brl /$3.50/mcf is also a 1x distribution coverage crossover point in a VNR estimated distribution coverage chart (per their press release dated 10/15/2014). Lacking equivalent distribution coverage estimates from other MLPs, I am using this as a general guideline, while understanding that it is company specific and therefore not the best reference.

The analysis was done to help better understand my personal Upstream MLP portfolio and it did provide some useful insights.

a. Based on the $75/ brl /$3.50/mcf guideline, all the MLPs have sufficient levels of hedging to maintain their current distributions through 2015. The differences between MLPs start to show up in looking at hedge support for 2016 and 2017.

b. Generally, LINE stands out in terms of having most secure distributions, largely having virtually 100% of their NG revenues hedged through 2017 and by consistently being able to hedge at the highest prices. A somewhat distant second in terms of hedging was the merged BBEP/QRE MLP.

c. Upstream MLPs have generally higher levels of hedging for NG than oil, which is not surprising given their main customers are assumed to be utilities, who may be looking to lock in supplies before NG exporting become a factor.

d. NSLP has an overall higher hedging rate in 2016 than in 2015, by virtue of the highest level of oil hedges in 2016 of all companies reviewed, but did not disclose any hedging information for 2017. Whether this is a strategy or an oversight is not clear. Likewise, EROC, while having rather high NG hedging in 2015 and 2016, did not disclose any gas hedging in 2017.

An x-factor in MLP analysis appears to be modeling of NGL. NGL typically account for 8% to 15% of the product mix, although for EROC, it may be up to 25%. LINE and NSLP did not discuss NGL in their product mix, probably for simplification, but adding to inconsistency. MLPs do not appear to discuss NGL as part of their hedging strategies.

Of course, hedging is only one facet of Upstream MLP operations, equally as important to consider in MLPs are differences in product mix, costs of extraction, longevity and quality of properties, and of course the expertise of management, all of which will impact profitability. Hedging provides control over the one key element of the MLP business that is beyond management control; the prevailing price of energy, and provides an element of stability in a rapidly changing environment.

This article has focused more on the worst-case energy price risks for Upstream MLPs. My analysis is that distributions and the underlying MLP business model is secure for 2015 and barring sustained worse case oil and gas pricing, for 2016. Going further out in time, as existing hedges wrap up and are replaced with new lower priced hedges, there is more concern about maintaining distribution coverage. While there is a case to be made for oil pricing to increase as rapidly as it has declined in the last quarter, history does suggest that once a significant price decline occurs, it takes several years for energy prices to return to previous highs. In that case, the larger risk for upstream MLPs may be in the 2017-2020 time frames, where either a lack of hedging leaves an MLP more vulnerable to market prices or maintaining a historical level of hedging may constrain distributions, even in an increasing energy price environment.

The MLP world is by its nature dynamic; the level of deal-making in all the MLPs over the last year testifies to their ongoing business volatility and changing property profiles. Upcoming changes in terms of US oil and gas exports, changing utility power plant profiles, changing interest rates, increased midstream infrastructure, and advancing processes in extraction will probably accelerate demand and impact pricing in the upstream MLP space.

As always, caveat emptor. I make no recommendations. I am sharing analysis done for my own personal use. All the above is based on my interpretations of information that I reviewed from public sources. I may have gotten it wrong, errors may have crept in. In talking about the future, you are almost always likely to get best parts wrong. That is part of what makes it interesting place to get to.

Disclosure: The author is long LINE, VNR, BBEP, QRE, NSLP, EROC.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.