Can These High-Yield Energy Stocks Grow Their Distributions?

Oil and gas MLPs are a great way for income investors to profit from America's historic energy boom. This article highlights three high-yielding upstream energy companies that have struggled to grow distributions lately in an effort to answer the question of whether investors should continue owning them.

Jul 22, 2014 at 9:41AM

America's energy boom is reaching epic proportions. Consider the following:

  • The US just became the world's no. 1 oil producer, with record-breaking oil production of 11 million barrels/day (bpd).
  • North Dakota recently achieved 1 million bpd after growing its oil production 31% annually over the last seven years.
  • The Permian Basin is estimated to hold 75 billion barrels of recoverable oil (an estimate that is up 50% in the last year), making it the single largest oil deposit on earth.
Investors have been gravitating toward upstream oil and gas MLPs to profit from this historic megatrend, and for good reason. Numerous studies show that high-yielding companies that grow their dividends/distributions over time and have low volatility make the best long-term investments. 
With an average yield of 9.63%, a projected industry distribution growth rate of 9.4%, and volatility that is 26% less than the S&P 500, upstream MLPs look to be a promising industry for long-term income investors. 
 
What happens when a vital component of that magic formula is potentially lost, though? This article looks at three upstream energy companies, QR Energy (NYSE: QRE), Linn Energy (NASDAQ:LINE), and its non-partnership alternative Linn Co (NASDAQ:LNCO), that have recently faced difficulty growing their distributions. My goal is to help long-term income investors determine whether or not these investments still deserve a place in your portfolio.
 
Troubled yield?
MLP Yield 10 year Projected Annual Distribution Growth Rate 12 Month Coverage Ratio Price/Standardized Measure Beta 10 Year Projected Annual Total Return
QR Energy 10.7% 2.01% 1.03 .61 0.65 12.71
Linn Energy 9.30% 1.27% 1.02 .88 0.66 10.57
Industry Average 9.63% 9.40% 1.05   0.74 19.03%
S&P 500 1.90%       1 9.20%

Sources: S&P Capital IQ, MLPdata.com, Yahoo Finance, Moneychimp.com, SEC 10K filings

This table highlights the fact that though QR Energy and Linn Energy have high, safe yields, Wall Street analysts are expecting their distribution growth rates to remain very low through 2023. This results in QR Energy and Linn Energy trading at substantial discounts, indicated by the price/standardized measure ratio being under one. Since standardized measure is the estimated present value of future cash flows from oil and gas reserves, the market is either warning about trouble at QR Energy and Linn Energy, or offering a long-term buying opportunity. 
 
What's wrong with QR Energy?
QR Energy went public in December 2010 and has always been undervalued by the market -- for good reason. Under its previous general partner (gp) fee structure, management was paid in QR Energy units, resulting in dilution of up to 10% per quarter. This threatened the security of the distribution and made future growth difficult. QR Energy bought out its gp, which will result in a final 20% dilution that is spread out over four years, but that was immediately 7% accretive to distributable cash flow (DCF)/unit. This represented a potential catalyst for distribution growth, but QR Energy recently made a bold move that upset Wall Street and destroyed the goodwill of its gp buyout.
 
Since its IPO, QR Energy has made $1.4 billion in immediately accretive acquisitions. These were already producing assets that could be used to drive DCF growth. Upstream MLPs favor this approach over investing in new wells because investing in existing assets introduces greater risk and slows short-term distribution growth. 
 
QR Energy recently announced that instead of making more accretive acquisitions, it would raise its capital expenditure budget by 82% and invest in increasing production from what it considers low-risk assets. Distribution growth is unlikely to rise before the first expansion projects come online in 2016. This is a long-term strategy that is out of favor with short-term Wall Street thinking, and it leaves QR Energy massively undervalued and an incredible, though riskier, long-term income investment opportunity.
 
What's wrong with Linn Energy?
Linn Energy ran into trouble when its Berry Petroleum acquisition ended up costing $600 million more than expected. In addition, Linn Energy was left with 55,000 acres of Permian land afterwards with high drilling costs and high decline rates.
 
To an MLP that must pay out almost all of its earnings as distributions, the combination of high depletion and high drilling costs threatened the security of its distribution and reduced future distribution growth estimates to near zero. As a result, Linn Energy is trading at a discount to its standardized measure. Note that the discount is now far higher after two major deals, but Linn Energy releases standardized measure data once a year. 
 
To solve its growth problems, Linn Energy recently executed deals with ExxonMobil and Devon Energy. The Exxon deal was a swap of 25,000 acres of oil-rich but high depleting Permian land for 500,000 acres of gas-rich, low decline, and already producing Hugoton, KS acreage. The deal was immediately accretive to DCF by $30 million to $40 million per year and secured Linn Energy's distribution.
 
From Devon, Linn Energy bought 900,000 net acres that are producing 275 million cubic feet/day of gas with a decline rate of 14% for $2.3 billion. To pay for the deal, Linn Energy is selling Granite Wash acres with 40% decline rates. The two deals together will save Linn Energy $400 million in annual capital expenditures and will hopefully help to restore its historical 3%-4% distribution growth.

Foolish takeaway
QR Energy and Linn Energy represent safe, high-quality yields that are massively undervalued due to lack of market confidence in their distribution growth prospects. Linn Energy's recent deals give me confidence that it will be able to restore its distribution growth to historical levels. QR Energy is a riskier investment,  but its high, safe yield and deep discount offers immense long-term profit opportunity. 

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Adam Galas has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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