Virtually anybody who reads the financial news or drives a car knows that the price of gasoline has surged lately. This has undoubtedly had an impact on the wallets of many American consumers including, quite possibly, many of you reading this.
Fortunately, there are things that we can do to mitigate the impact that rising gasoline prices have on us as end consumers. One way to do this is to invest in stocks that are likely to rise with the price of gasoline. For example, large oil companies such as ExxonMobil (NYSE:XOM), usually have stock prices that are at least somewhat correlated with oil (and gasoline) prices.
Another way to protect yourself against rising gasoline prices is to buy units of an upstream MLP. These investments have the advantage of paying relatively high distribution yields that can be used to help cover your costs of purchasing gasoline. One such MLP is LINN Energy (NASDAQ:LINE).
About LINN Energy
LINN Energy is a member of a relatively small group of publicly traded oil and gas partnership. The company purchases known productive, and usually mature, oil and gas properties with the intention of extracting the oil and gas from the ground, selling it, and sending as much of the profit as it can to its unitholders.
It usually targets properties with a low and known depletion rate so that management has a fairly reasonable idea of how much cash flow the property containing the well will generate in advance. It has been fairly successful at this and has paid a quarterly distribution to its unitholders for 27 consecutive quarters up until the end of 2012. Beginning in 2013, LINN Energy began to use a different payout schedule and currently pays its distributions monthly .
Declining Unit Price
Linn Energy's unit price has fallen precipitously since mid-February despite the strength in oil prices over the same period. This could present an opportunity for Foolish (not foolish with a small "f") investors to jump in. First, let's have a look at the magnitude of the decline. Here is the chart for LINN Energy over the past six months:
The reason for this rapid fall over the past month is that it suffered from a wave of downgrades as Jim Cramer , Howard Weil , and JP Morgan downgraded the stock. The reason for the downgrades is pretty much the same among all three parties. Basically, they are concerned that LINN Energy will not generate enough distributable cash flow to cover its per unit distribution this year .
Admittedly, these are certainly valid reasons to be concerned. After all, if LINN Energy does fail to generate enough distributable cash flow to cover its planned distributions then the company will either have to cut its distribution, take on debt, or dilute the existing unitholders by selling more partnership units in order to raise the money to make its planned distributions to the unitholders.
Reasons for Possible Difficulty
The reason for the concern surrounding LINN Energy's ability to make its distribution payments is due to the company's operations in the Permian Basin. These assets, which LINN Energy acquired last year , are somewhat outside of the company's core strategy because they require horizontal drilling techniques to access the oil located in them instead of the more conventional vertical drilling techniques that LINN Energy is normally able to use on its properties.
Unfortunately, horizontal drilling is much more expensive than vertical drilling. To address this, LINN Energy is looking to sell these assets outright or trade them for more mature assets that are better aligned with the company's core competency to operate. If it is successful in doing this, especially in obtaining the asset trade, then it should be able to reduce its capital expenditures and thus increase its distributable cash flow.
Company Can Use Hedging to Lock in Revenue
One of the advantages of LINN Energy's core strategy of purchasing mature oil and gas producing properties with stable decline rates (Permian assets notwithstanding) is that it can fairly accurately predict its production in any given year. This allows the company to lock in a sale price in advance for the majority of its production, which greatly helps the company to predict its revenue in a given year.
LINN Energy has done exactly this and has secured sales prices for all of its expected natural gas production from now until 2017 and all of its expected oil production this year. The company has also locked in prices for 50-60% of its expected oil production in 2015 and 2016 . This practice is known as hedging. By hedging its production and locking in oil prices, LINN Energy has effectively protected itself against a revenue decline should the price of oil and gas go down. Unfortunately, LINN Energy will also not benefit as much from the entire increase in oil and gas prices should they rise further than expected.
Speaking of the company's distributions, LINN Energy pays a high one. At the time of writing, LINN Energy units trade hands for $28.34 and the company pays an annualized distribution of $2.90 per unit. This gives the units a very high distribution yield of 10.24%. Although there is some risk that the company will not generate sufficient cash flow to cover this distribution and may have to cut it as discussed above, that risk certainly appears to be baked into the price at this level.
How does LINN Energy stack up to some of its MLP peers?
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Daniel Gibbs 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.