Don’t Go Dumpster Diving in the Upstream MLP Sector

Upstream MLPs are some of the highest yielding assets in the entire investing universe. However, investors must be careful not to buy into poorly managed partnerships whose distributions are insecure and have little prospects for growth.

Apr 9, 2014 at 9:46AM

Upstream MLPs are some of the highest-yielding assets in the entire investing universe. However, investors must be careful not to buy into poorly managed partnerships whose distributions are insecure and have little prospects for growth. 

MLPs are known for high yields, and among MLP sectors few yield better than the "upstream" exploration and production (E&P) MLPs. The downside to this high yield is slower distribution growth and a need for increased vigilance. This is because in order to pay out so much of their cash flows as distributions, E&P MLPs maintain very tight distribution coverage ratios. This leaves little margin of safety in case production is disrupted. 

This article is designed to help investors recognize warnings signs for bad E&P MLPs and how to invest in better alternatives. The case study for a bad upstream MLP is Eagle Rock Energy Partners (NASDAQ:EROC).

Eagle Rock is a formerly diversified combination midstream/upstream MLP. The company was unable to leverage its midstream assets into a steady source of fixed revenues. Due to financial difficulties combined with mounting debt concerns, the partnership decided to become a pure-play upstream MLP and sell its midstream assets to Regency Energy Partners for $1.325 billion. It is planning to use the proceeds to pay down $1 billion in debt and fund organic growth in its Oklahoma assets. This investment is designed to focus on oil, which has traditionally been a more profitable and stable source of earnings than natural gas. 

Eagle Rock recently dropped its distribution by 32% in an effort to shore up its finances. At the current level, the yield is 11.7% and the coverage ratio during the third quarter of 2013 was 1.05. Management is guiding for 1.05+ for 2014, but due to adverse weather conditions during the fourth quarter of 2013 the distribution coverage ratio declined to just .77. This highlights the danger that all upstream MLPs face. Eagle Rock faces two additional headwinds that make it a poor investment, however.

Due to their high yields, upstream MLPs retain very little earnings. Thus, to grow they have two options. They can either increase production on their existing lands by investing in new wells, or they can buy new assets that are already producing oil and gas. If these assets can be purchased cheap enough, then the acquisition is immediately accretive to distributions and benefits existing unit holders. This is very important given that MLPs have only two ways of financing growth-debt and equity.

Given that Eagle Rock is already overleveraged and using $1 billion of the Regency sale to pay off debt, it is unlikely to issue new debt soon. This leaves only equity issuances to finance new growth. The problem for the partnership is that its unit price is so low ($870 million market cap) that any large investments would require massive dilution of existing unit holders. 

Each new unit issued represents additional cash that must be paid out as distributions, which in turn lowers the distribution coverage ratio unless the investments achieve an IRR (internal rate of return) greater than the yield. In other words, Eagle Rock can print new units which act as an 11.7% permanent bond. If the money raised is used to expand existing oil production and returns 11.8% or more, existing investors benefit.

Achieving that high of a return can be a challenge, though, and that is one of the main reasons that Eagle Rock is likely to struggle over the long term. It's trapped in a Catch-22 situation. It can't grow until its unit price increases, but its unit price won't increase until it grows.

Of course, investors could always choose to invest in higher-quality upstream MLPs that yield nearly as much as Eagle Rock but have strong catalysts for growth and none of its company-specific problems. 

QRE Energy (NYSE:QRE) is a newer upstream MLP, but it represents a special opportunity. Because of a very unit-holder-unfriendly management fee agreement, the units were deeply discounted (trading at just 57% of the discounted value of the oil and gas in the ground, a standardized measure). 

Recently, the partnership bought out its general partner and ended this terrible fee arrangement (which paid management fees in unit issuances that deeply diluted existing investors every quarter). The buyout will create one final 20% dilution spread out over four years and commensurate on certain positive operating milestones being met (such as minimum coverage ratio of one, debt/EBITDA to not exceed four). The buyout is immediately 7% accretive to DCF and will likely cause the distribution to rise this year. This should take the current 10.8% yield above 11% with further room to grow in the future. 

Bottom line
Upstream MLP investors need to remember that the price of their high yields is eternal vigilance. This means buying only high-quality partnerships, with solid distribution coverage and decent growth prospects. Dumpster diving in this space and reaching for yield (an investment in Eagle Rock) is inadvisable when better alternatives such as QRE Energy are available.

Take advantage of this little-known tax "loophole" for energy investors
Record oil and natural gas production is revolutionizing the United States' energy position. Finding the right plays while historic amounts of capital expenditures are flooding the industry will pad your investment nest egg. For this reason, the Motley Fool is offering a look at three energy companies using a small IRS "loophole" to help line investor pockets. Learn this strategy, and the energy companies taking advantage, in our special report "The IRS Is Daring You To Make This Energy Investment." Don’t miss out on this timely opportunity; click here to access your report -- it’s absolutely free. 

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.

4 in 5 Americans Are Ignoring Buffett's Warning

Don't be one of them.

Jun 12, 2015 at 5:01PM

Admitting fear is difficult.

So you can imagine how shocked I was to find out Warren Buffett recently told a select number of investors about the cutting-edge technology that's keeping him awake at night.

This past May, The Motley Fool sent 8 of its best stock analysts to Omaha, Nebraska to attend the Berkshire Hathaway annual shareholder meeting. CEO Warren Buffett and Vice Chairman Charlie Munger fielded questions for nearly 6 hours.
The catch was: Attendees weren't allowed to record any of it. No audio. No video. 

Our team of analysts wrote down every single word Buffett and Munger uttered. Over 16,000 words. But only two words stood out to me as I read the detailed transcript of the event: "Real threat."

That's how Buffett responded when asked about this emerging market that is already expected to be worth more than $2 trillion in the U.S. alone. Google has already put some of its best engineers behind the technology powering this trend. 

The amazing thing is, while Buffett may be nervous, the rest of us can invest in this new industry BEFORE the old money realizes what hit them.

KPMG advises we're "on the cusp of revolutionary change" coming much "sooner than you think."

Even one legendary MIT professor had to recant his position that the technology was "beyond the capability of computer science." (He recently confessed to The Wall Street Journal that he's now a believer and amazed "how quickly this technology caught on.")

Yet according to one J.D. Power and Associates survey, only 1 in 5 Americans are even interested in this technology, much less ready to invest in it. Needless to say, you haven't missed your window of opportunity. 

Think about how many amazing technologies you've watched soar to new heights while you kick yourself thinking, "I knew about that technology before everyone was talking about it, but I just sat on my hands." 

Don't let that happen again. This time, it should be your family telling you, "I can't believe you knew about and invested in that technology so early on."

That's why I hope you take just a few minutes to access the exclusive research our team of analysts has put together on this industry and the one stock positioned to capitalize on this major shift.

Click here to learn about this incredible technology before Buffett stops being scared and starts buying!

David Hanson owns shares of Berkshire Hathaway and American Express. The Motley Fool recommends and owns shares of Berkshire Hathaway, Google, and Coca-Cola.We Fools don't 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.

©1995-2014 The Motley Fool. All rights reserved. | Privacy/Legal Information