Are These the Best Oil and Gas MLPs in America?

As part of a series covering the 11 most popular oil and gas producing MLPs, I'm diving into four key metrics investors should consider when investing in this industry. These metrics are: yield, distribution coverage ratio, long-term distribution growth rate, and valuation. 

For upstream MLPs, yield and distribution growth are the overwhelming drivers of total returns. Distribution coverage represents the security of the yield because cutting an MLP's distribution often leads to irreparable capital loss. EV/EBITDA is a great way to compare MLP valuation because it takes into account cash flows, debt, and cash reserves -- all vitally important in this capital-intensive industry.

Using these four metrics I turned my eye to two of my favorite upstream MLPs -- Vanguard Natural Resources (NASDAQ: VNR  ) , Linn Energy (NASDAQ: LINE  ) , and its non-MLP equivalent Linn Co (NASDAQ: LNCO  )  I was shocked by the results.

Good MLPs, but not the best

MLP Yield 10 year Projected Distribution Growth Rate 12 month Coverage Ratio EV/EBITDA 10 Year Projected Total Return
Vanguard Natural Resources 8% 4.57% 0.97 12.77 12.57
Linn Energy 9.30% 1.27% 1.02 12.47 10.57
IND AVG 9.65% 7.79% 1.01 12.17 17.44%

Sources: S&P Capital IQ, Yahoo! Finance

I was surprised to discover how poorly Vanguard Natural Resources and Linn Energy stacked up compared to the rest of the industry. However, when one digs deeper into these numbers it becomes clear that both Vanguard and Linn Energy are still high-quality MLPs currently suffering through temporary setbacks.

In the case of Vanguard Natural Resources the biggest issue is its concerning lack of distribution coverage, an average of just  85% over the last two quarters. 

The reason for this? The $581 million purchase of the Jonah and Pinedale gas fields in Wyoming is very different from Vanguard's 20 previous acquisitions in that it included only 192 net producing wells but 6,000 potential wells, which require substantial capital to drill.

This is why Vanguard Natural Resources' coverage ratio has been low and may continue to remain low for several more quarters, as it invests in production expansion. 

However, despite the poor showing relative to its industry peers, there are two reasons I think investors should still consider Vanguard Natural Resources: the nature of its assets and its long track record of quality management and growth.

Vanguard's Wyoming gas fields increased its total reserves by 80% and daily production by 55%, but with 6,000 potential drilling locations (many of them not counted in its current reserves) Vanguard's potential production growth is vast. What's more, the costs of drilling these assets is dropping, with Ultra Petroleum, Vanguard's operator in the fields, having cut the cost of drilling a well from $7 million in 2006 to $4 million. 

Vanguard's production costs are 22.3% of revenues vs a 26.5% industry average, and its administrative expenses are 44% lower than its peers: 4% of revenues vs 7.2%.

With strong production growth coming from its recent investments and 87% of gas production (and 90% of oil production) hedged through 2015, Vanguard's cash flows are assured, and its distribution coverage ratio is likely to skyrocket within the next few quarters. 

As for the quality of its management investors need only look at Vanguard's track record since its IPO in 2007 to know why I still recommend it: 

  • Reserve growth of 2,627% (60.4% CAGR)
  • Production growth 2,667% (61% CAGR)
  • Distribution growth of 48% (5.8% CAGR)
Linn Energy: still worth owning
Linn Energy's biggest problem compared to industry peers has stemmed from its troubled acquisition of Berry Petroleum, which cost $600 million more than expected. 
Much of the oil-rich land it acquired was fast depleting and expensive to drill, which threatened both the distribution coverage ratio and future distribution growth, thus the low analyst growth projections. 
 
However, Linn Energy's recent land swap deal with ExxonMobil proved that management is very capable of maximizing its resources and cash flows. That deal swapped 25,000 acres of Permian land, which is sitting on over 75 billion barrels of fast depleting oil, with 500,000 acres of slow depleting, already producing gas fields in Kansas. In the process, Linn Energy lowered its costs and increased distributable cash flow by $30 million to $40 million annually, securing its distribution. 
 
And Linn Energy is far from done with profitable deals. Just this week it announced the acquisition of $2.3 billion in gas assets from Devon Energy. Linn Energy paid 6.6 times 2013 EBITDA for 3,800 producing wells with another 1,000 potential drill sites. Current production is 275 million cubic feet/day of gas at a annual decline rate of 14%, which is far lower than the Granite Wash assets Linn Energy plans to sell to pay for the deal. 
With Linn Energy still owning 30,000 acres of Permian land and a $40 billion annual market for oil and gas mergers and acquisitions, Linn Energy is likely to continue making highly lucrative deals in the months and years ahead.
These acquisitions are likely to allow Linn Energy to grow its distribution faster than analyst projections, resulting in superior long-term total returns. 
 
Foolish takeaway
While quantitatively lagging its peers, Vanguard Natural Resources, Linn Energy, and Linn Co remain solid long-term income recommendations. Short-term opportunity costs have resulted in temporary setbacks for these MLPs but their track records of quality management, accretive deal making, and consistent distribution growth gives me confidence that these investments will generate strong and growing income while outperforming the market over the next decade. 
 

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