The price of oil has crashed to a five and a half year low, making for a painful ride for investors in oil and gas master limited partnerships Breitburn Energy Partners (BBEPQ), Vanguard Natural Resources (NASDAQ: VNR), and Linn Energy (LINEQ).
I believe the ferocious decline in these high-yielding investments is an overreaction by the market -- one that offers long-term income investors a wonderful opportunity for exceptional profit should the oil markets recover.
Quality assets trading at fire-sale prices
| MLP | Yield | P/Distributable Cash Flow | P/PV-10 | P/Adjusted PV-10 | Distribution Coverage Ratio |
| Linn Energy | 24.90% | 4 | 29% | 54% | 0.97 |
| Breitburn Energy Partners | 21.60% | 4.5 | 31% | 58% | 0.95 |
| Vanguard Natural Resources | 14.80% | 6.3 | 60% | 115% | 0.9 |
| S&P 500 | 1.94% |
Sources: Yahoo! Finance, MLP 10-Ks, Multpl.com
LINE Dividend Yield (TTM) data by YCharts
As this table and chart shows, these oil and gas producers are trading at valuations not seen since the financial crisis. Not only is Linn Energy and trading for as little as four times their last 12 months' distributable cash flow, or DCF, but nearly all of these partnerships are trading at substantial discounts to their PV-10 estimates.
PV-10 is the present value of future cash flow generated by oil and gas assets, discounted at a 10% annual rate. While the PV-10s seen above were derived in March 2014, when oil was at $100 per barrel, even if we decrease these values by 46% --the amount oil prices has fallen since that time--MLPs such as Linn Energy and Breitburn Energy Partners are still trading at substantial discounts to the value of their oil and gas assets.
In fact, since it is unlikely that oil prices will remain at current low levels over the next few decades, the time frame for which PV-10 measures, it's actually likely that all of these MLPs are trading at larger discounts to the value of their oil and gas. This would remain the case even if the price of oil fails to return to the $100 per barrel level seen over the last several years.
A great deal even if payouts get cut
The sky-high yields on these MLPs indicate that Wall Street is predicting almost certain distribution cuts from nearly all of them. With 12-month coverage ratios all under one, that is understandable.
Source: Linn Energy investor presentation.
All of these MLPs hedge against the potential for declining energy prices, which will protect cash flow in the short-to-medium term. For example, Linn Energy has almost all cash flow hedged through the next two years, greatly decreasing its exposure to the current collapse in oil prices. However, management still predicts a distribution coverage ratio of just 0.83 for the current quarter, representing a DCF shortfall of $94 million.
Similarly, Breitburn Energy Partners has hedged its production through 2018 at an average oil and gas price of $90 per barrel and $4.6 per MMbtu, respectively. However, the proportion of production that is hedged decreases over time. For instance, Breitburn's oil production through 2015 is 71% hedged at $94 per barrel, while 2016 production is only 60% hedged and at lower prices.
Source: Vanguard Natural Resources investor presentation.
Similarly, from this table you can see that Vanguard Natural Resources' current monthly distribution is sustainable only if oil and gas prices rebound to about $70 per barrel and $4 per MMbtu, which currently sit at around $57.88 and $3.69, respectively. But what happens if energy prices remain at today's rates throughout 2015?
In that case it's highly probable that all of these MLPs would be forced to cut their distributions, but they could still represent amazing long-term investment opportunities. That's because even if these partnerships are forced to cut their payouts by 33%--at which point I believe they should be sustainable even if energy prices remain this low for several years--their new yields would be between 9.8% and 16.6%.
Risks you should know about
The largest risk to this investment thesis is for oil prices to remain at today's levels for years to come. Andy Xie, the former head economist for Morgan Stanley and the International Monetary Fund, recently told CNBC that he believes oil could fall as low as $43 per barrel and remain near $60 per barrel through 2019.
If such a scenario plays out, these partnerships might be forced to reduce their payouts not just once, but potentially several times over the next few years as their protective hedges roll off and cash flow continues to weaken. I don't believe that Xie's grim forecast is likely to come to pass, but potential investors should be aware this scenario is possible.
In addition, investors should be aware that these MLPs have taken on a substantial amount of debt to fund their recent acquisitions. For example Linn Energy and Breitburn have debt/equity ratios of 2.5 and .91 respectively, compared to the industry average of .5. In a rising interest rate environment and with oil prices severely depresses, Linn Energy in particular may have a difficult time rolling over its debt. This is why Wall Street has recently pushed yields on its 6.5% coupon 2019 bonds up to 11.5%.
Bottom line: now is the time to buy high-yield oil and gas MLPs
Warren Buffett famously said that the best way to beat the market was to "Be greedy when others are fearful," and few sectors of the market have as much sheer terror baked in right now as u[stream oil and gas MLPs. With quality MLPs trading at immense discounts to the future cash flows of their oil and gas assets, long-term income investors have an opportunity to buy $1 worth of oil and gas for as little as $0.54 to $0.58 through the likes of Linn Energy and Breitburn Energy Partners. While there is a very real risk that low oil prices in 2015 will force some or all of these MLPs to cut their distributions, strong hedging strategies mean that even after such cuts the potential for long-term income and capital gains will likely be substantial. This is especially true for long-term investors brave enough to buy at today's supremely undervalued prices.
