Master limited partnerships, or MLPs, are great ways to build income. They often operate in mature fields with predictable cash flow, and return nearly all cash to unitholders. Look at these "upstream" MLPs as another tool in the income investor's box. While these names have high yields, typically over 8%, upstream MLPs produce hard assets. They can also grow distributions. This makes the space an attractive alternative to "junk" bonds or mortgage REITs.
Unfortunately there is now a lot of headline risk on these names: Linn Energy (NASDAQ:LINE), the biggest of all upstream MLPs, is under an informal inquiry by the SEC after vociferous attacks by short sellers on its accounting practices. While I highly doubt anything will come of this, the retail income investor may want to avoid Linn's headline risk and go with some alternatives.
Memorial Production Partners (NASDAQ:MEMP) and Vanguard Natural Resources (NASDAQ:VNR) may be two safer alternatives. Both partnerships have long-term, low-cost hedging policies. Both have good distribution coverage, both are primarily nat gas producers and have upside potential if nat gas prices increase for the long term. I'll go over both partnerships point-by-point and compare them with Linn.
Both Memorial's and Vanguard's distributable cash flow, or DCF, cover distributions by about 1.1 times this year. This compares well to Linn's 0.96 times for 2013.
Looking at valuation, both names are more expensive than Linn. Linn currently trades at around 9 times DCF, Vanguard at 10 times, and Memorial at 11 times. Yield is a similar story: Linn yields a huge 11.1%, while Vanguard and Memorial yield 9.8% and 9% respectively. This discount is a result of Linn's headline risk.
Memorial has made an interesting set of acquisitions which has diversified its production from 88% gas to only 63% today. Memorial picked up "drop downs" from its parent company in the Permian Basin, Rockies, and a small set of acreage in California, adding some oil to its mix. Most of the partnership's acquisitions do come from the parent company, Memorial Resource Development. The acquired fields are all mature, and the geology has already been mapped out. Some of them, particularly one piece of the California acreage, came with 100 experienced employees. All Memorial needs to do is continue operating the properties and collect the cash.
Vanguard, for its part, has gone in the other direction: picking up natural gas acreage on the cheap in the Fayetteville in Arkansas, the Rockies, and the Permian. Portions of each geography are profitable right now, but more of the acreage will become profitable if natural gas prices go higher and stay there. Vanguard is betting that prices will rise and stay at a level higher than today's.
Gas is currently cheaper to hedge out for longer time periods than is oil. Memorial and Vanguard both hedge most production out for a long time. For Vanguard, 85% of gas production is hedged through 2017 and 85% of oil is hedged through 2015. Memorial hedges 80% of both its oil and gas through 2015 and over half through 2018.
For hedging, both companies engage in no-cost and low-cost swaps and "collar" strategies. The latter of which limits both upside and downside. By contrast, much of Linn's current hedge book is made up of puts which establish only a price floor (with unlimited upside). Vanguard's and Memorial's strategy is much cheaper, but lacks the upside of Linn. As we can see, these two are a more conservative choice at this time.
Vanguard and Memorial are more conservative and gassier than Linn and other upstream MLPs. Both Memorial and Vanguard would be safe choices right now, with potential upside if gas prices go higher and stay there. The income investor should consider them both.
Casey Hoerth is long LINE. 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.