Income investors are understandably drawn to MLPs due to their high yields. Exploration and production (E&P) MLPs usually offer the highest yields because they pay out almost all of their distributable cash flow as distributions to unit holders. The cost of this high-yield is typically slow distribution growth because the partnerships are depleting their reserves and must acquire new production sources to grow. With slow distribution growth comes slow unit price appreciation, unless one can find partnerships trading at a severe discount. In this article I will explore three such companies and explain the catalysts for strong capital gains.
The metric I am using to find these undervalued partnerships is one most investors have never heard of yet is very important to understand when investing in E&P MLPs. Standardized measure is simply the present day value of net revenues generated by the partnership's reserves. It's calculated by taking the last year's average price for oil and gas and assumes the same cost of extraction. Revenues are discounted by 10%. The standardized measure can be found in a partnership's 10-K.
The measure is not an exact estimate of the value of the resources because it doesn't take into account generalized administrative costs, hedging activity, interest expenses, or taxes. However, it does give a general snapshot of what a company's reserves are worth. Think of it as a "book value" for E&P MLPs.
There are three E&P partnerships that are trading at a discount to their standardized measures: QR Energy (UNKNOWN:QRE.DL), BreitBurn Energy Partners (NASDAQOTH:BBEPQ), and Linn Energy (NASDAQOTH:LINEQ).
|Company||Yield||Standardized Measure ($millions)||Market Cap ($millions)||Discount (%)||Standardized Measure Growth Rate 2 year CAGR|
As seen in the above table these partnerships are trading at deep discounts to their standardized measures yet have fast-growing reserves (due to acquisitions and increased production investment). The investment thesis is that these partnerships will grow their "book values" and eventually the market will price them appropriately. This will result in large capital gains and in the meantime investors can collect generous distributions.
Of course there is a reason that all three partnerships are trading so cheap. Some catalyst caused the market to deeply discount each one, and the above investment thesis only holds if those catalysts are temporary or a new catalyst reverses the situation.
QR Energy is a new E&P MLP and unlike most had a general partner (gp) in Quantum Energy Resources. The gp was entitled to a "management incentive fee" that was very unfriendly to limited partners (general investors). It allowed the gp to take its fees in the form units that diluted existing investors. As an example of how damaging this fee structure was, in the fourth quarter of 2012 the gp converted its $3 million management fee into $110 million worth of equity. This diluted existing investors by 10%.
While this management incentive fee existed the partnership would have a very difficult time growing distributions because of such rampant unit issuances. However, on March 3, 2013, the partnership announced it had bought out its gp in exchange for 11.6 million units to take place over four years and only if certain operating benchmarks are met. While the buyout represents a 20% dilution it is spread out over four years and is a large improvement over the previous perpetual dilution fee structure. In 2014 alone the buyout will be 7% accretive to distributable cash flow.
With a distribution coverage ratio of 1.2 (1 including the full dilution) and management guiding for 6.4%-10.3% increased production in 2014, the path is clear for strong distribution growth ahead.
BreitBurn Energy Partners has recently faced a distribution coverage ratio of .93 in the most recent quarter. This was due to severe winter weather and a delay in a CO2 oil recovery system coming online. These two things negatively affected production and temporarily threatened the distribution.
The positive catalysts for BreitBurn include its recent acquisition of Oklahoma Panhandle oil assets that will be immediately accretive to distributable cash flow. 2014 guidance calls for: $600 million in additional accretive acquisitions, a 217% increase in production and a 36% increase in Adjusted EBITDA. This will secure the distribution and allow for distribution growth of 4%-5% moving forward.
Linn Energy's gp recently purchased Berry Petroleum for its rich liquid assets. Unfortunately it made the purchase by issuing stock and was forced to raise the purchase price due to a drop in the share price. The additional $600 million it had to pay made the deal non-accretive to distributable cash flow. In addition the cost of expanding production of Linn's Permian basin assets has caused management to guide for a distribution coverage ratio of 1 for 2014. This concern over distribution security has led JPMorgan to downgrade the partnership's units.
The catalyst for Linn Energy is its strategic option of trading some or all of its midland basin assets, (which will require expensive horizontal drilling) for long-life mature assets that will be immediately accretive to dcf. Even if management can't execute on this strategy it has 100% of oil and gas production hedged for 2014, ensuring reliable cash flow that will cover the current distribution.
With QRE Energy, BreitBurn Energy Partners and Linn Energy investors have a chance to lock in high, secure yields and purchase quality energy assets at deep discounts. The mentioned catalysts will possibly result in very strong capital gains while the high-yield minimizes downside risk.