Master limited partnerships (MLPs) focused on upstream energy exploration and production usually pay the highest yields but must also constantly acquire new assets. While these partnerships have historically acquired assets from traditional E&P companies, we could soon see consolidation in the space and acquisitions of other partnerships. Look to distributable cash flow (DCF) and coverage ratios for value in the major players and potential accretive value as a takeover target.
A constant need for acquisitions
Upstream partners do less exploration than most E&P companies, choosing instead to buy producing assets and drill additional wells. This means they are more exposed to depletion and must constantly increase drilling or buy new assets. We have already seen consolidation in the upstream space with the Linn Energy (NASDAQ:LINE) acquisition of Berry Petroleum last year. The deal helped to increase Linn's distributable cash flow and have helped the shares surge 36% from last year's low of $22.79 per unit.
Profits are much more a function of drilling success and resources in contrast to midstream partnerships that derive their profits from volume of product passing through pipelines. While much of the expected production is hedged to lock in prices, upstream partnerships have much more exposure to rising or falling commodity prices than their midstream peers.
The table below presents twelve upstream energy MLPs and the general data I look at when analyzing value. All data are from the most recent filing and believed to be current.
Highlighted are the best three partnerships in each category of distribution coverage, unit price-to-DCF, and yield. While higher yields may be tempting, I prefer the coverage ratio as my favorite metric for two reasons. First, a partnership that can cover its distribution is more likely to increase the payout and less likely to issue more units. Second, a partnership with a high coverage ratio is a more attractive target because its cash flow can help support a lower coverage ratio at another partnership.
Atlas Resource Partners (NYSE:ARP) offers the lowest cost to DCF and the second-highest yield of the group. The company is active in the Barnett Shale, Appalachian Basin, the Raton Basin, the Black Warrior Basin and the Mississippi Lime with an interest in over 12,000 producing natural gas and oil wells. The partnership's coverage ratio just missed a top rank as well, and the units could be a solid addition. May saw insider purchases by four officers for 52,530 units at an average price of $19.73 per unit with no insider selling in the past twelve months.
Eagle Rock Energy Partners (NASDAQ:EROC) is also relatively attractive on valuation and yield, but the coverage ratio is a concern. The company sold its midstream assets to Regency Energy Partners (NYSE:RGP) in December to become a pure-play upstream partnership. The $1.3 billion asset sale will be used to pay down debt and for acquisitions and could help to turn around the company's poor performance. Eagle Rock is active in the Barnett Shale, Eagle Ford, the Permian Basin, and the Cana Shale. Fellow Fool contributor Dajahi Wiley recently outlined the buy case and an improving balance sheet after the company's sale of assets and management's new focus.
Even though LINN Energy is not one of the top three among the categories, I have owned shares since early last year and will continue to hold. MLPs may not be appropriate for a trading portfolio because some of the deferred taxes on distributions are counted as income when the units are sold. Instead of trading in and out of MLPs, I generally look to valuation to increase or start a new position.
Right now, the upstream partners have two important points in their favor. First, interest rates continue to hover around historic lows and the debt market is hungry for higher yield. This should continue for at least another year and allow companies to raise money through debt to fund acquisitions. Share prices are fairly strong, which will also allow the companies to issue more units to raise cash for acquisitions. While issuing more units is not optimal since it dilutes current holders, using the cash for acquisitions should increase distributable cash flow so it is not usually met with the negativity seen when other companies issue more shares.
You will want to look at how partnership assets fit with possible acquirers to cement your acquisition thesis. Proximity to current wells and any midstream assets usually make a good case for a merger or acquisition. I would not necessarily take a position in a partnership on the hope for a buyout alone, but valuation and coverage metrics can also be used to make the case for adding units to a portfolio. With the developing theme of U.S. energy production and independence, even the partnerships that do not get bought should provide strong income and returns over the next several years.
Joseph Hogue has a position in Linn Energy. 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.