BreitBurn Energy Partners (NASDAQOTH:BBEPQ) is wagering a lot of money that it can drill horizontal wells in the Permian Basin in an MLP-friendly way. However, the horizontal growth strategy it is pursuing is the same one that fellow master limited partnership LINN Energy (NASDAQOTH:LINEQ) recently abandoned as it found the decline rates from horizontal drilling to be too steep to overcome. That example makes it a curious strategy for BreitBurn, so let's drill down to see why the company thinks it can make it work.
Building a position
BreitBurn Energy Partners announced in October that it would pay roughly $100 million in cash and stock for additional acreage (and thus more horizontal drilling inventory) in the Permian Basin. It was a curious move, as the MLP typically acquires producing assets that provide current cash flow to grow its lucrative distribution. However, this time it had its eyes on future cash flow from horizontal drilling.
BreitBurn thinks it can replicate other energy companies' success in the Permian Basin in an MLP-friendly manner. What this means is that the company believes it can drill high-growth, high returns horizontal wells but at the same time enjoying steady cash flow from those wells despite the fact that this production declines rapidly. This will take some creativity as the decline rate of these wells requires a lot of capital reinvestment just to maintain production, which cuts into cash flow. However, BreitBurn sees this as a compelling opportunity that is just too good to pass up as the company is tempted by the results from the numerous horizontal wells that have been drilled in and around its primary development area, which can be seen on the following slide.
To get started the company plans to spend $100 million over the next year to drill about one horizontal well per month. At that rate, BreitBurn could drill for the next 19 years just in its primary development area. Furthermore, throughout its position in the Permian, the company sees a drilling inventory that could take 50 years to drill. This is why it aims to be creative in developing the acreage; BreitBurn is using its initial $100 million investment to gather information so that it can create the most value out of its position.
Looking at the options
One option being considered is to bring on financial partners to fund two more rigs by the middle of next year, as noted on the following slide.
Ideally, these partner-funded rigs would be structured in such a way that it would make the horizontal wells more MLP-friendly by providing steady cash flow while minimizing the production decline. On the company's last conference call, CEO Hal Washburn noted that BreitBurn has several options to participate in the upside from drilling these wells , while mitigating the downside that comes from the steep decline rate.
For example, according to Washburn: "Several structures we're looking at give the disproportionate share of the production, and with it, the high decline to the financial partner, to the operating partner. So we're looking at different ways to synthetically take the high-decline initial production out of the BreitBurn portfolio." Structures such as the one that Washburn is describing have the potential to deliver the cash flow focused growth BreitBurn is looking to capture from this opportunity.
However, that is just one of the handful of options the company is exploring for its acreage, with the rest noted on the following slide.
Washburn said the company could pursue a combination of these options in order to maximize the value of its position if that would best serve investors. That suggests BreitBurn is open to the idea of divesting some or all of the position at some point if that turns out to be the best direction. That strategy would follow the path laid out by LINN Energy when it reviewed its own strategic options in the Permian Basin.
LINN Energy's first strategy was to develop horizontal wells to prove its acreage did indeed have solid horizontal assets. Once it proved that its assets held value, the company then traded or sold off its acreage for more MLP-friendly assets around the country. That reshuffle enabled LINN Energy to lower its decline rate to provide more stability to its distribution, putting the company in a much stronger position to keep growing.
BreitBurn Energy Partners is exploring all of its options in the Permian Basin. If it can find a way to develop its horizontal assets that fits the structure of an MLP, then it's quite possible the company will do just that. However, if it can't find the right partner then it can simply follow in LINN Energy's footsteps and deal away its acreage for more MLP-friendly assets. Either way, it appears the company is looking for the best way to create value for its investors over the long term while avoiding the pitfalls the come from the rapid decline rates of horizontal oil wells.
Matt DiLallo owns shares of Linn Energy, LLC. The Motley Fool recommends BreitBurn Energy Partners. 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.