The strongest oil price collapse since the financial crisis has seen crude plunge to six-year lows.
A new report from Goldman Sachs paints a grim picture for the prospects of a quick recovery in oil prices in 2015. However, in my opinion, the oil collapse presents a great long-term profit and income potential for investors in four particular high-yielding oil and gas producing investments: Breitburn Energy Partners (NASDAQ:BBEP), Vanguard Natural Resources (NASDAQ:VNR), Linn Energy (NASDAQ:LINE), and its non-MLP equivalent LinnCo (NASDAQ:LNCO).
Note that LinnCo is a holding company for units of Linn Energy and exists to allow investors who don't want to deal with the tax implications of MLPs to invest in the partnership. Investors should be aware that any reference made to Linn Energy applies equally to both securities.
Why Goldman is so bearish on crude prices
Goldman Sachs analysts predict that oil will need to drop to $40 per barrel for six months before U.S. shale production declines enough for the world's oil glut, estimated at 2 million barrels per day, to reverse course.
The analysts also lowered their respective six- and 12-month West Texas Intermediate oil price forecasts down from $75 and $80 per barrel to just $39 and $65 per barrel. They cited global oil storage capacity of approximately 365 million barrels and a belief that OPEC won't cut production at its next meeting, scheduled for June 5, as key reasons for their estimate that oil will average $55 per barrel over the next year.
What makes these upstream MLPs well-suited to weather the oil price storm
There are two main reasons I think these four investments are relatively secure in a time of cheap oil: strong short-term hedging portfolios and their recent distribution and capital spending cuts.
As this image shows, Breitburn has 75% of its oil and 71% of its natural gas production hedged this year.
Similarly, as indicated in the above slide, Vanguard has 70% and 81% of its respective oil and gas production hedged.
Meanwhile, Linn's hedge portfolio covers 90% to 100% of its natural gas production through 2016 with this year's oil hedged up to 70%, and 60% going into 2016.
Linn Energy recently slashed its annual distribution by 56% from $2.90 per unit to $1.25 per unit, making its new yield 13.1%. As the above image illustrates, this payout is sustainable as long as the average oil price for the year remains at $52.5 or above, which would be in line with Goldman's six- and 12-month forecasts.
Why is management so confident that it can maintain this distribution in the face of oil prices that seem to crash lower on a daily basis? The answer lies in its 2015 budget, which cuts capital expenditures by 53%, from $1.55 billion to just $730 million.
That's $820 million of cash available to support the new payout as management streamlines its spending to focus on maintaining current production levels and drilling only its most productive and slowest declining assets.
Slashing the distribution and capital investment budget are painful but necessary moves that Breitburn also recently made. In the case of Breitburn, on Jan 2. it announced it was cutting distribution and capital spending for 2015 by 52% and 47%, respectively. The annual distribution is falling from $2.08 per unit to $1 per unit while capital expenditures are declining from $375 million to $200 million. Like Linn Energy, Breitburn's management is focused on mainly maintaining existing production and being far more selective with new drilling. Only the most profitable areas will receive growth capital unless oil prices rebound sharply.
Vanguard Natural Resources has yet to announce similar measures. However, given that it hasn't been able to cover its distribution -- which now yields 18.9% -- for three of the last four quarters and has a 12 month distribution coverage ratio of 0.9; I expect it to follow suit sooner rather than later.
That being said, Vanguard's distribution cut may not be as severe as Linn Energy and Breitburn's were courtesy of its smaller dependence on oil production. Specifically, Vanguard's production is 68% focused on gas compared to Linn and Breitburn whose production is composed of 54% and 36% natural gas, respectively. While natural gas prices have declined 30% in the last six months, that pales in comparison to oil's 55% collapse over the same period.
Vanguard is focusing its remaining 2014 capital expenditure budget very heavily on gas, with 63% of its fourth-quarter budgeting targeting the gas rich Green River basin and only 18% of funds going to the oil rich Permian Basin. Thanks to less exposure to oil than either Linn Energy or Breitburn, I think Vanguard's distribution cut may be more along the lines of a 33% to 40% cut. This would bring Vanguard's 2015 yield to a still generous 11.3% to 12.5% on today's price while achieving a 2015 coverage ratio of 1.20 to 1.26. That's along the lines of Linn Energy's and Breitburn's projected 2015 distribution coverage ratios of 1.18 and 1.35, respectively.
Risks worth considering
The biggest risk to buying these MLPs today are that oil prices could remain weak for several years and natural gas prices might also continue falling. Beginning in 2016 many of Vanguard's hedges end. And by 2017, Breitburn and Linn Energy would be likewise exposed to far lower commodity prices for their production. While I don't expect that scenario to play out, should energy prices continue to fall and remain lower than most analysts are currently predicting through 2016 and 2017, all three MLPs and LinnCo would likely be forced to cut their distributions even further.
Bottom line: When others are fearful, being greedy is the best way to earn out-sized returns
If Goldman Sachs is right and oil prices remain low throughout 2015 the best way for long-term investors to position themselves to profit from crude's eventual recovery is to stick with large, well-managed MLPs like Breitburn Energy Partners, Vanguard Natural Resources, Linn Energy, and its non-MLP alternative, LinnCo. All four are well protected by sizable hedging, and after their recent distribution cuts, Linn Energy and Breitburn Energy Partners' new distributions should prove sustainable as long as low oil prices don't persist into 2016. Meanwhile, investors might want to consider dollar-cost averaging into Vanguard Natural Resources, which may be forced to cut its own distribution in the coming weeks. As seen on Jan 2, with Linn Energy's distribution cut announcement -- which saw the unit price jump 12% that day -- the market's reaction to such a painful but strategically smart decision can be unpredictable. Thus, trying to time your entry based on an anticipated distribution cut and subsequent price drop may not work out as you might expect.
Adam Galas has no position in any stocks mentioned. The Motley Fool recommends BreitBurn Energy Partners and Goldman Sachs. 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.
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