There's no gentle way to put this: Breitburn Energy Partners' (BBEP +0.00%) performance was atrocious last year. The company was far too bullish on oil, made obvious by its debt-fueled oil acquisition binge of recent years, leaving it vulnerable when the price of petroleum collapsed.
Now, Breitburn Energy in the year ahead must fix two big problems that were exposed by the major downdraft in the price of oil.
No. 1 problem to fix: Its balance sheet
Breitburn Energy Partners' debt load was already running a bit hot before oil went into a nosedive. Its credit situation will only worsen if oil prices remain at their current level for more than a year, because the company's oil hedges will wind down, which will cut even deeper into its cash flow. This means the company needs to fix its balance sheet this year.
The problem is that there isn't a whole lot it can do. Breitburn's credit line is already 88% drawn, and that line could be cut this year as banks redetermine its borrowing rate. The company tried to issue bonds a few months ago, but canceled that offering when it didn't like what it saw on the market as the interest rate and terms weren't within the company's comfort levels. Things have only gotten worse since that point, meaning Breitburn might be forced to take what it can get in order to relieve the pressure on its credit line. The company might also need to sell assets this year to whittle down its debt, with its Permian Basin position the most likely to go. It's not an ideal situation, but it's better than going belly up.
No. 2 problem to fix: The instability of its distribution
As an upstream master limited partnership, Breitburn Energy Partners' biggest draw to investors is a high distribution yield that grows over time. However, 2015 has already marked the second time in the past few years the company has significantly cut its payout. Clearly, the current business model is pushing the company too close to the edge
Breitburn has two options here. One option is to become much more conservative. It can reduce its leverage, hedge 100% of its production several years in advance, and keep its distribution coverage ratio in the 1.25 times range. This will reduce both upside and downside risk, helping to ensure its cash flow isn't affected by a major sell-off in commodity prices.
On the other hand, the company could simply switch to a variable distribution rate, which would ebb and flow alongside commodity prices. This would keep investors from becoming accustomed to a fixed rate, as the distribution would change each quarter based on commodity prices and cash flow from the prior quarter. The company could also adjust quickly to changes because its distribution would now be backward looking.
Investor takeaway
Breitburn Energy Partners, like almost every other energy company, was just too bullish on oil. This caused the company to misjudge the potential for a major price disruption, which has become reality. Now, the company must repair its balance sheet and reconsider its business model in which its distribution is proving to be a liability.
