One of the greatest fears of investors in high-yielding oil MLPs is that the current oil crash will force a series of severe distribution cuts, especially for highly indebted MLPs such as Breitburn Energy Partners (NASDAQOTH:BBEPQ), and Linn Energy (NASDAQOTH:LINEQ).
With Breitburn's announcement on Sunday, March 29, that it was cutting its distribution in half...again, it appears this fear is more than justified. Yet there are two reasons to believe Linn Energy won't necessarily share Breitburn's fate, and that its current payout might prove sustainable should oil prices recover within the next few quarters -- as the International Energy Agency's latest monthly oil report seems to indicate.
Why Breitburn had to slash its distribution for the second time
Breitburn's problems had to do with its existing credit facility, which it had tapped to make its largest-ever acquisition -- a $3 billion purchase of QR Energy. As of the most recent quarter, Breitburn's credit facility stood at $2.5 billion, of which $2.2 billion had already been spent.
In April, the MLP's 35 creditors were set to reevaluate the borrowing limit, and analysts were concerned that -- because of the oil crash -- this facility would be reduced by 10% to 20%, as had occurred with some of Breitburn's competitors.
Option's for raising cash such as secondary offerings or bond issuances were limited by highly unfavorable terms so Breitburn instead struck a deal for a $1 billion cash infusion from the private equity group EIG Global Energy Partners. Breitburn was able to pre-emptively reset its borrowing limit to $1.8 billion and pay down all but $1.24 billion of its existing debts. This leaves it with $560 million in liquidity, with which management says it can make strategic acquisitions of quality oil and gas assets that are selling at fire-sale prices.
Of course $560 million isn't all that much liquidity should oil prices stay low or even drop even further in coming quarters, which might cause Breitburn to continue to burn cash at a fast rate. While management may try to put lipstick on a pig by proclaiming this private equity deal is a way for them to take advantage of "strategic opportunities", the fact that Breitburn was forced to slash its distribution so soon after its last major payout cut to seal the deal suggests that Breitburn had backed itself into a corner and was forced to act out of desperation. I don't believe Breitburn will be able to make any accretive acquisitions because doing so would force it to once more max out its credit facility and risk yet another distribution cut -- which would only further damage management's credibility.
Why Linn Energy is better off
In my opinion Linn Energy's management is just plain better than Breitburn's. Last year it began wheeling and dealing away its high cost, high decline assets before the oil crash began and its latest private equity deals are for terms that I think are pretty favorable to investors.
The first deal was with GSO Capital Partners, which created a joint venture called DrillCo, in which GSO will provide up to $500 million for drilling on Linn's land and receive 85% of the cash flow until it recoups 115% of its investment. At that point, Linn Energy will get 95% of the cash flow until the new wells runs dry. This brilliant deal allows Linn Energy to fund drilling -- targeted at low-cost, low-decline assets -- without putting any of its own cash at risk, nor does it require further equity dilution or debt.
The second deal is with Quantum Energy Partners and creates a joint venture called AcqCo, which will allow Linn Energy to leverage the $1 billion in potential new equity sales it recently filed with the SEC, into a potential $2.5 billion in acquisitions. This will not only allow Linn Energy to potentially snap up great assets on the cheap, but the joint venture will also be able to invest in non-oil-based assets. AcqCo will also serve as a source of "drop-downs" for Linn in the future, guaranteeing it a quality source of acquisitions that can drive future distribution growth once oil prices recover.
In addition Linn doesn't have any bonds maturing until July 1, 2018 and the majority of its debt doesn't come due until 2019 and 2020. This gives Linn more time for oil prices to recover and its cash flow situation to improve.
Payout risk still remains
That being said Linn's payout is not 100% safe, either. Management's previous 2015 guidance assumed an average of $55 per barrel and thus far this year oil prices are lower than management was anticipating and may still have further to drop. Even with its strong hedging portfolio -- as the below graphic shows -- Linn still needs the average price it receives per barrel of oil to be at or above $52.5 for the year in order to ensure the safety of its current payout.
In addition Linn Energy is still a highly indebted MLP with $12.3 billion in total debt which created $588 million in interest payments last year -- consuming 34% of Linn's operating cash flow in 2014.
Without an oil recovery in the second half of the year, It's still possible that Linn's payout will need further cutting in order to bring the MLP's balance sheet in line with the current realities of the oil industry.
Takeaway: Linn Energy's payout is safer than Breitburn's was but is still risky
In my opinion the oil crash is showing Linn Energy's management to be more proactive and capable than that of Breitburn. However, it's not without its own faults. Linn's excessive debt load -- acquired when oil prices were in the triple digits -- potentially hangs like a sword of Damocles over the payout, threatening to fall and slash the distribution again should oil prices not recover during the second half of the year.