Emerge Energy Services (NYSE: EMES) had already slashed its distribution 29% in Q1 and reduced its annual 2015 distribution guidance 47% because of the oil crash. With crude prices once again heading lower many income investors are understandably concerned that more payout cuts might be right around the corner.
Let's take a look at three key facts about how the MLP is dealing with cratering crude prices and, more importantly, what high-yield income investors should expect from this frac-sand MLP in the coming quarters.
Q2 distribution slashed and Q3's isn't looking so hot
Emerge Energy is a variable-pay MLP, meaning that it pays out 100% of its distributable cash flow each quarter, which can create high payout variability.
Given the disastrous effect crashing oil prices have had on U.S. rig counts and frac-sand demand, during its first-quarter conference call, management warned investors to expect another payout cut in the second quarter.
True to its word, Emerge recently announced another distribution cut of 33% from last quarter and a 43% decline year over year.
Further bad news came from the MLP's chairman, Ted Beneski, who during the most recent conference call lowered 2015's distribution guidance from $3 per unit to a range of $2.50 to $3, and warned investors that another distribution cut might be in the offing. According to Beneski:
"As we look to our third quarter, our expectation is that we could have another sequentially down distribution. At the same time, we continue to work on a number of opportunities that could mitigate or even eliminate a lower distribution."
What are the chances that Emerge may be able to hold the line on the current payout, which yields a still generous 13.6%? That will depend on two key insights management recently provided, regarding both the short-term outlook for the oil industry and its cost-reduction plans.
Management is cautiously optimistic about a possible turnaround in oil
Talking to our customers as well as E&P companies in several key basins, the timing of any near-term recovery is uncertain. However, we do remain optimistic that a recovery both in the price of oil and in market demand and potentially pricing for frac sand will occur within the next 6 to 12 months.-- Beneski
The reason Emerge is warning investors about the potential for another distribution cut is that no one can predict short-term oil prices. Furthermore, Wall Street's reaction to Emerge's first two distribution cuts has been exaggerated to say the least -- a 61% decline since the Q1 payout cut was announced on April 24.
Thus, management is eager for investors to understand that while it will do everything in its power to prevent another cut, the MLP's first obligation is to insure its long-term survival, which necessitates maintaining a strong balance sheet. Specifically, that means complying with its debt covenants that require that its debt-to-long-term-adjusted-EBITDA ratio not exceed 3.5. As of the end of Q2, that ratio stands at 2.2, and according to Beneski:
"While we expect our leverage to increase by the end of the year, we believe that we will be within our covenants for the remainder of the year."
With its debt covenants seemingly secured for now, let's look at another important step management is taking to potentially prevent further payout reductions.
Cutting the fat
According to Emerge CEO Rick Shearer, the MLP is hard at work reducing its expenses in an effort to maximize profitability during this difficult industry downturn.
For example, it has laid off employees and negotiated lower trucking, transload terminal, and rail rates that kicked in during the first half of the year. In addition, Emerge is pushing off delivery of new rail cars until next year, as well as striving to eliminate idle rail cars in its system via subleasing.
It's also testing a new hydro mining technique that could potentially reduce frac-sand production costs by $2.50 to $3 per ton.
Takeaway: A combination of variable-pay MLP and the oil crash means more payout cuts may be needed
Investors in variable-pay commodity-based MLPs need to understand that such payout cuts -- and their commensurate unit price collapses -- are to be expected. While management can cut expenses to try to prevent further distribution reductions, in the end Emerge's payout is at the mercy of the oil markets.
Thus long-term investors need to be prepared for several more potential quarterly distribution cuts. However, If you believe as I do that America has a bright future in shale oil and gas production -- which means future frac-sand demand will probably soar -- take advantage of the price weakness caused by the chaos of crashing crude. Consider using the mighty power of dollar-cost averaging to bolster your position and await the eventual recovery in oil prices -- whenever that finally comes -- to potentially supercharge your diversified portfolio's long-term capital gains and income generating power.
Adam Galas owns units in Emerge Energy Services and leads The Grand Adventure dividend project, which recommends Emerge Energy Services. 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.