Source: KNOT Offshore Partners.
Oil prices recently hit an 11-year low, which has sent many energy stocks, including shuttle tanker MLP KNOT Offshore Partners (KNOP -0.59%), falling to all-time lows and sending their yields sky-high -- in this case, 15.5%.
Yet such periodic market crashes can offer superb long-term income investing opportunities if the underlying business model of a company can continue to generate strong and predictable cash flows that results in a sustainable payout.
To illustrate why this is probably the case with KNOT Offshore Partners, let's look at a few key management comments from the company's most recent earnings call to see why this MLP could prove to be one of the best high-yield dividend stocks of 2016 and beyond.
Wall Street is overly pessimistic about the shuttle tanker industry
Investor perception seems to be that the shuttle tanker demand will vary with crude oil prices and the resulting appetite for offshore drilling, they perceive charter rates will come under pressure if the low oil price persists. Perception is not reality. --CEO John Costain
While it's true that low oil prices could hurt global offshore drilling demand in the long term should they remain very low for many years, investors' fears regarding short-to-medium-term charter rate declines for this niche tanker market fail to take into account one important fact.
Deep sea oil projects take several years to bring online, and even though oil companies have slashed their capital budgets in 2015 and 2016, new offshore projects -- for which investments have largely been completed -- are likely to continue driving strong demand for shuttle tankers over the next few years.
In the North Sea, where 40% of KNOT Offshore's tankers operate, Statoil (EQNR -0.04%) is continuing with a $7 billion oil project and considering a second. Together these two projects have the potential to employ five additional shuttle tankers alone, each under lucrative long-term contracts.
Meanwhile, offshore Brazilian oil projects have a breakeven price of around $40 per barrel. That's low enough for BG Group -- which Royal Dutch Shell (RDS.A) (NYSE: RDS-B) is acquiring -- to have signed long-term contracts for three of KNOT Offshore's five potential dropdown candidates.
Midstream MLP business model
KNOT Offshore Partners LP is, in essence, a midstream mobile pipeline business, with fully contracted revenue streams and ... before ordering a new vessel, KNOT Offshore will always agree a long-term employment contract for the vessel, there is no speculative ordering, so our MLP will yield both stable and sustainable revenues. -- Costain
Source: KNOT Offshore Partners investor presentation.
KNOT Offshore's current yield implies a substantial short-term threat of a distribution cut yet its distribution coverage ratio of 1.07 shows that it may be sustainable. What's more, its distributable cash flow is secured by contracts with an average remaining length, including extension options, of 8.3 years.
In addition, the companies KNOT Offshore does business with are hardly some fly by-night operators but instead some of the world's largest oil giants, such as Statoil, ExxonMobil, and Shell. The strength of these counterparties means that contract defaults are very unlikely and yet another reason that this MLP's high yield is, in my view, unjustified.
No short-term liquidity problems
[We] were pleased to announce the purchase of Ingrid Knutsen from our sponsor for $115 million. Originally delivered to the charter by our sponsor Knutsen NYK in December 2013, the vessel is on a 10-year time charter to Standard Marine Tønsberg AS, a Norwegian subsidiary of ExxonMobil...We financed the acquisition by the assumption of $104.5 million of outstanding indebtedness and cash in hand. The partnership has since repaid $27 million on closing of the acquisition. Today, we have an aggregate of $77.5 million of secured debt related to Ingrid Knutsen. -- Costain
I point out this quote to highlight the importance of debt funding to KNOT Offshore's continued growth in this market environment. With the unit price so low, debt funding is pretty much the only way for the MLP to acquire the five dropdown candidates in its sponsor's dropdown pipeline.
However, just because an MLP has continued access to debt markets doesn't mean its balance sheet is strong enough to support continued borrowing until a recovery in oil prices makes equity financing possible again.
The good news for KNOT Offshore Partners is that its current debt load of $610 million is entirely in the form of senior secured term loans, and not from a revolving credit facility, whose debt covenants could threaten its ability to continue paying distributions.
In addition, the MLP's cash balance of $67 million is large enough to cover the cost of the $56 million in debt coming due through 2016, meaning that the KNOT Offshore shouldn't have too many short-to-medium-term problems servicing its debts.
Bottom line
The simple fact is that KNOT Offshore's long-term, fixed-price contracts grant it a midstream business model that means its distribution is largely insulated from short-to-medium term oil prices. This is why, in my opinion, Wall Street's absurd valuation of this MLP makes it one of the better hidden long-term income opportunities of 2016.
