How Safe is this Best-of-Breed Upstream LP's Distribution?

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A peek at the Upstream MLP group reveals some striking yields.  With interest rates so incredibly low, everyone out there is yield starved making these high yielders even more interesting.  On the flip side, in an election year with the potential for tax changes looming, it may not be an ideal time to test the political waters.  Nothing’s worse than a tax-advantaged investment gone bad.  It’s not hard to envision getting trampled in the mad rush to get out, given a change in the group’s tax status.  Three of the more established Upstream MLPs, Breitburn Energy Partners (NASDAQ: BBEP), Legacy Reserves LP (NASDAQ: LGCY) and Linn Energy LLC (NASDAQ: LINE) present an opportunity for decent yield in this poor yield environment.  How safe are those distributions, though?  Surprisingly, arguably the strongest of the bunch, Linn Energy, hit a slick patch and they’ll need some drilling success in Q3 to reverse the trend.

Technically, Linn isn’t an MLP since it lacks a General Partner, but for tax purposes you’ll get a K-1 and distributions will be tax deferred just like an MLP’s distribution.  The MLP universe is carved up into Upstream, Midstream and Downstream segments.  The Upstream MLPs produce oil and natural gas.  The Midstream MLPs transport product, and the Downstream MLPs refine.  Upstream MLPs are not however, your run-of-the-mill oil company.  They operate mature fields with heavily hedged production and slow decline rates, focusing solely on development.  These are low risk operations aimed at generating predictable cash flows and reliable distributions. . Yet, accidents can happen.  Investors need to be wary that yield is far from the only concern.  It’s not just what they pay that’s an issue.  It’s what they can pay that’s just as critical.

With MLPs, it’s all about tracking the cash.  Many MLPs report their distributable cash flow (DCF) on a quarterly basis.  DCF is simply the cash they take in that’s available to pass back to you.  In finance speak, it’s the quarter’s adjusted EBITDA less debt service cost, and maintenance capex.  Generally, that’s the capex required to keep current production flowing, not including capex for additional drilling or acquisitions.  Exactly what individual MLPs report as capex can vary; this is a non-GAAP number and there are no standards.  So, direct comparisons from one company to another can be apples-to-oranges.  Looking at historical trends for an individual company of interest though, is very informative.  It’s this cash flow you should be tracking.  Other metrics like earnings and PEs are relatively unimportant.

A few MLPs won’t directly provide DCF, instead focusing on DCF coverage in presentations.  That’s the ratio of DCF to the distribution; what they could pay divided by what they actually pay.  In general, a healthy MLP will cover its distribution at least 1.1 times with its cash flow.  All three of these companies actually aim higher.  The remainder serves as a cushion.  Lose the cushion, and you have to start worrying about a trim in distribution next quarter.  While infrequent, they can happen.  Breitburn’s history includes complete suspension of distributions in 2008 and 2009, likely the reason for their high yield.  The goal for most investors in this space is safe, repeatable yield.  Investors still wary of Breitburn are demanding higher compensation for greater perceived risk. 

That said, Breitburn’s problem was actually liquidity with their revolver in the credit crunch, not cash flow.  These are different times and BBEP’s coverage ratio is forecast at a healthy 1.2 to 1.3 times its distribution in the second half.  That’s actually plenty of wiggle room; more than their peers.  Legacy’s distribution coverage was about 1.2 in 2011, but tightened in the front half of 2012 to 1.05.  I’m not quite as concerned with their coverage ratio given their high percentage of liquid reserves (70% liquids; 62% oil).  They’re better set up to withstand this soft natural gas pricing environment with that much oil behind the bit. 

Surprisingly, it’s Linn Energy’s last quarter that had an unpleasant negative surprise for unitholders.  Historically LINE covers their distribution over 1.1x, but that unraveled last quarter.  Linn’s had a strong history of distribution growth.  The credit crunch caused a pause in that growth, but Linn resumed its hikes in the fourth quarter of 2010.  In fact, Linn’s raised their distribution every third quarter since then, with the last raise occurring in Q1 of 2012.  It’s this last move that looks a little bit premature in hindsight.  Linn shifted operations to “wet” gas properties in the Granite Wash in 2012, with the intention of using natural gas liquids from these wells (NGL) to offset weak natural gas pricing.  NGLs are larger alkanes like propane and butane found in some natural gas that normally fetch a much higher price than “dry” gas, which is mostly methane.  Unfortunately, everyone else is emphasizing wet gas properties and NGL pricing dipped dramatically in Q2 on rising supply.  Uncharacteristically, Linn got caught with their pants down and didn’t cover their distribution fully in Q2; coverage fell to 0.97 times DCF (see Figure).  That’s not a problem short term, since Linn has ample liquidity.  It can of course become a problem if it persists long term. 

 

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To compensate, they’ve adjusted their current Granite Wash drilling from wet gas zones to the Hogshooter formation in western Oklahoma.  The Granite Wash is a play in the panhandle region typically associated with tight gas formations, but certain strata like the Hogshooter contain sizeable oil reserves.  LINE had already earmarked a large amount of their 2012 capex for the Granite Wash, since they had a ready inventory of wet gas prospects.  With the collapse of NGL pricing, they’ll now shift focus from wet gas zones to oil-bearing Hogshooter pay zones to boost cash flow.  New Hogshooter wells are anticipated in Q3 that should correct the coverage shortfall.  Unitholders would be wise to keep a close eye on Linn’s Hogshooter progress.  Guidance is for 20 wells in the second half with a planned average initial production of 1,700 Bbls/day of oil to fill that DCF gap.  That seems like a conservative bet, given that initial production from the three wells drilled in Q2 averaged 2,500 Bbls/day.  Still, performance in the Granite Wash both in well count and production bears watching.  Any further slip and a trim could be necessary. 

With an Enterprise Value sitting at 14 times 2011’s EBITDA compared to multiples around 9 times for Legacy and Breitburn, Linn’s valuation appears rich.  You pay a premium for best in breed.  Surprisingly though, LINE's distribution coverage is the weakest of the three; Breitburn and Legacy appear okay on that front.  Continued weakness in Linn's coverage could lead to a distribution cut if Linn can't improve their DCF through new drilling.  Any trim should lead to a pullback in LINE's premium.  Alternatively, there's the danger that they'd pull from their revolver to support the distribution; an unhealthy solution, to say the least. Investors get a better yield from BBEP, and LGCY is interesting because it’s oilier.  Despite that, LINE still remains the gold standard for the group with investors.  Their track record of strong growth is hard to dismiss and they’ve recently been on an acquisition binge, meaning lots of potential for growth down the road.  Just watch that coverage ratio.  For now, all focus appears to be on the Granite Wash for LINE unitholders.


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