Is This MLP Spending Your Money Well?
Peter is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
The Upstream MLP group provides some compelling yields. Four in particular stand out with near double digit yields: Breitburn Energy (NASDAQ: BBEP), QR Energy (NYSE: QRE), LRR Energy, and Memorial Production Partners. These last three are newcomers to the stage. All three provide plenty of cash for investors, but little, if any track record. There’s just not much to go on. That’s why yields are so high. How safe are they as investments? It’s easy to just focus on the distribution, but in the long run other fundamentals are just as important; particularly with young partnerships. Ultimately, disciplined growth through acquisition is critical for any MLP’s long term success. When you buy their units, you’re buying their reserves. The price they’ve paid is important. Let’s take a look at how well they’ve spent their investors’ money, starting with QR Energy.
Upstream MLPs produce oil and natural gas, aiming for low risk, predictable development projects. A large component of their steady performance comes from hedging, making them a favorite with income investors. However, this conservative, development-centered business model is incompatible with organic growth, making Upstream MLPs highly dependent on acquisitions for long-term growth. With these new partnerships, we lack a solid track record of managements’ ability to identify, price and close on acquisitions. How well they buy barrels in the ground is important. To be fair, none of the three are totally new operations. All three spring from experienced energy sector Private Equity. Yet, the relationship between an MLP and their General Partner (GP) is an equally critical factor. An experienced sponsor isn’t an advantage if they fail to pass well-priced deals to their limited partners. This intangible isn’t well established with these new MLPs.
The table below gives a look at operating statistics, current valuations and yield for a segment of the upstream group. All three recent entries have tempting yields. Given sufficient DCF (distributable cash flow) coverage, it’s tempting to just focus on the cash with MLPs and dismiss other fundamentals. That simple focus is more appropriate with proven operators, though. This is just the beginning of the road for these three. What comes later is too much of an unknown. MLPs are geared for growth. Acquisitions will continue, and it’s highly unlikely that operations and capex budgets will be similarly sized five years from now. How well they’ll manage their cash through that growth is an unknown. We need to look elsewhere for hints at management quality and future success.
Quantum’s still a puppy in just its second year of operation. Yet, growth has been rapid. Production was a mere 5.4 MBOEd (thousand barrels of oil equivalent per day) at inception, and stood at 14.5 MBOEd in Q2 (a 64% CAGR). That’s already half of Breitburn’s production and a seventh of juggernaut Linn Energy's (NASDAQ: LINE). Strong growth was driven by asset “drop-downs” from their sponsor, Quantum Resource Funds (more on those later). As a result of these drop-downs, they have the largest reserve base of the triplets.
Not surprisingly, they also carry the highest Enterprise Value (EV) and debt. Their valuation seems fairly high on a reserve basis ($21.29 of EV per BOE), as they’re considerably more expensive than two of their senior peers (Breitburn and Linn). That premium may be justified though, given their richer liquids content (see Table). Legacy (NASDAQ: LGCY), which has an even higher liquids percentage, is pricier on a reserve basis.
So far, all sounds good. Yet, digging a little deeper suggests that part of QRE’s high valuation might result from overpaying for some reserves. Reserves are inventory and it’s tough to make money when you overpay for inventory. Evidence of discipline in acquisitions is an important element. Have they been spent their investors’ money well?
Lately, the answer’s definitely yes. Their recent buying performance is actually promising. In April, QR Energy purchased oil and gas assets totaling 13.3 MMBOE from Prize Petroleum for $225 million ($16.92 per BOE). For comps on deals, I think it’s simplest to just look at the competition, and no one in the MLP arena provides a more aggressive comp than Linn Energy. Linn’s 2011 acquisitions averaged $19.88 per BOE. That’s a good comp for QRE. Score one for equity holders. The other recent acquisition was a drop-down that occurred in October of 2011.
Drop-downs are acquisitions sourced from an MLP’s sponsor. Last October, QR Energy’s sponsor dropped down 37.1 MMBOE of assets to the partnership at $15.55 a BOE. Again, that’s a pretty good price. The bulk of these assets were oily Permian acreage, and Linn paid an average of $17.05 for its Permian Basin acquisitions in 2011. It’s a good sign that the sponsor’s dropping assets down at a good price. Given the captive nature of the limited partner, it’s easy for them to get a bad deal forced down their throat. Score two for good corporate governance.
The trouble is that going back to the IPO, the sponsor owed unit holders a good deal. A game that they played at inception was lost in the shuffle. Quantum Resources dropped down 30.4 MMBOE of reserves in exchange for $300 million in cash raised from the IPO, $225 million in assumed debt, and a great big sweetener. Hiding in plain site were an additional 11.3 million QRE partnership units and 7.1 million subordinate units that went to the sponsor. Since the IPO went off at $20, the deal mushroomed out to $894 million or $29.41 per BOE dropped down as a result of those extra units. Compare that to Linn’s average 2010 Permian purchases at $14.54 per BOE. That’s a whopping 100% premium for that IPO drop-down.
Worse yet, those common units were dumped by Quantum Resources in a secondary offering this August. Secondary offerings are a fact of life for MLP holders. They’re frequently used to raise capital for acquisitions or large scale development capex. This one however, did little more than facilitate a convenient large scale exit for Quantum Resources. Apparently the market wasn’t amused, since the secondary preceded a 3 month tailspin to $16 that’s only recently been undone.
Reportedly, an additional drop-down is likely to occur in early 2013. We’ll have to see who shows up. Will it be the good Quantum or the bad Quantum? When that next drop drop-down occurs, keep an eye on its pricing and the fine print. With MLPs it’s always tempting to focus only on the cash, but losing track of those reserves is a mistake. In the long run, the MLPS that buy assets better should outperform those that aren’t disciplined in pricing their acquisitions.
JustMee01 has a position in Linn Energy. The Motley Fool has no positions in the stocks mentioned above. 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.If you have questions about this post or the Fool’s blog network, click here for information.