With Friends Like These, Who Needs Enemies?

Peter is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

The MLP universe has three recent upstream additions that are an interesting option for income investors, but people need to be careful they understand the risks in what they’re buying.

Yields of LRR Energy LP (NYSE: LRE), QR Energy LP (NYSE: QRE), and Memorial Production Partners (NASDAQ: MEMP) are tempting. Double-digit yields are rare in any market. In this yield-starved market, they’re almost impossible to uncover. Those high yields suggest a lot of risk, and investors would be wise to take notice. These three sponsored MLPs are built a little different than some of their peer group. This difference from top peers like Linn Energy (NASDAQ: LINE) and Legacy Resources LP (NASDAQ: LGCY) produces some unique corporate governance issues.

Unlike other peers that hunt for acquisitions on their own, all three of these new MLPs are "sponsored" by private equity groups. That has some advantages that management likes to point out. It also has some potential detractions that management avoids pointing out.

It’s comforting that the sponsor has a ready and waiting pile of assets that can be fed, or "dropped-down" to the Limited Partner at will. This knife cuts both ways, though. Since the sponsor controls the General Partner that manages the LP, these drop-downs come at the will of the sponsor. If the deals aren’t fairly priced, this relationship becomes less of an advantage and more of a problem. There’s a potential conflict of interest inherent in the structure.

LRR Energy is only a year old. It’s had a tight coverage ratio in its short life, and that’s concerning. With MLPs, it’s all cash flow. They give you the cash they bring in, minus expenses. An MLP’s distributable cash flow (DCF) is far more important than any traditional metric. DCF is the quarterly cash flow (EBITDA), less maintenance capex required to keep the oil flowing. It excludes any capex required for growth. You want to see DCF growth on a per share basis.

The distribution coverage ratio is equally critical. It’s the ratio of the distributable cash flow (DCF) to the distribution itself. In essence, it’s the wiggle room that the partnership has to cover what it pays to you, the unitholder. The better partnerships seek to keep it at 1.1 or higher. In Q2, LRE’s coverage was 1.06, and it’s ticked up nicely to 1.14 due to a recent drop-down from their sponsor, Lime Rock Resources. That’s the advantage of a sponsor. When short on cash flow, the partners can count on a little help from above.

The drop-down provides some much needed production. What it doesn’t provide is a suitable long term solution. The proven reserves transferred are too small and the price is too big. LRE paid Lime Rock Resources $67 million for the bolt-on acquisition. Production was only 765 BOEd (barrels of oil equivalent per day), but every little bit helps as the improved coverage ratio indicates. The bulk of the drop-down was also in the oily Permian Basin, and reserves were 83% liquids. Mostly liquid acquisitions are nice in this horrible natural gas pricing environment.

The problem is the cost on a reserve basis. The drop-down adds only 1.73 MMBOE (million barrels of oil equivalent) in proved reserves. At a $67MM cost, that’s $38.73 per BOE in the ground, a very high price. When looking for a comp on an acquisition, I think it’s easiest to look to peers for pricing, and no one provides a more aggressive comp than Linn Energy. Linn operates overlapping properties and has the same focus on mature, long-lived production assets. More to the point, Linn is very active and very disciplined in its acquisitions. Linn’s always in the market and does not overpay.

Looking to Linn for a comp suggests LRE Energy badly overpaid. Linn made two Permian acquisitions in 2011, averaging $17.45 per BOE. That’s less than half of what LRE’s sponsor charged its own partnership. In fact, Linn didn’t make a single transaction in the last year and a half that cost more than $26 per BOE. The $39 price LRR Energy paid their sponsor isn’t a positive sign for good corporate governance.

That highlights the inherent General Partner risk that exists in sponsored MLPs. In the case of all three of the new Upstream MLPs, the sponsors are private equity, and when it comes right down to it, the LP is a financing vehicle that the sponsor is using to monetize assets. The sponsors own the GP and call the shots. As a captive partner beholden to the decisions of the GP, you need to be keeping an eye on what you’re being forced to pay with any sponsored acquisition.

With only 6.5 MBOEd (thousand BOE per day) of production and only 31 MMBOE of reserves at quarter’s end, LRR Energy is definitely a lightweight. Therein lies the real problem. Growth through acquisition is necessary for any MLP to grow its distribution and that likely means more drop-downs from Lime Rock Resources. Investors need to be wary of the pricing of these future deals. A Big Brother just isn’t much of an advantage when he steals your lunch money.

JustMee01 owns units of LINE, but holds no financial position in any other companies mentioned above. 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.

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