Why is This MLP an Opportunity for Investors?

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Devon Energy (NYSE: DVN), an independent oil and gas exploration company focused on U.S. and Canadian assets, is planning on spinning off its natural gas gathering and processing assets in Texas, Oklahoma and Wyoming into a midstream MLP (Master Limited Partnership) to be filed in Q3 2013 for an initial public offering contingent on market conditions.

Devon will be the general partner of the MLP, and Devon will use the proceeds, estimated at $300-500 million, to fund its own continuing operations.

Master Limited Partnerships

MLPs are “pass through” entities that don’t pay corporate taxes and pass profits directly to investors (shareholders) in quarterly and sometimes monthly distributions, therefore avoiding the corporate double taxation from normal dividends. These distributions are not taxed like a normal dividend--up to 80%-90% of the distribution is considered a return on capital of the initial investment in the MLP, and is therefore not immediately taxable. The other 10%-20% of the distribution gets taxed at regular income tax rates. This continues to reduce the cost basis until the units are sold or the cost basis drops to zero, at which point long-term capital gains/loss and/or regular income tax rates would apply. Taxes are deferred until investors sell their units.

MLPs in the oil and gas exploration and production industry can be classified based on the assets being spun-off. Upstream MLPs acquire oil and gas producing properties, making them more susceptible to commodity price fluctuation risk but capable of paying higher distributed cash flow (DCF). Midstream MLPs derive revenues from the transportation of the fuel through pipeline assets and pay out a more conservative DCF due to the lower risk. They are presumed to be more stable and aren’t materially affected by fuel price fluctuations. Downstream MLPs own the processing refineries and distribution assets like gas stations.

SEC Scrutiny into MLPs

On July 1, 2013, the largest upstream MLP, Linn Energy, LLC (NASDAQ: LINE) and its spin-off, LinnCo (NASDAQ: LNCO), voluntarily disclosed information in a non-formal inquiry being conducted by the Securities and Exchange Commission (SEC) into LinnCo’s proposed merger with Barry Petroleum Company, the use of non-gap financial measures, and hedging strategy. This announcement sent shockwaves across the upstream MLP sector. Linn Energy and LinnCo shares collapsed over 30% from $33 to $20.14 and $37 to $22.82, respectively.

SEC informal inquiries are non-public and a preliminary step to determine if a formal investigation is warranted. Companies are left to their own discretion to voluntarily disclose at this stage. The market impact was dramatic on just the informal inquiry. While shares have recovered a majority of the losses, the market is waiting on eggshells for the SEC findings and if formal investigations will commence.

Upon further scrutiny, it appears that Linn Energy’s use of non-GAAP accounting may be more company than sector specific. One of the issues involves the cost of hedging against future fuel price drops, which involves using derivatives like put options. While Linn Energy reported the $583 million spent on derivatives to hedge against fuel price drops in their GAAP financials, they did not recognize it in their non-gaap DCF. Linn Energy proclaims the costs of derivatives as a capital investment rather than an expense. This has allowed Linn Energy to offset $0.50 per unit in order to cover last year’s distribution. According to HedgeEye, Linn Energy is the only MLP out of 30 that does this.

However, following the voluntary disclosure by Linn Energy of the SEC inquiry, unrelated MLPs saw their stock prices collapse 20%-30% indiscriminately. Atlas Resource Partners, LP sank from $22 to $18.30. Brietburn Energy Partners, LP sank from the $18.50 to $14.01. QR Energy, LP sank from $17.70 to $14.72. While shares managed to rebound partially, the sector hinges on whether or not the SEC will proceed with a formal investigation.

Investor Sentiment Tipping Point?

It will be prudent for investors to look into Devon’s MLP registration statements carefully in respect to its accounting and hedging strategy. More importantly, the landscape for the MLP sector could be in jeopardy depending on how the SEC proceeds.

Linn Energy could be a cautionary tale moving forward for MLPs. Many Linn Energy investors are trapped underwater. having held shares long term to take advantage of the deferred tax benefit. This could backfire if Linn Energy collapses further, as short sellers make the case that Linn Energy is fairly valued in the single digits under GAAP accounting rules.

Bears contend that high-yielding MLPs operate in an unsustainable pyramid model. The need to continually make acquisitions, accumulating more debt to offset quickly-depreciating asset bases in order to maintain growing distribution payments, are a formula for disaster. As the largest upstream MLP, this could be disastrous for the whole sector.

Devon’s planned registration for their midstream MLP is contingent on market conditions. These conditions can be affected across the entire sector by the SEC’s actions, justified or not, which could warrant heavier regulations down the road. Investor confidence plays a major role in these market conditions, and any further shockwaves could be disastrous for the oil and gas MLP sector. 

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Mike Thiessen has no position in any stocks mentioned. The Motley Fool owns shares of Devon Energy. 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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