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Insiders at Upstream Energy Partnership Defy Critics
By Michael Brush
Exclusively for InvestorIdeas.com
July 24, 2007
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Energy sector limited partnerships are up nicely since I suggested buying them three years ago (http://moneycentral.msn.com/content/P72085.asp).
They’ve done so well, in fact, that Wall Street has decided to roll out a new version of them – a version that has some critics scratching their heads.
Here’s the story. Several years ago, “master limited partnerships” (MLPs) in energy were used chiefly to house “midstream” operations like pipelines and processing plants. These fairly boring activities made MLP revenue streams -- and “dividend” distributions -- fairly predictable because the MLPs were essentially toll takers. They charged a fee for the oil and natural gas flowing through their systems.
Now, Wall Street has moved the whole MLP game “upstream” to house riskier exploration and production activities. Critics say this is a questionable move that could wind up hurting investors. Their chief complaint: At a time when elevated energy prices have created a bidding war for energy assets, how do these newfangled limited partnerships plan to compete and grow?
- Merrill Lynch (MER), for example, recently lowered its ratings on several MLPs, stating valuations “assume significant acquisition activity” which may be “misguided."
- Analysts at Morningstar caution that the upstream MLPs will bid up the prices on suitable long-life mature assets. Many of these assets are controlled by exploration and production companies which will want to spin them off into their own MLPs, anyway.
Ho, ho, ho
But insiders at one upstream energy MLP are saying ho, ho, ho. At Linn Energy (LINE), insiders were steady buyers for much of last year when the “units” of their MLP were trading 46% below current levels of $37. Then finance chief Kolja Rockov bought $936,000 more in mid-July, even though Linn Energy units had just jumped 13% to about $37.40.
What made Linn Energy units jump so much?
That would be news of Linn Energy’s huge $2 billion acquisition of oil and gas properties from Dominion Resources (DOM) on July 2. The purchase was one of those acquisitions that upstream energy MLPs weren’t supposed to be able to pull off.
Overnight, the move:
- Doubled Linn Energy’s proved reserve base to about 1.6 trillion cubic feet equivalent (Tcfe) of energy;
- Added over 2,500 producing wells in Oklahoma, the Texas Panhandle and Kansas;
- Layered on “significantly accretive” cash flow which will increase distributions per unit to $2.52 beginning in the fourth quarter, for a 6.8% yield at current unit prices.
“This is a transforming event for our company which demonstrates our ability to move quickly and take advantage of a remarkable acquisition opportunity,” Linn Energy chief Michael Linn said at the time of the acquisition.
The purchase looks smart, too, because the properties mainly produce natural gas. They are 93% natural gas and natural gas liquids, and 7% oil. Because of underlying production shortages in North America, natural gas prices should remain firm or go up in the medium term.
More to come
The fact that Linn’s finance chief bought such a big position after the price spike tells me insiders believe they can continue to make decent acquisitions – despite what critics say about upstream MLPs. The history of the company suggests the same thing. Consider these factoids.
- Linn Energy began operations in March 2003 and came public in an initial public offering in January 2006.
- From 2003 to 2007 the company made 17 acquisitions that brought in 4,246 wells, for about $1.1 billion.
- Total production grew 123% in 2006, and revenue from oil and gas sales grew 80% to $80.4 million -- after growing 129% in 2005.
- Proved developed reserves grew 150% last year.
- Revenue from oil and gas sales grew 139% in the first quarter compared to the year before, and adjusted cash flow grew 53%.
- Before the Dominion Resources acquisition, the company was projecting second half 2007 production would grow 30% -- not assuming any acquisitions.
Hedging, with upside potential
Linn Energy won’t be subject to the whims of energy prices because – at least before the recent acquisition -- it was almost fully hedged for 2007 and 2008, and “substantially” hedged for 2009 through 2011.
Before the acquisition, the company says it had about half its portfolio protected against downside through ownership of put options. These give the company the right to sell energy at a pre-agreed price no matter how low it sinks. This arrangement also leaves the company free to participate in much of the upside.
The company has put on additional hedges since the acquisition.
Linn Energy has assets in West Virginia, Pennsylvania, New York, Virginia, California, Oklahoma and Texas.
Risks
One risk is that the U.S. could revoke the tax break for MLPs. At a time when many energy companies are making record profits, resentment against tax breaks for energy companies is on the rise. Canada just changed the rules and made royalty trusts – similar to MLPs -- liable for traditional taxes as of 2011.
And since MLPs are income producing instruments – like bonds – they would get hit by rising interest rates.
The basics
If you are not familiar with MLPs, here are the basics.
- MLPs are partnerships that have to distribute virtually all of their cash to unit holders. Profits are not taxed inside the MLP. But unit holders have to pay their share of the partnership's income taxes, which can make filing taxes more complicated.
- Most MLPs offer attractive yields, often in the 5%-6% range.
- With MLPs, investors buy units of a partnership, rather than shares of a stock. But the units trade like stocks on the exchanges.
For more of the basics, see this piece I wrote on MLPs in 2004: http://moneycentral.msn.com/content/P72085.asp.
The bottom line : If you need income-producing investments and you can stand the extra paperwork at tax time, Linn Energy looks like an upstream MLP that might be right for your portfolio.
Disclaimer
At the time of publication, Michael Brush did not own or control shares in any of the companies listed in this column. Mr. Brush is an independent columnist for this web site.
For more on Insiders Corner disclosure, see the disclosure section in About Insiders Corner: http://www.investorideas.com/insiderscorner/. InvestorI deas.com Disclaimer: www.InvestorIdeas.com/About/Disclaimer.asp . InvestorIdeas is not affiliated or compensated by the companies mentioned in this article.
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