oil/energy transmission pipeline investments - opinions?

[cowboyinasia]

Recently Money or Kipplinger's ran an article discussing where to find good yields now that interest rates are low. Towards the end of the article, where yields were trending up, they suggested the idea of oil and energy pipeline transmission companies. The reasoning being
- their business is very stable, yet expected to trend upwards
- they yield attractive dividends

If I recall, yields around 8% to 10% were mentioned, which is good enough for me!

A little research today yielded some names:
Kinder Morgan (KMG) (now 6.2% yield, 5 year average)
Energy Transfer Partners (ETP) 5 year div yield of 6.0%
Buckeye Partners (BPL) 5 year div yeild of 6.3%
Tortoise Energy Infrascture (a fund?) (TYG) yield 14.2%
Energy Income and Growth Fund (FEN) yield 9.3%

Over the past couple of decades I've stayed 85% to 90% in equities, with the rest is cash (except for my flat now being rented out). Now, at 43 years old I want to diversify into some fixed income or high dividend investments, but with interest rates so low, and an eventual interest rate increase destined to hurt bond prices (it may take a while, but I believe it will happen at some point) I would like to consider other, safe, vehicles. Surely other opportunities exist, which may be lucrative, even if not as common or simple as bonds or bond funds.

Does anyone have any opinions, experience, or suggestions on oil and energy transmission pipeline stock, companies, or funds?


Thank you in advance.

[alvinsch]

I own 12 energy mlps, 8 midstream (pipelines) and 4 E&P mlps. If you want to learn more about these I'd strongly suggest you check out the InvestorVillage mlp group:

http://www.investorvillage.com/smbd.asp?mb=5028&pt=m&d=-1&r=&pm=&nh=25

But equally important would be to join the yahoo mlp_research groups where research reports and primers from the major brokerage houses are posted and you can learn alot about the differences. The mlp_research4 contains general research on the industry while mlp_research and mlp_research2 contain research report on specific mlp's.

http://finance.groups.yahoo.com/group/mlp_research4/

FWIW: I own the following energy mlps:

Midstream:
- no IDR gatherers and processors: MWE, CPNO
- GP's: EPE (GP for EPD and TPP), MGG (GP for MMP)
- interstate pipelines: NS, PAA, EEQ, KMR
E&P: LINE, VNR, BBEP, CEP

Hope this helps.
- Al

[soaring]

Below is a boglehead link where Alvinsch discusses MLP's in detail. It helped me with the basics when I was researching MLP's. Scroll about halfway down the thread to find the info.
gene

viewtopic.php?p=253045&highlight=

[Curtis Lowe]

run a search for "alvinsch" as the author. there are numerous threads where he has given wonderful information...run a search with me as author and you will find a thread or two where alvinsch and some of the other well informed MLP investors provided great info..good luck..

[living for dividends]

Recently Money or Kipplinger's ran an article discussing where to find good yields now that interest rates are low. Towards the end of the article, where yields were trending up, they suggested the idea of oil and energy pipeline transmission companies. The reasoning being
- their business is very stable, yet expected to trend upwards
- they yield attractive dividends

I was very tempted to invest in these assets - they look to be a dividend investors dream.

I have read that some of the energy MLPS or LPs have tended to have price / earnings declines when energy was rising because they tend to purchase crazy amounts of options / futures against gas / oil.

Some of these firms has made crazy bets that have come to bite them in the ass. Some of the firms have made bets on volumes of gas/oil that were larger than their annual production.

I get the impression that many MLPs/LPs operate like hedge funds. I want a good steady dividend payor. I do not want to speculate.

What does Swedroe, Ferri and the other gurus out there know about this risky behavoir of MLPs/LPs ??

Thanks in advance

[dbr]

Larry's new book on alternative investments may contain some analysis. Perhaps someone can remind of the content.

[alvinsch]

I have read that some of the energy MLPS or LPs have tended to have price / earnings declines when energy was rising because they tend to purchase crazy amounts of options / futures against gas / oil.

Some of these firms has made crazy bets that have come to bite them in the ass. Some of the firms have made bets on volumes of gas/oil that were larger than their annual production.

I get the impression that many MLPs/LPs operate like hedge funds. I want a good steady dividend payor. I do not want to speculate.

This is probably the most misunderstood part of the E&P mlps (which are definitely more risky than the midstream pipeline mlps). They purchase mature oil/gas fields for their long and predictable life. They then usually hedge 70-100% of the production of these fields out for 3 or 4 years to dramatically lower their risk and increase their ability to maintain a steady dividend. In many cases, the banks they have borrowed from actually require them to have these hedges in place to better secure the loans.

However, since these mlps have to mark to market their hedges, you will see large swings in earnings/losses because if prices soar they will show huge paper losses but it basically has no affect on their cash flow as they are offset by the higher selling price for their oil/NG. It just allows them to purchase future hedges more cheaply. Likewise if oil/NG prices crash then they will show huge earnings gains but it has virtually no affect on their cash flow in this case either because they will be selling the oil/NG for less. So most people value these on price to distributable cash flow or NAV based on discounted future distribution assumptions as P/E is pretty meaningless in their environment.

Now it is certainly possible for mlps to screw up and there was one case of the private GP of one of these E&P mlps (Semgroup), speculating on the market and going bankrupt. However, in the E&P mlp world, many of them are actually LLCs without GP's (LINE) or the GP's have no IDR rights so they are essentially the same entity (BBEP, VNR, etc.).

There was also a case of fraud (embezzlement?) in one small E&P as the CEO (QELP) was caught siphoning off funds but isn't that a risk in all small / microcaps? One has to do the research if one is going to buy individual companies and understand the risks. That is why I strongly recommend following the websites I mentioned previously as their are some extremely knowledgeable people over there that do the financial analysis on these companies.

Hope this helps.
- Al

[living for dividends]

This is probably the most misunderstood part of the E&P mlps (which are definitely more risky than the midstream pipeline mlps). They purchase mature oil/gas fields for their long and predictable life. They then usually hedge 70-100% of the production of these fields out for 3 or 4 years to dramatically lower their risk and increase their ability to maintain a steady dividend. In many cases, the banks they have borrowed from actually require them to have these hedges in place to better secure the loans.

Now it is certainly possible for mlps to screw up and there was one case of the private GP of one of these E&P mlps (Semgroup), speculating on the market and going bankrupt. However, in the E&P mlp world, many of them are actually LLCs without GP's (LINE) or the GP's have no IDR rights so they are essentially the same entity (BBEP, VNR, etc.).

Hope this helps.
- Al

It ssure does help, Al.

I am seeking a stable dividend. What is better for me:
1. E&P mlps ..or..
2. midstream pipeline mlps

Is it better to pick an MLP that does NOT have a GP ?

Also, is it better to hold these MLPS
1. in a taxable account or
2. a sheltered account?

[alvinsch]

It ssure does help, Al.

I am seeking a stable dividend. What is better for me:
1. E&P mlps ..or..
2. midstream pipeline mlps

Is it better to pick an MLP that does NOT have a GP ?

Also, is it better to hold these MLPS
1. in a taxable account or
2. a sheltered account?

I wouldn't presume to know what is better for your situation but would suggest the following.

Midstream mlps are paying in the 8-12% range now with expected distribution growth on top of that in the 5-15% range. Since these are mostly fee based services their businesses are relatively stable, not very tied to the price of energy and have tradionally, until lately, had much lower betas than the market in addition to low correlation to other stocks (similar to REITs?).

E&P mlps are paying in the 15-25% range but have much more limited opportunities for growth, especially with the tight credit conditions. Some paying near 25% may be running at a 1:1 distribution coverage ratio so they probably aren't drilling sufficient new wells to maintain that rate while many paying in the 15% range probably will have low single digit growth over the next ten years.

So it depends on whether you just want a stable income stream (midstream) or also want some hedging against possible higher energy prices over the next decade (E&P).

Whether it is better to own a mlp without a GP is a very complicated question and I'm sure I won't do justice to the question but I'll try to point out some of the issues.

Most GP's receive incentive distribution rights (IDR's), such that for each additional dollar in cash flow the LP receives, the GP receives up to half of it. This can ultimately become a big drag on the growth opportunities for the mlp because it makes it much harder to find deals that will be accretive to the bottom line once the GP's cut is considered. The idea of the IDR, besides making the GP sponsor rich, is to provide incentive for them to growth the business. However, it also limits the growth opportunities. So in theory, IDR's constrict growth but there are some mlps like kinder morgan (KMP/KMR), where the GP is deep into the 50% cuts but they have no problem growing 10% per year anyway. In other cases a well capitalized GP will provide funding for purchases in difficult market times like these so it can vary greatly between LP/GP combinations. Having said all that, I do prefer low or no IDR mlps or the GP's themselves.

Almost all midstream mlps eventually will get to 50% IDRs but there are a handful of exceptions. EPD (enterprise) and TPP (Teppco) have a GP (EPE) that has limited IDRs to a maximum of 25%. This is also true of Nustar (NS). There are now two midstream partnerships in the gathering and processing area (G&P) that have no IDR's. Markwest (MWE) which is a mlp with no IDR's and Copano (CPNO) which is structured as an LLC.

The other consideration you have to make is that many mlps have public GP's so one can buy the GP and participate in leveraged growth over the LP's. In most cases the distribution will grow more than twice as fast for the GP than the LP so the GP's normally trade at a lower yield (1 or 2% lower than LP). However, with all the turmoil in the markets some GP's have been yielding almost the same as the LP's which is hard to reconcile. At this point I'd favor some of the GP's (I do own two GP's EPE and MGG).

In the E&P world, most of the mlp's have GP's with low or no IDR's. For example, LINE is a LLC with no IDR's but gives out lots of internal employee options, while BBEP and VNR are mlps with 0-2% IDR's.

The primary advantages of mlps is realized by holding them in a taxable account as 70-100% of the distribution is tax deferred until your basis is reduced to $0. This advantage is wasted in an IRA/401k and further many mlps throw off something called UBTI which means part of the income in the IRA may become taxable. I have no direction knowledge of the implications of this other than what I've read which is that UBTI is far to ugly to risk putting mlp's in a IRA.

However, if you want to have mlp exposure in a mlp/401k then you have two choices. Either buy an mlp mutual fund or buy the two mlps that offer what are called ishares (KMR and EEQ) where the distributions are rolled back into additional shares avoiding any messy tax issues. These are also an alternative for taxable accounts if you don't want to deal with K1's at tax time.

As I've noted the real experts are on the other forums and you'll get better explanations reading the primers on yahoo but hopefully this will get you started.

- Al

[stratton]

However, if you want to have mlp exposure in a mlp/401k then you have two choices. Either buy an mlp mutual fund or buy the two mlps that offer what are called ishares (KMR and EEQ) where the distributions are rolled back into additional shares avoiding any messy tax issues. These are also an alternative for taxable accounts if you don't want to deal with K1's at tax time.

There are several corporate ones too. Most appear to be GPs:

XTXI
SE
OKE
EP
TRP (Canadian)

Paul

[larryswedroe]

My book does not cover MLPs

could not cover everything, and no real low cost effective way to own this stuff--see next point

They, at least the infrastructure plays, have some interesting characteristics, but hard to get rid of the unsystematic risks, which I don't like taking

And right now they are being thrown under the bus with everything else--meaning getting hit by flight to quality. They may even be cheapest ever been now.

We are actually looking at a way to see if it can be done in diversified manner with reasonable costs--problem is the pain in the neck with taxes on all the K-1s.

[HueyLD]

...problem is the pain in the neck with taxes on all the K-1s

This is a real problem with lots of investors/taxpayers who got into MLPs without knowing the potential tax issues. The tax accountants love them because of the above average revenues associated with preparing tax returns for those with MLPs.

However, AlvinSch appears to know how to deal with both the investment and tax issues associated with the MLPs. So MLPs probably work well for him. As with every investment, if you don't know what you are getting, don't buy it.

[stratton]

We are actually looking at a way to see if it can be done in diversified manner with reasonable costs--problem is the pain in the neck with taxes on all the K-1s.

The problem is they can be as late as June (?) and are expensive to handle. Either invest in one item with a K-1 to keep it simple or get alot of them with a high enough payout to make it worth the expenses.

There are currently three ways to duck the K-1s.

1. Buy corporate versions or institutional shares. I think there is about 10 corporate versions out there.

2. The Bear Stearn Alerian MLP ETN (BSR). The risk is its an ETN. Since its now owned by JP Morgan Chase and they are too big to fail (?) it might be viable. The ER is a high 0.85%

3. Buy a closed end fund with an ER 0.97 and up and they have ~35% leverage. There appears to be corporate governancd issues here. Tortoise was issuing daily press releases last week over ratio compliance. They also had a propensity for issuing more shares to the detriment of existing shareholders. Kayne Anderson funds are more expensive (~1.35% ER and leveraged), but appear to be more shareholder friendly. The ones with MLP emphasis such as KYN pass through 90+ percent of the return of capital you'd have with an MLP without the k-1.

Larry, a suggestion for a fund. Since "real" mutual funds can't contain more than 25% in partnerships (?) an "index" could be formed by using corporate and institutional shares for 75% of the fund and the other 25% filled with actual MLPs for the smaller firms. The larger 75% could be weighted by the corporate market weight and their MLP weights together, but only represented by the corporate and institutional versions.

Paul

[cflannagan]

...problem is the pain in the neck with taxes on all the K-1s

This is a real problem with lots of investors/taxpayers who got into MLPs without knowing the potential tax issues. The tax accountants love them because of the above average revenues associated with preparing tax returns for those with MLPs.

However, AlvinSch appears to know how to deal with both the investment and tax issues associated with the MLPs. So MLPs probably work well for him. As with every investment, if you don't know what you are getting, don't buy it.

Like myself for example. The complexity was enough to scare me out of about 6 MLPs I bought, without knowing what I really was getting into.

I don't know if this is the kind of thing that could be simplified with better tax code.. maybe if they simplify it enough, I could get interested in MLPs again.

[larryswedroe]

Paul

Pain in neck and not enough diversification as far as I am concerned

Too bad as asset class has some interesting characteristics

[stratton]

Paul

Pain in neck and not enough diversification as far as I am concerned

Too bad as asset class has some interesting characteristics

I'm thinking about that too. I'm currently reviewing everything in my asset allocation and 5% play money fund. I'm like WBern in that I'm an asset junky, but it can be a pain.

Paul

[cowboyinasia]

Thanks All, for the comments and links. This helps me understand them better, and more importantly know more about what I do not know. While they still sound promising if I can get a handle on them, I realize that I need to gain some better knowledge first before I do anything . . . .

[alvinsch]

Regarding tax difficulty of K1's.

I dealt with K1's for almost 20 years as in the early 80's I was "sold" several RELP's by my broker when I was first starting to invest. I admit I dreaded those stupid things every year because it was only for a few dollars and it was a constant reminder of my ignorance/stupidity for buying into a non-publicly traded investment. There was no escape and I'll never buy into a non tradeable investment again.

While I only bought my MLPs this year so I haven't gone through their K1's yet, everything I've read on the forums says they are much easier now days as everything can be entered directly from the K1 into Turbotax (or Taxact), and it does all the calculations and interactions with other forms. Also most mlps appear to have online access where one can download their K1 as soon as they are available. Obviously can't attest to this directly but I've read articles saying the mlps have dramatically improved their turnaround time on the K1's so usually one can file by April 15th. However, I'll let you know what really happens next spring on my 11 K1's (10 energy plus 1 timber, EEQ and KMR are ishares so no K1).

However, my understanding is that the worst tax situations are if you want to sell only a portion of a holding in which you bought at several different times/prices. Evidently because you are a direct owner there are no separate lots but it is considered one single holding. But since early lots received more distributions than later lots, and these reduce your basis it gets really messy alloting the basis correctly if you sell only a portion of your holdings. My plan is to either only sell the entire holding at once or assume they were bought at the same time since I'm not planning on buying a holding across multiple years.

I agree diversification is an issue. Which is why I decided that having 8 midstream and 4 E&P would give me adequate diversification for an investment making up a maximum of 10% of my portfolio (i.e. no single company greater than 1% of portfolio).

I don't really see the point of buying C-corps in this area because that negates the primary benefits of a mlp, in that as a pass through entity they don't pay corporate income tax. That's the reason many of these mlps were spun off from corporations in the first place and why they have much higher yields. Also I assume you don't get the tax deferral either on the distributions as the C-corps dividends would be fully taxed.

Definitely agree these aren't for everyone but for those with limited tax advantaged space, they allow one some real asset diversification with usually low correlation to S&P500 and bonds (similar to REIT diversification).

Caveat Emptor
- Al

[Wagnerjb]

This is probably the most misunderstood part of the E&P mlps (which are definitely more risky than the midstream pipeline mlps). They purchase mature oil/gas fields for their long and predictable life. They then usually hedge 70-100% of the production of these fields out for 3 or 4 years to dramatically lower their risk and increase their ability to maintain a steady dividend.

I suspect this can be a misleading issue for investors. They see a high current yield, and naively assume it will continue indefinately. However, these "mature" oil and gas fields have short lives. If most of the cash flows are paid out to investors, there is little left to buy new wells and fields.

This is less true for a pipeline. They have already made the major capital investment, and they can operate for many years paying out most of the cash flows.

But whenever I see a high yield on such an investment I have a strong suspicion either the cash flows will deteriorate, or the investment value could plunge.

While I am not saying these are horrible investments, I also don't think there is a free lunch here.

Best wishes.

[alvinsch]

I suspect this can be a misleading issue for investors. They see a high current yield, and naively assume it will continue indefinately. However, these "mature" oil and gas fields have short lives. If most of the cash flows are paid out to investors, there is little left to buy new wells and fields.

This is less true for a pipeline. They have already made the major capital investment, and they can operate for many years paying out most of the cash flows.

But whenever I see a high yield on such an investment I have a strong suspicion either the cash flows will deteriorate, or the investment value could plunge.

While I am not saying these are horrible investments, I also don't think there is a free lunch here.

Best wishes.

Actually these E&P's mlps only buy long life fields. They have projected lives of just their proven reserves of 15-20 years and most reserve roughly 20+% of cash flow for on going drilling as they hope to increase their production at 3-5% a year (i.e. LINE, BBEP, VNR).

While I agree there are very few free lunches in life, I don't expect to ever see a better free lunch in my lifetime than what happened with mlps this month. These mlps typically have beta's well under 0.5 but were moving +/- 20% a day this month. The primary holders of these were investment institutions like Lehman, hedge funds, and private investors who financed many of the E&P purchases with PIPEs that were unlocking this year. When 20-40% of a company needs to be dumped into a thin market with almost no individual demand bizarre things happen.

One could just watch the SEC filings from Lehman as they dumped major holdings at least until they got them under 10%. When a whole spectrum of mlps that normally trade 100k-200k a day were getting hit with multiple 400K to 2M block trades during the day, doesn't take genius to figure out something bizarre is going on. During the week ending Oct 10, the Alerian mlp index dropped a record 24% while the next week it rose a record 26%. The fever only broke when a bunch of the mlps pre-announced distribution increases for November and reiterated that most had no need for additional financing through 2009 and even then could cut back on pipeline projects if credit is unavailable in 2010 and beyond.

Consider an E&P stock like LINE which is nearly 100% hedged through 2011, with no need for additional equity or bond funding, a distribution coverage ratio greater than 1.2 including a CAPEX drilling plan to increase production 3-5% per year, but has an effective yield of 23.5% at the bottom. Sure seems like a free lunch to me.

Consider a midstream like MWE with no need for equity or bond financing before 2010, which has grown distributions 15-20% for that last 5 years and have already done most of the CAPEX spending to continue growing 15-20% for the next 5 years, has an effective yield of 18.5% with a 1.6 distribution coverage ratio. Seems like a free lunch to me.

While it's true that if we re-enter the stone age these will turn out to be bad investments, anything short of that seems like a free lunch relative to the rest of the market to me.

Just my two cents.
- Al

[Wagnerjb]

Actually these E&P's mlps only buy long life fields. They have projected lives of just their proven reserves of 15-20 years and most reserve roughly 20+% of cash flow for on going drilling as they hope to increase their production at 3-5% a year (i.e. LINE, BBEP, VNR).

Al - I suspect these companies cannot actually increase production at 3-5% per year with only 20% of cash flow going into drilling. Exxon and Chevron and Shell would LOVE to be able to increase production even 3% per year, but they cannot do it....even with much higher reinvestment rates.

Just ask yourself, "Why doesn't Exxon generate an incredibly high payout yield to investors, all the while growing production at 3-5%?". Because you cannot have both. Exxon is working its tail off to replace production, and thus cannot pay out such high yields. The MLP is milking the assets, but I suspect you are really getting some "principal" back every year.

Consider an E&P stock like LINE which is nearly 100% hedged through 2011, with no need for additional equity or bond funding, a distribution coverage ratio greater than 1.2 including a CAPEX drilling plan to increase production 3-5% per year, but has an effective yield of 23.5% at the bottom. Sure seems like a free lunch to me.

Again - ask yourself why BP cannot do this.

Best wishes.

[Valuethinker]

Actually these E&P's mlps only buy long life fields. They have projected lives of just their proven reserves of 15-20 years and most reserve roughly 20+% of cash flow for on going drilling as they hope to increase their production at 3-5% a year (i.e. LINE, BBEP, VNR).

Al - I suspect these companies cannot actually increase production at 3-5% per year with only 20% of cash flow going into drilling. Exxon and Chevron and Shell would LOVE to be able to increase production even 3% per year, but they cannot do it....even with much higher reinvestment rates.

Is that not because of the necessary size of field for Big Oil to grow production by 3-5% pa?

For a smaller co, this might simply mean buying a bit more acreage and investing more in drilling?

Whereas for Exxon, that is like finding another North Slope every 3-4 years?

Just ask yourself, "Why doesn't Exxon generate an incredibly high payout yield to investors, all the while growing production at 3-5%?". Because you cannot have both. Exxon is working its tail off to replace production, and thus cannot pay out such high yields. The MLP is milking the assets, but I suspect you are really getting some "principal" back every year.

The Canadian equivalent to MLP is something called an 'Income Trust' that the government has now phased out (too much tax leakage). However ITs were/are doing exactly that ie paying back capital as well as income.

Consider an E&P stock like LINE which is nearly 100% hedged through 2011, with no need for additional equity or bond funding, a distribution coverage ratio greater than 1.2 including a CAPEX drilling plan to increase production 3-5% per year, but has an effective yield of 23.5% at the bottom. Sure seems like a free lunch to me.

Again - ask yourself why BP cannot do this.

Best wishes.

[/quote]

My best guess is that it is because BP is huge, and needs to open up big new acreage to increase production?

Whereas a small co only needs to add, say 10k barrels/ day and it can do that by investing more.

[alvinsch]

Al - I suspect these companies cannot actually increase production at 3-5% per year with only 20% of cash flow going into drilling. Exxon and Chevron and Shell would LOVE to be able to increase production even 3% per year, but they cannot do it....even with much higher reinvestment rates.

Just ask yourself, "Why doesn't Exxon generate an incredibly high payout yield to investors, all the while growing production at 3-5%?". Because you cannot have both. Exxon is working its tail off to replace production, and thus cannot pay out such high yields. The MLP is milking the assets, but I suspect you are really getting some "principal" back every year.

Consider an E&P stock like LINE which is nearly 100% hedged through 2011, with no need for additional equity or bond funding, a distribution coverage ratio greater than 1.2 including a CAPEX drilling plan to increase production 3-5% per year, but has an effective yield of 23.5% at the bottom. Sure seems like a free lunch to me.

Again - ask yourself why BP cannot do this.

Best wishes.

It's fine to be skeptical but the facts are it is what they have been doing. They currently believe they will have achieved 8% organic production growth for 2008 and they have 15 years of engineered drilling sites at their current drilling pace. For 2008, their distribution coverage ratio is roughly 1.6 before maintenance capex and 1.3 after capex which is how I estimated the roughly 20% on spending on additional drilling.

So fine, assume no growth whatsoever and they just maintain their current production level for 15-20 years. Do you believe a 23% 100% tax deferred annual distribution makes sense when we're told that 10% total return is optimistic? Well evidently the market doesn't either as it is now already up 46% from it's low of just over a week ago.

As of yesterday, all 12 of my mlps are up between 25% and 55% from their October lows once all the forced selling abated. I have no illusions of changing your mind but it sure feels like a free lunch to me. With the forced selling appearing to be done and the big runup they may no longer be free lunches but they still seem like very attractive investments for the right people. This at a time the Dow/S&P500 are retesting their 5? year lows?

Anyway, here's a few bullet points from their last presentation if you wish to delve into this further at www.linnenergy.com instead of just repeat that it can't be.

Large, long life and high quality reserve base
- 1.7 Tcfe total proved reserves􀂃
- 21 year reserve life index (1)
- 69% proved developed
- 51% oil and NGLs/ 49% gas
- Operate 85% of production
Large inventory of lower risk development opportunities
- Over 4,100 engineered locations; ~15 years at current drilling pace
- 1.7 Tcfe of low-risk inventory (0.5 Tcfe of PUD and 1.2 Tcfe of High Confidence Inventory
Growing production profile
- Organic production growth in 2008E of approximately 8%
- 3%-5% annual organic production growth target
Strong financial liquidity
- High percentage of production hedged for 5 years with upside participation through puts and collars (oil hedged for 7 years)
- Attractive, tax-advantaged yield
- Yield of approximately 15% ($2.52 / $16.86)
- Linn Energy’s tax shield was ~165% in 2006 and ~300% in 2007

Regards,
- Al

[Wagnerjb]

Is that not because of the necessary size of field for Big Oil to grow production by 3-5% pa?

For a smaller co, this might simply mean buying a bit more acreage and investing more in drilling?

Whereas for Exxon, that is like finding another North Slope every 3-4 years?

I don't think that is the issue. Exxon has the very best geologists and a mountain of money, so they could simply drill a million tiny wells if that would be a smart use of their money and an efficient way to increase production by 5%. It isn't, because those are high cost wells. It is more cost effective for Exxon to drill for the large findings.

If the tiny local company spends more to increase production, one of two things happens. Either they have a payout less than Exxon (obviously not the case), or their total return will be less since they are less efficient than Exxon. How will their total return be less? Their production dries up over time....or their dividend dries up if they spend all the capital to drill more wells. One or the other.

Best wishes.

[Wagnerjb]

It's fine to be skeptical but the facts are it is what they have been doing. They currently believe they will have achieved 8% organic production growth for 2008 and they have 15 years of engineered drilling sites at their current drilling pace. For 2008, their distribution coverage ratio is roughly 1.6 before maintenance capex and 1.3 after capex which is how I estimated the roughly 20% on spending on additional drilling.

So fine, assume no growth whatsoever and they just maintain their current production level for 15-20 years. Do you believe a 23% 100% tax deferred annual distribution makes sense when we're told that 10% total return is optimistic? Well evidently the market doesn't either as it is now already up 46% from it's low of just over a week ago.

Al - I think we may have to agree to disagree on this one. First of all, I am not disputing that these MLPs may have been a brief bargain during the recent turmoil. I am rather focusing on the long-term merits of such companies.

When a company tells you its reserves will last 21 years, that doesn't mean that the annual production will stay high every year, then suddenly dry up in year 21. It will begin declining today and every day until the very last drop comes out in 21 years. The company has to fight this "natural decline" with aggressive investment. It appears to me that most of these high yielding MLPs are aggressively paying out cash, so I just struggle to see how their production profile will remain flat over the longer term.

Let's come back in 5 years and see what happened.

Best wishes.

[living for dividends]

2. The Bear Stearn Alerian MLP ETN (BSR). The risk is its an ETN. Since its now owned by JP Morgan Chase and they are too big to fail (?) it might be viable. The ER is a high 0.85%

Paul -

I looked into the Alerian MLP ETN (BSR). You are correct about the risks. and the problems.
1.) It is an ETN. an ETN is basically a derivative. An ETN is not backed up by hard assets, liquid assets such as actual stocks of the underlying shares. If JP Morgan goes bankrupt - you're hosed.
2.) The ER of 0.85% !! who are they kidding.

The ETN is not an option IMHO

[alvinsch]

Is that not because of the necessary size of field for Big Oil to grow production by 3-5% pa?

For a smaller co, this might simply mean buying a bit more acreage and investing more in drilling?

Whereas for Exxon, that is like finding another North Slope every 3-4 years?

I don't think that is the issue. Exxon has the very best geologists and a mountain of money, so they could simply drill a million tiny wells if that would be a smart use of their money and an efficient way to increase production by 5%. It isn't, because those are high cost wells. It is more cost effective for Exxon to drill for the large findings.

If the tiny local company spends more to increase production, one of two things happens. Either they have a payout less than Exxon (obviously not the case), or their total return will be less since they are less efficient than Exxon. How will their total return be less? Their production dries up over time....or their dividend dries up if they spend all the capital to drill more wells. One or the other.

Best wishes.

Just a few other thoughts. First of all don't forget that pesky max corporate tax rate of 35% that LINE isn't subject to like Exxon. That sure frees up a lot of cash flow.

Second, prior to the last year, companies like LINE were yielding in the 8% range. Since then their production has gone up, distributions are steady, if not growing, and only the price of the stock has cratered from around the prior $20-$40 price range down to a low of $10.90 with energy prices back down to where they were when prices were in the $20-$40 range. Seems like an 8-10% yield made sense relative to the majors and the difference in risk and tax issues. However over that last 2 years XOM is basically flat while LINE has dropped more than 50% at its low. So if Exxon is your benchmark, how can both prices be correct?

You look at the data and assume that is impossible in an efficient market so therefore another shoe must drop. I look at the data and see a market reacting to a massive temporary supply / demand imbalance that could only be fixed by a huge price distortion like a pig going thru a snake. I believe the big snapback has vindicated my view but that doesn't mean the snake won't swallow another pig at some point if the credit crisis deteriorates further. No guarantees but when large owners are forced to dump in an illiquid market one can stack the odds in their favor by supplying liquidity.

One other thought I had which I'd be interested in your thoughts on is that the majors like Exxon face huge risk in terms of windfall profits tax on their US production whenever prices are in their favor. The prior windfall profit tax and the ones that were proposed this summer only applied to the large producers not these small companies. Doesn't this just force the majors to go oversees on risky projects instead of the US because if they hit the jackpot here they'll just get whacked by politicians at the margin.

Regards,
- Al

[Wagnerjb]

Second, prior to the last year, companies like LINE were yielding in the 8% range. Since then their production has gone up, distributions are steady, if not growing, and only the price of the stock has cratered from around the prior $20-$40 price range

Al – I took a look at LINN’s financial statements. They made a massive $2.7 Billion acquisition in 2007, financed by selling new units and borrowings of $1.3 Billion. To put this in context, their dividend payments were $150 Million.

It isn’t hard to increase production when you leverage the company like that. It is also very easy to increase dividends when you are looking at $100 crude oil and $13 natural gas. Production will naturally decline over time, and with today’s plummeting energy prices it is easy to paint a picture in which their payouts simply aren’t sustainable.

One other thought I had which I'd be interested in your thoughts on is that the majors like Exxon face huge risk in terms of windfall profits tax on their US production whenever prices are in their favor. The prior windfall profit tax and the ones that were proposed this summer only applied to the large producers not these small companies. Doesn't this just force the majors to go oversees on risky projects instead of the US because if they hit the jackpot here they'll just get whacked by politicians at the margin.

No, I think the opposite is generally true. The majors would LOVE to have all of their reserves in stable countries like the US and Europe. Unfortunately, there simply isn’t enough oil left here. Look at what just happened to Exxon and ConocoPhillips in Venezuela – Chavez nationalized their fields. A windfall profits tax looks pretty mild when compared to losing your assets. The Majors would love to avoid places like Vietnam, Libya, Iran and Russia….but that is where the oil is.


Best wishes.

[alvinsch]

Al – I took a look at LINN’s financial statements. They made a massive $2.7 Billion acquisition in 2007, financed by selling new units and borrowings of $1.3 Billion. To put this in context, their dividend payments were $150 Million.

It isn’t hard to increase production when you leverage the company like that. It is also very easy to increase dividends when you are looking at $100 crude oil and $13 natural gas. Production will naturally decline over time, and with today’s plummeting energy prices it is easy to paint a picture in which their payouts simply aren’t sustainable.

So by that logic, the fact that they've sold over $1B in risky property this year not appropriate for the low risk drilling they do, means their production must have fallen this year. Picking out one data point is pretty meaningless but at least you now acknowledge that it's indeed possible for them to increase production, though not indefinitely as they will eventually run out of drilling sites (15 years I believe at current drilling rate).

As I said before, they have a 1.3 coverage ratio AFTER maintenance CAPEX. As I hope you know maintenance capex is what is needed to keep the same level of production. That leaves another 0.3x for expansion of production.

Since they are almost 100% hedged thru 2011/12 they have a good probability of maintaining the distribution for many years at current prices. Obviously if oil is still $50-$70 in 2012 the distribution might need to be cut at some point if their increased production can't keep up and their coverage ratio drops. However, 4-5 years of 23% distributions before then would mean one have recovered their entire investment already. However, if the world eventually returns to normal they will be able to grow even faster by acquisition.

I think the real reason the prices got so dirt cheap and allowed for a 23% distribution is because of the fear that the whole financial system collapses and the counterparties to all the hedges default (they did get hit by Lehman failure). Obviously if that happened and they had to sell oil and gas at today's prices, they'd have to drop their distributions but once again that is the back to the stone age scenario where all bets are off.

I'm not trying to push this on anyone, just trying to defend against misinformation that it's impossible to have had a 23% distribution and still have some growth.

- Al

[cowboyinasia]

It seems one of the biggest drawbacks, is the tax paperwork.

To get around that, would it be a good idea to invest via an IRA?

[cato]

It seems one of the biggest drawbacks, is the tax paperwork.

To get around that, would it be a good idea to invest via an IRA?

No, unless it's in very small amounts. Some portion of the MLP distribution is typically UBTI income. If that portion exceeds $1000, you will actually have to pay taxes on it. Yes, in your IRA! And there's a lot of paperwork associated with it.

Dealing with the K-1s in taxable accounts is no longer a big deal at all. Most of the MLPs give you a log in site, where you can actually directly load your data into TurboTax.

This asset class has been amazingly good for me for the last 15 years. Sometime, I'll post my portfolio vs. the S&P. You'll ask why I don't run my own hedge fund.....