Profiting from Upstream MLPs

Submitted by Investing Daily as part of our contributors program.

The oil and gas industry is typically divided into three major components: upstream, midstream and downstream.

“Upstream” is commonly used to refer to the searching for and the recovery and production of crude oil and natural gas. It’s also known as the exploration and production (E&P) sector.

Upstream activities include searching for potential underground or underwater oil and gas fields, drilling of exploratory wells, and subsequently drilling and operating the wells that recover and bring the crude oil and/or raw natural gas to the surface. These activities and the financial results therefrom are highly sensitive to changes in commodity prices.

Linn Energy LLC (NSDQ: LINE) is the largest publicly traded partnership in the upstream MLP sector. Its reserves are concentrated in the Mid-Continent, including the Granite Wash play, the Permian Basin of West Texas and New Mexico, the Antrim Shale in Michigan, the Los Angeles Basin in California and the Williston Basin in North Dakota.

Reserves are approximately 45 percent crude oil and natural gas liquids (NGLs) and 55 percent natural gas, with a relatively long reserve life of 17 years.

In addition to its size and balanced commodity mix, what sets Linn apart from other upstream master limited partnerships is the extent of its hedging program and the degree to which it mitigates commodity-price-risk exposure.

Linn has hedged basically 100 percent of its expected natural gas production through 2017 and approximately 100 percent of its expected oil production through 2016. That means cash flow is locked in for about half a decade and its distribution is secure.

Linn units generated a flat total return in 2012 despite the fact that oil and NGLs prices decline precipitously during the year.

Linn’s low cost of capital is an even bigger advantage after the rollout of the LinnCo (NSDQ: LNCO) vehicle. LinnCo is a traditional corporation that pays dividends to shareholders, who will receive a Form 1099 at tax time rather than a Form K-1. A share of LinnCo represents essentially the same economic interest that a unit of Linn Energy represents.

The traditional share structure and streamlined tax reporting should avail the MLP access a larger equity pool. And after opening on Oct. 12, 2012, at a slight discount to the MLP LinnCo is now trading at a slight premium, suggesting investors appreciate the opportunity to invest in Linn Energy’s proposition without perceived tax complexities and that the rollout is working.

Lower capital costs will help Linn Energy continue and accelerate its growth-by-acquisition strategy.

Another upstream MLP that I like is much smaller than Linn–which in fact is bigger than all the other exploration and production (E&P) publicly traded partnerships combined.

Legacy Reserves LP (NSDQ: LGCY) has hedged 61 percent of estimated 2013 production, 52 percent for 2014, 31 percent for 2015 and 9 percent for 2016. Sixty-eight percent of current production is weighted to oil and NGLs.

According to Wells Fargo Securities, upstream MLPs have hedged, on average, 79 percent, 72 percent, 59 percent, 40 percent and 27 percent of estimated 2012, 2013, 2014, 2015, and 2016 production, respectively.

The MLP has sold forward its production at a below-average pace in the MLP E&P space, which means it has greater exposure to price swings.

This is good news when the global economy is on a strong growth path, less good news when growth is jagged and lumpy.

Legacy is, however, well positioned to benefit from fundamentals that favor higher crude oil prices over the long term. The MLP posted a loss, including distributions, of 8.7 percent in 2012. At the same time, however, Legacy has posted a two-day gain of 5.6 percent as the threat of the US going over the fiscal cliff and threatening global growth abated.

Management recently closed the acquisition of Permian Basin oil and natural gas properties from Concho Resources Inc with estimated production of 5,238 barrels of oil equivalent per day in the first quarter of 2013 from 1,584 existing wells. Proved reserves are estimated to be 25.6 million barrels of oil equivalent, 71 percent of which are considered “proved developed producing” and 14 percent of which are considered “proved developed non-producing.”

More than 90 percent of the properties are operated, and 100 percent of the reserves are located in counties where Legacy currently has operations or has adjacent operations.

The acquisition extends Legacy’s Permian footprint, adds significant scale to operations and should provide decades of cash flow for unitholders.

Legacy financed the acquisition with the proceeds from a recent offering of 9.2 million units and a recent USD300 million, 8 percent senior unsecured notes offering.

Legacy also announced that it secured commitments from its syndicate of bank lenders to expand its borrowing base to USD800 million from USD600 million. (See more top MLP picks.)