- Over the last seven years, the majority of upstream MLPs have been unable to cover their investment and distribution costs through operating cash flows.
- Upstream MLPs seems to be indicative of the broader upstream oil and gas industry with respect to investing and distribution/dividend coverage.
- While some of the upstream majors appear to be fairly priced, high-quality independents tend to be over-capitalized, while under-capitalized firms tend to be of lower quality.
- The majority of economic value in the oil and gas industry is realized further downstream.
- Investors who insist on exposure to upstream oil and gas assets are likely better served by focusing on high-quality integrated majors.
Since oil prices tanked back in late 2014, I have been infatuated with learning the nuts and bolts of the oil and gas industry in order to capitalize on the ensuing market panic. My logic at the time seemed simple enough: the market would panic, prices would then overshoot on the downside, and I could have bought well-run companies on the cheap. However, I have lamented at the apparent lack of value in publicly traded upstream companies. Although it is possible to locate decent downstream assets trading on the cheap and midstream assets that reliably produce discretionary cash, I have so far been unable to find any compelling value in the upstream. While some of the majors appear to be fairly priced, high-quality independents tend to be over-capitalized, while under-capitalized firms tend to be of lower quality. Either way, the net result does not portend well for long-term value investing. Unless you to stick solely to well-run integrated majors, I would hazard right-headed investors to steer clear of the upstream oil and gas industry either until we either see valuations come down further, commodity prices surge, or systemic cost structures dramatically improve.
Identifying any combination of value and quality in the upstream (i.e., exploration and production) industry has proven challenging. After eight months of searching for value in the upstream oil and gas industry, I am beginning to realize that although a continuous supply of oil and gas is an economic necessity, upstream businesses tend not to be overly economical. More specifically, most oil and gas companies have been unable to finance all-in costs through operating (i.e., internally generated) cash flows. I contend that this forebodes badly for long-term value creation.
Even though cash flow deficits are fairly normal in growing companies (including upstream producers, which invest heavily in production and reserves growth), it is abnormal for these companies to pay aggressive yields and engage in buybacks. Disturbingly, it appears as though over at least the last several years, the great majority of oil and gas companies have actually become accustomed to taking on extra financial capital for the explicit purpose of covering capital and financing costs, in addition to operating costs. This observation is especially true when one considers the costs of capital for upstream Master Limited Partnerships (MLPS) and royalty trusts.
Case Study: Investing and Distribution Coverage Ratios of Twelve Major Upstream MLPs
To demonstrate this point, I have analyzed twelve upstream oil and MLPs (and LLCs) to determine the sustainability of their respective cash distribution yields. I chose to focus on MLPs since the group’s overall strategy is to generate cash more stable cash flows by investing in low-risk resource plays and hedging a significant part of future production. I did not include partnerships whose underlying asset bases consisted primarily of royalty and/or net revenue interest (NRI) generating assets.
For MLP investors, the value proposition is simple. Unitholders of MLP units are entitled to tax-advantaged distributions, which the General Partner (GP) typically pegs to distributable cash flow (DCF). DCF is roughly equal to the amount of cash leftover after all operating and maintenance capital expenditures have been paid. The conditions for value creation are that distributions should be stable and/or growing, and financed through internally generated cash flows and/or through relatively cheap capital which can be employed at a relatively greater returns.
In this respect, MLPs should fare better than their incorporated counterparts in terms of distribution (i.e., dividend) coverage during periods of depressed commodity prices due to their core operating philosophies, which emphasize low-risk development and hedging. Their overall higher costs of capital should be mostly offset by lower taxes. Distributions are usually tax deductible to the GP (i.e., distributions allow the GP to defer corporate taxes). Unlike corporate profits, which are paid out as dividends, distributions are taxed one time at the unitholder’s individual tax rate.
In order to quantify the sustainability of distributions, I have compared distributions over the last seven years to free cash flow. In this instance, free cash flow has been defined as the difference between cash flow from operating and investing activities, which is the most objective way I know to estimate the amount of discretionary cash that was left over to pay distributions. I use seven years of financial data (or less if fewer than seven years of financial data were available from the vendor) as my baseline for evaluation to encompass the effects of approximately one whole commodities cycle.
Summary results are included below:
Table 1: Cash Flow Metrics of Twelve Upstream MLPs
|Ticker||# of annual data periods used||Sum of Operating Cash Flows (7 years)||Sum of Investing Cash Flows (7 years)||Sum of Distributions Paid (7 years)|
Table 2: Investment Coverage Ratios of Twelve Upstream MLPs
Source: Portfolio123; Author’s calculations
|Ticker||# of annual data periods used||Investment Coverage Ratio (excl. distributions)*||Investment Coverage Ratio (incl. distributions)**|
Notes to Table 2:
Summary of Results
In summary, only two of the twelve upstream MLPs over the last seven years have generated cash in excess of investing needs and therefore could paid for any distributions using internally generated funds. The remainder must have relied on external financing sources to pay any distributions (and/or to finance any equity or debt repurchases). Moreover, of those two, only one was able to fund its all previous seven years of distributions through free cash flow.
Even though Eagle Rock Energy Partners LP generated less operating cash flow than it spent, it deserves honorable mention due to its relatively high investment coverage ratios both excluding and excluding distributions.
Over the last seven years, LRR Energy LP generated approximately $550 MM cash through operations and used about $366 MM for investing. In theory, this would have left about $195 of discretionary cash flow. However, over the same time period, LRE paid over $860 MM in distributions, leaving a significant cash shortfall.
Based on these simple metrics, it appears to be no coincidence that Vanguard Natural Resources is attempting to acquire both EROC and LRE. If one must dredge through the muck, one should attempt to pick the least mucky muck to dredge through.
Sanchez Production Partners LP was the only upstream MLP in this study which was able to cover all its previous seven years of distributions with free cash flow. Not coincidentally, it is the only one which does not pay any distributions (and has not since 2009).
Analysis of Case Study
Although the operating philosophies of upstream MLPs sound nice in theory, it appears that GPs have become dependent on rosy projections and easy-come, easy-go investment capital to pay for distributions. Clearly, this is not a sustainable business practice and should be troubling to investors. What will happen if/when interest rates rise and the seemingly endless pool of cheap capital and investor enthusiasm dries up? My guess is that those remaining investors will find themselves at the foot of the pyramid, footing the bill.
Moreover, and perhaps more troubling, is that this scenario pretty much repeats itself across the oil and gas upstream universe, including trusts and, to a somewhat lesser degree, C-Corps. Christopher Aublinger has undertaken an ambitious series on Seeking Alpha to document the all-in costs of producing a barrel of oil for most publicly traded upstream companies. Along the way, he has consistently documented the dire cash flow situation for the industry. Although on a purely GAAP basis, many companies are able to declare accounting profits, Chris notes that the great majority of companies have been unable to cover their all-in cash costs through operations. No matter the clime and place, two investing adages tend to hold true: GAAP is crap; cash in King.
The implications of the cash flow situations for upstream companies suggests two possible scenarios: the upstream business is marginally economical; and/or, upstream companies have become capitally inefficient due to a prolonged cycle of their being over-capitalized. Neither of these cases bodes well for long-term investors. When I recently expressed this sentiment to a co-worker who worked in the upstream business for several years, she candidly replied, “No Duh.” Boy, did I feel like a dunce.
Although exceptions to overly broad observations surely exist, they have proven exceedingly difficult to locate. Through all my last eight months of searching, I keep circling back to where I started — to Exxon Mobil (NYSE:XOM). Not only has Exxon been able to consistently fund its dividend through internally generated cash flows and consistently grown its reserve base, but it is also probably the best run and most capitally efficient of all the major oil producers. In addition, Exxon Mobil operates the largest and one of the most sophisticated downstream refining and chemical operations in the world. Unlike the upstream business, the downstream business tends to be extremely cash flow positive, capitally efficient, and a beneficiary of depressed commodity prices.
The oil and gas exploration and production industry is a fascinating part of the world economy and absolutely crucial to the elevated standard of living much of the world has grown accustomed to. For this reason, I will probably continue show my interest in the oil and gas business by seeking to invest in related companies. However, I would hazard right-headed prospective investors to steer clear of the upstream, especially from those concerns with temptingly high yields such as the majority of upstream MLPs. To put it bluntly, trying to pick out the most fiscally disciplined upstream MLP is like trying to pick out the best time to go sailing during hurricane season; you might get lucky, but you’ll probably get hosed.
For those who insist on exposure to the oil and gas industry, I would direct value-oriented individuals to the downstream, where assets can be bought below replacement value and where most of the industry’s economic value tends to be realized. Income-oriented investors may choose to dabble in the midstream. And for those who insist on including at least some upstream in their portfolios, I will concede that some of the better run upstream integrated majors, such as Exxon Mobil, appear to be safe long-term investments… for now at least.