A Solid Income Stream with Inflation Protection Built In
James Keller is an analyst with Thermopolis Partners, LLC. Located in Jackson Hole Wyoming, Thermopolis Partners is an infrequent contributor to Oil and Gas Investments Bulletin. MMcfe = million cubic feet equivalent.
Investors today are starved for yield. Witness the 10-year treasury yield trading near 2.5%, and municipal bonds (iShares S&P Municipal Bond ETF) near 3.6%. If you are an investor looking for yield but at the same time nervous or downright scared of the possibility of inflation, these are not the vehicles you want to own. Inflation will eat away at the purchasing power of your principal, and many would argue that as inflation increases, so will interest rates, which will turn your fixed income capital gains into capital losses.
In order to find inflation-protected yields, you have to look harder and deeper at high-yielding equities. I’m not talking about low single-digit yields like you’ll find in the large, blue-chip dividend payers. We’re looking for much higher dividend payouts.
If you screen for high-yielding equity assets in the US, you find a majority of them are tobacco, financial or energy companies. For the purposes of this article, we’ll focus on an oil & gas company.
The go-to income based equities for US retail investors are usually midstream Master Limited Partnerships (“MLPs”). A note of explaination about MLPs: Typically US-listed entities that receive at least 90% of their income from the production, distribution or processing of natural resources such as oil, coal, iron ore or natural gas. MLPs distribute a large portion of their cash flows to investors in the form of distributions. These distributions are tax-advantaged because a large portion of the distribution is considered “return of capital” by the IRS. Return of capital is not taxed on the day of distribution; rather, it reduces your cost basis and allows investors to defer their tax payments on the distribution until the units are sold.
These are fine vehicles for dividends, but we have a few issues with MLPs that may leave some investors disappointed. MLPs, in general, have garnered so much attention recently that they have become relatively expensive in our view. It seems like every month there is a new billion dollar MLP ETF or MLP fund created. Hence, many of the mid-stream MLPs now trade at 5-6% dividend yields, where an 8-10% yield was usually the norm.
In addition, some of the largest MLPs have structures where the General Partners (management) can take, as a first cut, a huge amount of the cash flow that would have otherwise been paid to the owners of the common LP units. For example, one of the largest midstream MLPs has a clause in its partnership agreement that allows them to pay the General Partner 50% of the cash flow the partnership generates in any period after reaching certain milestones. Since the milestones have been met, cash available for distributions to the LP units is now just 50% of the cash flow that is generated by the entire business.
Which leads us to an interesting oil & gas producing MLP that has an attractive dividend yield (7.5%) and does not have a cash-draining GP/LP structure. This company is also poised to grow cash flow significantly in the near future. The Company is Linn Energy (NASDAQ:LINE), based in Houston. All LINE units represent direct ownership of the General Partner: Linn Energy, LLC.
Linn Energy has a boring business model. They acquire mature US-based oil and gas assets and they hedge out nearly 100% of their production for 5 years. In the interim, they pay out a tax-advantaged dividend, currently in the 7-8% range. Their tax advantage is driven by a combination of the cost of drilling wells and production/depletion credits.
Linn’s dividend is made possible by the nature of the investments they make, and the prices at which they are able to hedge. For instance, in the last 12 months, they have made Permian Basin acquisitions for a cost of $10-$12 per barrel of reserves in the ground. After the acquisitions, they hedge out roughly 100% of that production at $85-$90 per barrel, essentially locking in a $48-$60 profit per barrel for the next 5 years (after operating costs in the $20-$25 per barrel range). And because they use a combination of puts, collars and swaps,* they are providing 100% downside protection while also being able to participate on the upside should oil prices rise over the long term.
So how is a Company with such a boring business model going to increase production and cash flow in the near term without making a rash of acquisitions? The answer is technology. We’ve all heard about the recent developments in horizontal drilling and fracturing technologies that are unlocking massive amounts of shale oil and gas. Linn Energy is poised to utilize this new technology on one of their large, horizontally undeveloped properties, which will grow both production and cash flow significantly in the years to come.
As part of its strategy to accumulate and hedge out mature assets, Linn purchased the largest land package in the Granite Wash basin on the border of Northern Texas and Western Oklahoma for $2.1 billion a few years ago. The Granite Wash is a mature gas play that has turned into a winning lottery ticket for Linn Energy. By applying horizontal drilling and completion technology, the Company has unlocked a giant resource of liquids-rich gas under the substantial acreage they purchased. We estimate that the value of Linn Energy’s Granite Wash acreage is worth up to $5 billion today.
The Granite Wash basin includes up to 7 producing zones (most of which are wet gas, condensate-rich zones). They have drilled about 400 vertical wells on the property to date, which provides the company with a detailed picture of the reservoir. While Linn continued to drill vertical wells on their property, there were many companies applying horizontal techniques to the Granite Wash basin acreage surrounding them. Linn took note, waiting for the optimal time to apply horizontal technology to their acreage.
In June of 2010, Linn drilled a horizontal well in one zone of the Granite Wash section, and it initially produced at 19 MMcfe per day. The well cost $7.5 million, but it will pay off within 9 months due to the high liquids content of the Granite Wash wells. Their second horizontal well was even better, achieving initial production of 60 MMcfe per day, paying off their original well cost in only 3 weeks. This well has maintained 40 MMcfe of production after 45 days, and all of these wells are expected to decline to a rate of 2.5 MMcfe per day after 5 to 6 years. Not all of the future wells will come online at 60 MMcfe per day, but even at 8 to 15MMcfe per day (which the company believes is the base-line for all of the Granite Wash initial wells), cash-flow break-even is always within the first year assuming $70 oil and $4 natural gas.
At current drilling plan levels, they expect to drill this prospect out for the next 3 to 5 years. However, since there are up to 7 potential producing zones within the Granite Wash basin, this drilling inventory could be multiples higher.
Linn Energy is poised to grow production and cash flow by 20-30% per year for the next 3 to 5 years. The company will not pay out all of that cash to investors however; they plan to raise the dividend much more modestly, in the 3-5% range.
Linn Energy’s future is looking brighter than ever. The cash that they will be able to generate from this winning lottery ticket will give them a much greater cost of capital advantage over their competitors. The excess cash flow will be plowed back into their bread & butter business model of acquiring, maintaining, and hedging out mature oil and gas fields. The Granite Wash will provide the company with years of above average growth, increased dividend payments and a solid long-term production platform.
Editor’s Note: Oddly enough, the founder and namesake of the company has recently sold a significant portion of his holdings in the company. The stated reason was to diversify his holdings, which is understandable. Unfortunately, it is hard to find assets with this much upside paying out 7.5% dividend yields, so from our standpoint, it would appear to be a case of “de-worsification”.
Disclosure: Thermopolis Partners owns Linn Energy common shares.
*Puts are financial contracts between two parties, the writer (seller) and the buyer of the option. The buyer acquires a short position by purchasing the right to sell the underlying instrument to the seller of the option for a specified price (the strike price) during a specified period of time. If the option buyer exercises their right, the seller is obligated to buy the underlying instrument from them at the agreed upon strike price, regardless of the current market price. In exchange for having this option, the buyer pays the seller or option writer a fee (the option premium). A Collar is an option strategy that limits the range of possible positive or negative returns on an underlying to a specific range. A commodity swap is an agreement whereby a floating (or market or spot) price is exchanged for a fixed price over a specified period.
