Hedgeye senior Energy sector analyst Kevin Kaiser expands his work in upstream MLPs, a group he considers ripe for shorting. In Tuesday’s institutional call he laid out the short case for Breitburn Energy Partners (BBEP), an upstream MLP, and Pacific Coast Oil Trust (ROYT), an oil royalty trust.
You have probably heard the screeching around Kaiser’s work on LINN Energy, a battle that has been raging in the pages of Barron’s and on television, as well as across the Twittersphere.
In June the SEC put pressure on LINN to be more transparent in their accounting and followed up last week with an SEC inquiry – an announcement that dropped the price of LINN’s publicly traded units and won Kaiser some instant converts in the investing world.
Kaiser put out a full note on BBEP a week ago. A few key takeaways were highlighted in Tuesday’s call:
The General Partner of BBEP no longer has any direct economic interest in the MLP after the LP acquired the GP stake in 2008. Most GPs retain only a small ownership of around 2%, which counts as “skin in the game,” if only just. Zero is about as skinless as you can get – while still drawing management fees.
Kaiser’s calculations clash with BBEP’s. His evaluation of operating fields the MLP acquired just a month ago indicates BBEP paid $770 million for properties worth not more than $690 million.
This becomes more complicated, because BBEP funded the acquisition completely through bank borrowings. In order to obtain the financing, BBEP had its banks amend the loan covenants, allowing the company to take on more indebtedness. Kaiser estimates BBEP will have to do an equity raise before the end of the third quarter, or risk breaching their new debt ratio limits. Kaiser believes this will result in around 12% dilution to current unit holders.
Another key number affecting Distributable Cash Flow (DCF – the money out of which you get paid as a unitholder) is “maintenance capex,” the amount of money an oil and gas producer has to pay each year just to maintain the same level of production.
BBEP never provides a full and clear accounting of their DCF. They mention numbers and project distributions on their conference calls, but they don’t publish a breakdown of DCF. This means you either have to take their word for it – which most investors apparently do – or do your own work. Which Kaiser did.
BBEP also doesn’t publish a clear definition of what they consider maintenance capex, and Kaiser says their working definition appears to differ from conference call to conference call. For this year, BBEP management estimates a requirement of $88 million maintenance capex. Kaiser’s calculation is a whopping $228 million, based on its Depreciation, Depletion & Amortization rate (the standard method of accounting for exploration and development of new oil and gas reserves).
All in, Kaiser figures NAV for BBEP is around $7 per unit, or less than half today’s price in the marketplace. The NAV is, at any given moment, the most realistic measure of the expectation of all future payouts the trust should be able to deliver – thus, while NAV may not be the price of an MLP, it is the best proxy for the actual value. Enthusiastic write-ups from major Wall Street firms notwithstanding, Kaiser says no investor should ever pay above NAV for an MLP, a mistake investors routinely make, especially in the early years of the trust’s trading history when most of the in-ground assets remain and the trust’s finances are still pretty straightforward.
Cutting to the chase, Kaiser calculates the NAV of ROYT at around $9 at current commodity prices, or about half its current market price.
ROYT is a royalty trust, a tax-advantaged entity that has ownership rights to in-ground oil and gas. Like an MLP, a royalty trust benefits from the sales of those deposits, and like an MLP, it distributes the lion’s share of those cash flows to unit holders. Like MLPs, many royalty trusts pay high dividends – the current yield on ROYT is over 10%. Unlike MLPs, the trusts do not acquire additional operating properties to bolster future payments. When the assets conveyed to the trust are depleted, the trust simply ceases to exist. As with the MLPs that have recently come under Kaiser’s lens, royalty trusts may also take advantage of financial engineering to make sure they meet dividend payments,
Affiliates of BBEP brought ROYT public last year, taking advantage of a pricing anomaly in domestic oil that has since started fading from the markets – though apparently not from enthusiastic analyst valuations for ROYT.
ROYT’s home fields in California produce a grade of crude oil that generally trades anywhere from $5 to $12 a barrel below the NYMEX WTI benchmark. Starting in mid-2011, the price lines crossed, and California crude traded at a premium through the end of last year. Prices have since started declining, and look to revert to their historical relationship some time next year – which is coincidentally also when ROYT’s hedge on its oil and gas properties will roll off. This combination could produce a double-whammy for ROYT unitholders.
Kaiser says no one should pay a penny above a concretely demonstrable NAV for ROYT. In particular, a conservative NAV calculation must be based on a realistic projection of oil prices, which Kaiser says ROYT’s current price is definitely not. With the units trading at about a 100% premium to what Kaiser calls a reasonable NAV, that spells S-E-L-L.
Conclusion: Up the Stream Without a Paddle?
Kaiser believes the whole high-yield oil and gas sector is vulnerable, in particular the eleven publicly-traded upstream MLPs, whose distributions come from cash flows from oil and gas producing operations.
Kaiser sees the group as largely characterized by aggressive or irregular accounting and heavy dependence on non-GAAP measures in order to arrive at the reported free cash flow numbers they need to justify their distributions. Opaque accounting and reporting practices are often promoted in an atmosphere of poor corporate governance, with little effort made to mask interlocking ownerships and nested interests.
So far, both the IRS and the SEC have permitted the loose and idiosyncratic accounting and reporting that characterizes these entities. Many of these companies have gone through the initial production stages of their properties and now face low organic growth prospects. Since they must keep making payments in order to satisfy unitholders, there is clear incentive to raise cash By Any Means Necessary. This can result in MLPs routinely paying out distributions well in excess of actual cash flows generated by their business.
Kaiser notes that the royalty trusts as a group are down about 40% from last year. This has the perverse effect of making them look more attractive, because the distributions work out in many cases to near-double digit yields, based on price. The great majority of unitholders are individual investors who buy only on basis of quoted yield. Kaiser says this is the absolute worst way to value these vehicles.
For one thing, the payments are largely not derived from actual oil or gas production – indeed, in some cases they may not be based at all on actual production, but on a combination of accounting offsets, and the distribution of proceeds from capital raises.
The recent SEC inquiry into LINN’s accounting practices may be the tip of a fast-melting iceberg. We believe market transparency is a good thing – though we also recognize that forcing it at this time will hurt large numbers of individual investors, a consideration that may temper the SEC’s zeal to force more disclosure too soon.
These companies’ market prices are generally well protected because there’s a powerful narrative around them, coupled with the knee-jerk reaction of Short Sellers = Very Bad Guys. It is significant to note that major brokerage firms came out with upbeat BUY recommendations on LINN immediately after the stock dropped on news of the SEC inquiry. We read a couple of reports from household name firms, looking in vain for a set of calculations that might call Kaiser’s thesis into question. In fact, these reports simply said “this is still a great stock to buy” and contained no factual analysis – the most informative numbers were the page numbers.
If the SEC is looking at possible manipulation of the markets, maybe they should start by asking why major brokerage firms, whose retail brokers have sold these MLP to so many of their customers over the years, should be touting these stocks without even addressing arguments about their viability.
There have been some cheap shots at Hedgeye over Kaiser’s work, and at Kaiser personally. There has been lots of indignation expressed – by managements of these companies, by shareholders, and by the brokerage community. But so far no one has produced a scrap of analytical work tackling Kaiser’s analysis head on.
Time to sell your upstream MLP? That time started long ago. The clock’s ticking.