Patience Will Reward Upstream LP Investors

Let's say you buy tickets to the greatest party of the year. There will be music, dancing, free refreshments, and U2 might make an appearance if Bono can make it back from his latest meeting with the U.N. Security Council. Then, on the day of the party, you hear a rumor that the high-priced tickets are now getting sold at steep discounts. Looks like the ticket sellers are worried no one's going to show. Your best friend calls and says the rumors must be true. He went to the party and the deejay was still getting set up. The refreshments weren't free, after all. So you bemoan your wasted tickets, and you call all your friends and tell them not to bother going to the party.

Glory Days for LPs...
In a Stock Strategist article published last summer, we discussed the growing buzz around upstream oil and natural-gas limited partnerships (LPs). The upstream LPs were being afforded premium valuations because of their acquisitive growth prospects and their tax advantages. Exploration and production companies were looking at LPs as a way of monetizing mature assets via spin-off or sale. Many new entrants were expected to come to market.

The upstream LPs bought bigger and bigger asset packages. Some were able to quickly gain access to large amounts of capital using private investments in public equity (PIPEs). These large private placements allowed the upstream LPs to sidestep the time-consuming SEC registration process in order to snap up available acquisitions. But by not marketing their deals to a broad shareholder base, these LPs were unwittingly creating major problems for themselves.

...Until Financing Dries Up
As uncertainty struck the market, the funds investing in PIPEs began demanding wider discounts on their investments. It made sense: They couldn't sell their units until the SEC declared the initial registration effective. In the meantime, they had no liquidity. But they were willing to continue funding acquisitions as long as the short-term future appeared bright. (Immediate accretion leading to sudden pops in unit prices can be addictive.)

When the credit crunch hit, overleveraged investors may have been forced into liquidation. This sparked additional negative pressure. Nervous PIPE investors, exposed and illiquid, may have begun shorting LP units in the open market to offset the investments they were not yet able to trade on the open market. Although not all upstream LPs were PIPE-financed, the overhang weighed on the entire fledgling sector. Furthermore, the falling unit prices made it harder for the upstream LPs to use their equity as currency, and so the deal market ground to a halt. Without deals, the acquisitive upside of the upstream LPs vanished.

Now we find ourselves plumbing new depths of negativity about the structure. Unit prices have collapsed. Planned IPOs have been downsized or completely yanked. The market seems to have declared the upstream LP a failed experiment, doomed never to live up to its great expectations.

Opportunity in LPs?
Is the distress permanent? We don't think so. In the short term, there may be continuing turbulence as the institutional unitholder base is more widely distributed. It will take time for retail investors to learn about and gradually soak up the discarded LP units. Once the selling pressure abates, however, the focus may return to the business. And the business, despite its challenges, still offers opportunities.

The tax advantages of the upstream LP are hard to ignore. Buying assets and bringing them under the tax-exempt umbrella can immediately create value. And there are a lot of mature oil and gas assets that could fit in these structures. Additionally, the acquisition and divestiture market is less likely to get overbid when capital is not as readily available as it used to be.

Internally, the upstream LPs generally have greater development opportunities now than they did a year ago. They can use low-risk prospects to maintain modest organic growth until conditions for acquisitions get better. To improve internal execution while digesting their large deals,  Linn Energy  and  BreitBurn Energy Partners  have appointed experienced COOs who were former executives at  ConocoPhillips (COP) and  Anadarko , respectively. The upstream LPs have solid hedging programs that will protect their cash flows from commodity price weakness for the next few years. The potential downside to that protection is that costs may rise in the interim, squeezing margins, but we don't think this is a huge issue. The extensive hedging programs can also create paper losses in interim reporting that don't reflect the true cash flows of the business, potentially scaring off investors focused on bottom-line earnings. It will take time for investors to become accustomed to the volatility of these noncash charges.

The upstream LPs still face considerable uncertainty. The PIPE selling may still weigh on unit prices. Access to capital will likely remain an issue over the near term; debt may be expensive, and equity isn't really an attractive financing option at these prices. Executives may regret the rapidity with which they grew and their reliance on a concentrated unitholder base, but deal fever isn't easy to shake; there will always be integration risk from new acquisitions. In addition, the tax advantages of these exempt entities may someday be overturned by the government.

However, we feel the current negative environment may offer an opportunity for investors to acquire upstream LP units at or below appropriate margins of safety to our fair value estimates. Here are profiles of the upstream limited partnerships we cover (please follow the links to our Analyst Reports for greater detail):

 BreitBurn Energy Partners LP BBEP
Moat: None | Price/Fair Value Estimate Ratio*: 0.59 | 5 Stars
Originally spun off by  Provident Energy Trust , this limited partnership was transformed by the purchase of  Quicksilver's  Antrim Shale properties. With a reduced ownership interest--and the complexity of its businesses leading to a discount of its own--Provident is now looking to sell its stake in BreitBurn. Aside from the issue of who ends up buying Provident's general partner, we don't see this having an impact on BreitBurn's business. The sale process is likely to be long and methodical, rather than any sort of immediate jettisoning of units. BreitBurn may use its financial flexibility to pursue deals later in the year.

 EV Energy Partners LP EVEP
Moat: None | Price/Fair Value Estimate Ratio*: 0.72 | 4 Stars
EV was created and is run by EnerVest Management and EnCap Investments, firms which manage and invest in oil and gas assets. EnerVest takes on more risk to drill for upside in its properties, then is able to drop down its low-risk assets into EV. This gives EV the opportunity to acquire assets at more affordable prices than it might find at auction. EV can also buy assets from third parties. We're impressed with EV's record of reasonably priced acquisitions, but we also note that EV's general partner is entitled to an increasing proportion of the LP's cash flows because of its incentive distribution rights.

 Legacy Reserves LP LGCY
Moat: None | Price/Fair Value Estimate Ratio*: 0.74 | 4 Stars
Legacy possesses the clearest focus of any of the upstream LPs we cover. We feel its strategy to negotiate deals with smaller players in the Permian Basin will lead to better acquisition metrics and smoother integration of assets than many of its peers. We're also confident its disciplined management will not overpay for assets. While currently not quite as undervalued as some of the other names on our list, investors should keep their eyes open for entry opportunities.

 Linn Energy LLC LINE
Moat: None | Price/Fair Value Estimate Ratio*: 0.60 | 5 Stars
Perhaps the most beleaguered player in the sector, Linn has been severely punished by the market because of its reliance on PIPE financing. Recent selling has pushed it below our Consider Buying price of $20.80, and though we think more turbulence can be expected in the near term, we think the business as it stands will be fine over the long term. Much of its heavier-than-average debt load is swapped at a reasonable financing level. Linn has a multitude of drilling opportunities from its  Dominion (D) acquisition last summer.

In sum, we feel rumors of this party's demise may be premature. We're not saying Bono and the gang will show up right away, or ever. But don't get rid of your tickets just yet--the night is still young.

*Price/fair value ratios calculated using fair value estimates, closing prices, and cost of equity estimates as of Tuesday, Feb. 19, 2008.