Energy 'Experts' Are Wrong Again! Take This Opportunity To Lock In 20% MLP Yields

The price of a barrel of the benchmark West Texas Intermediate – WTI – has fallen from the mid $90s to below $60, resulting in a an energy sector selloff the likes of which the markets have not seen for half a decade. The big drop in crude oil and energy stocks has put a lot of fear into the market.

To “help”, experts who never saw the coming drop in WTI are now saying lower prices are here to stay and going lower. I say the experts are as wrong now as they were six months ago. The reason is that crude oil has a unique, built-in self-correcting mechanism that will push the price of crude higher as we go through 2015.

The current fear in the market plus the recovery in oil next year makes the current low prices and high yields of the upstream master limited partnership – MLP – companies very attractive. If you have the guts to buck the experts and current energy sell-off and invest in these high yield energy companies, you should be very happy with your choice as we move through 2015 and beyond. Let me explain why the consensus of continued lower crude oil prices is wrong.

The major cost to produce crude oil comes from the drilling operations to bring in a producing well. Once the energy company has a producing well, the costs to maintain the well and gather the oil are relatively low, something in the $20 per barrel range. With a high price of crude, energy producers can spend excess profits to drill new wells and increase the ongoing daily production of crude oil.

According to the U.S. Energy Information Agency, in 2014 the world will consume 91.4 million barrels of oil per day. The EIA forecasts that consumption will increase to 92.3 million bpd. That 0.8 million bpd means that energy companies must find and produce an additional 290 million barrels over the course of a year. Global consumption is expected to increase by 1.5% each year.

Even more important when looking at crude oil production and consumption is the natural decline rate of oil wells and oil fields. Once a new well starts to produce, the energy company will be able to collect oil from the well for years. However, the rate of oil coming from the well will decline every year. On average, across the world, the decline rate of existing wells is 8% per year. This means that energy companies must drill wells to bring in new production gains of 9% to 10% above current production rates each year. In the U.S. in 2014, it took 62% of the new well production to offset the decline from existing wells. In 2015 that percentage is forecast to climb to 78% and then up to 90% towards the end of the decade.

As noted above, in most energy producing plays it costs a lot to drill new wells and those costs increase by 10% to 12% per year. When the price of crude drops, many energy producers – either companies or countries – will have less capital to invest in the drilling of new wells. So they will spend less money and drill fewer wells. You can see from the discussion above that it takes just a modest reduction in production growth capital spending to stop or reverse the growth in crude supply. The recent drop in oil will start to wash out the producers who cannot make money at $60, $70 or even $80 oil. The excess supply that has caused the drop in crude can be absorbed in a hurry as companies start to cut back on their drilling activity.

Upstream MLPs Have Financial Resources to Weather the Storm and Maintain Distributions

Since the general investing public for the most part does not understand the factors discussed above, the market has hammered the upstream MLPs. Unit values are down 50% or more from where they were at the end of the summer. This means that if the MLPs can maintain their existing distribution rates, yields on these oil and gas producers have climbed to 17% to over 20%. These upstream MLPs have hedged their expected production out for 2 to 3 years or longer in the future. Even at the current low price of oil, the hedge positions will allow these MLPs to earn $90 plus per barrel on 90% or more of the oil they produce and sell in 2015.

The two years of hedge production allows the price of oil to recover and these companies to restructure business operations to support distributable cash flow in a lower energy price environment. A sharp example of how well these companies can survive and thrive when energy prices fluctuate can be seen on this chart provided by upstream MLP Legacy Reserves (Nasdaq: LGCY):

LGCY_distributions_vs_WTI_640px

In 2008 crude dropped dramatically from $140 per barrel to less than $40. Legacy was able to maintain its distribution rate and then start growing it again at the end of 2010. All of the upstream MLPs that existed during the last energy selloff were able to maintain their distribution rates. Now these MLPs are at such low prices, the yields look too good to be true. Yet if history repeats and my analysis of the oil price recovery is correct, investors can buy these MLPs now and lock in 20% yields. Here are the main, well-hedged upstream MLPs with yields of this writing:

  • Linn Energy LLC (Nasdaq: LINE), current yield: 19.8%.
  • LinnCo LLC (Nasdaq: LNCO), current yield: 22.6%. Each LNCO unit is backed by one LINE unit.
  • BreitBurn Energy Partners LP (Nasdaq: BBEP), current yield: 20.3%.
  • Vanguard Natural Resources, LLC (Nasdaq: VNR), current yield: 13.6%.
  • Memorial Production Partners LP (Nasdaq: MEMP), current yield: 15.4%
  • Legacy Reserves LP (Nasdaq: LGCY), current yield: 17.4%

Do your research and add one or two of these high yield energy companies to your income portfolio. For the January issue of The Dividend Hunter, I will be providing an in-depth review of two that have been recommended to our newsletter subscribers.

Or get started right now with the newly released “Quick Start Guide to MLP Investing” with ...

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Susan Miller 9 years ago Member's comment

The only difference here is that in 2008, the US wasn't producing the amount of oil it is now. Does that effect the recovery?

Tim Plaehn 9 years ago Author's comment

Susan good question. My first thought is that crude is a global commodity, so overall pricing is not that dependent on U.S. production. We will see how it goes from here. The upstream MLPs have moved up nicely since I wrote this article.