Kevin Smith: Generate Huge Cash Distributions with MLPs and Royalty Trusts
Interview

The Energy Report: Could you start by explaining the differences between royalty trusts and master limited partnerships (MLPs)?

Kevin Smith: Absolutely. There are some unique differences between the two. Royalty trusts and the upstream MLPs I cover are both typically focused on oil and gas production, and that is how they generate cash flow. The difference comes down to whether or not the management team wants to be acquisition-oriented.

Upstream MLPs can be great vehicles for acquiring and consolidating mature oil- and gas-producing properties. However, a lot of explorer and producer (E&P) operators are great developers and operators of properties but don't want to go out and be forced to acquire more assets. The latter category fits much better into a royalty trust because it has a finite life. And because it does have a maturity, as well as its structure, it's fairly low maintenance. Other public companies are utilizing royalty trusts because they think it's a great financing vehicle that will allow them to fund growth capital expenditure plans in a balance sheet friendly way.

Both the MLP and the trust are very much yield-oriented vehicles and can represent very attractive opportunities for the retail investor as well as institutional investors to gain exposure to the bullish uptrend in commodity prices.

TER: Would you think of royalty trusts as unmanaged asset portfolios?

KS: By definition, they're non-operated trusts; however, what we have seen is that trusts do have a limited ability to drill new wells, at least developed trusts. Now we're seeing more drilling trusts that have a commitment to drill a certain number of wells, but that don't have the ability to add new properties or drill wells above and beyond what's originally stipulated. These structured capital spending plans can provide very nice production and distribution growth in the early life of the trust.

TER: How does taxation vary between MLPs and trusts?

KS: Royalty trusts typically generate very, very minimal amounts of unrelated business taxable income (UBTI), if any; therefore, they are typically much friendlier in an IRA versus MLPs. Some royalty trusts are actually 1099 filers, which is similar to C-corporations.

MLPs are a bit more cumbersome. They are generally K-1 filers, so you have to deal with the nuances of that. A few royalty trusts are K-1 filers as well.

TER: What is the first line of due diligence that an investor should perform when looking at an MLP?

KS: You need to understand how the partnership generates its cash flow. Look at the assets first. We want to understand how capital-intensive the asset mix is and how stable and reliable the cash flow is in different commodity price cycles. Once you get a good feel for that, then you can start looking at the corporate structure. But cash-flow generation will tell you how sustainable the distribution is, as well as its potential for growth.

TER: This is not quite as critical in the royalty trusts, is it?

KS: No, it's absolutely not. The key point of focus with royalty trusts is their termination date. They are very finite-life vehicles. For example, what we have seen recently are 20-year trusts, so investors need to understand how much cash flow they are going to receive over that 20-year period. Investors get into trouble if they assume that the cash flow is in perpetuity, and then overvalue some of the trusts based on those metrics. There are some perpetual trusts out there, but we don't cover any at this time.

TER: So, generally speaking, the trusts are depreciating assets and investors should understand that they are getting part of their principal back in addition to income.

KS: Exactly.

TER: Clearly, there's been major damage to all types of equity instruments over the past few months. But investors in MLPs and U.S. royalty trusts have done pretty well growth- and income-wise over the past year. Aren't investors supposed to be getting yield at the expense of growth?

KS: That's a good question. Historically that is true, but we think we have entered into a golden era of yields from commodity exposure. Because it seems like every government is running its currency printing press on its maximum setting, we are expecting an inflationary environment at the end of the day. Oil and gas prices, especially oil, have historically done very well in an inflationary price environment. In this very low-interest environment, combined with the unsettling macro news, people are clamoring for yield, and we think these upstream yield-oriented products are going to do well in delivering both growth and yield. We expect these distributions, especially in the upstream MLP space, to continue to grow over the next five years as oil prices continue to strengthen and as we see further consolidation in the upstream space. For royalty trusts, we continue to see high demand from both investors as well as issuers. We cover several royalty trusts that have a yield to maturity of 10%, which is extremely attractive in these uncertain times.

TER: Kevin, with bond yields so low and cap rates low or non-existent in commercial real estate, I'm wondering if a lot of traditional real estate investors may have trickled into the oil and gas MLP and royalty trust space.

KS: We think it's very attractive for all investors, and a lot of people are looking to hide out in yield names. The S&P has been essentially flat over the past four years, and the Dow is even worse. Some of these investments with 7% and 8% yields and potential distribution growth are very attractive and will do extremely well over the next four to five years compared to the general stock market.

TER: Which seems to perform better in a strong commodity environment—MLPs or royalty trusts?

KS: Very good question. The upstream MLPs typically have a much more stable cash-flow profile because they hedge a higher percentage of their production and have the ability to add on new hedges. Typically, the upstream MLP world is hedged four to five years out, whereas royalty trusts only have the ability to put on hedges at the very beginning of the trust. With no ability to add on new hedges, after four or five years trusts have a high level of commodity price exposure and are very sensitive to oil and gas prices. So in a rising commodity-price environment, royalty trusts will outperform upstream MLPs. But in a very stable price environment, we would expect MLPs to outperform.

TER: You're currently bullish on oil-related limited partnerships and trusts right now, aren't you?

KS: Yes, we are. Leading the pack, we like LINN Energy LLC (LINE:NASDAQ), an LLC, and EV Energy Partners, L.P. (EVEP:NASDAQ). EV Energy Partners has a tremendous amount of upside with its undeveloped Utica Shale acreage. I really think that can be a game-changer for the stock. LINN Energy is doing a fantastic job of developing its horizontal Granite Wash acreage. We think it's going to lead the group in distribution growth this year and will be set up for an even stronger 2012. Both of those names are extremely attractive at their current valuations. On the royalty trust side, our favorite name right now is VOC Energy Trust (VOC:NYSE), with a yield to maturity over 10%. We think those investors are going to do phenomenally well.

TER: You've got a target price of $46 on LINN, which would represent pretty good upside from its current price of $37, given that this is an income instrument. It was battered in July along with everything else, but it has recovered quite nicely. Where is this support and growth coming from?

KS: A large portion of the partnership's growth is its horizontal Granite Wash play. Organically it is growing production roughly 30% on an annual basis, and that is unheard of in the upstream MLP space. Some of these wells are paying out within seven to nine months. So, the partnership is essentially acquiring earnings before interest, taxes, depreciation and amortization (EBITDA) at less than one times EBITDA and trading at roughly nine times EBITDA, which is phenomenally attractive. The thing to point out here is how fast it is growing distribution. Last quarter LINN raised its distribution by almost 5% on a sequential basis, which is very strong growth. We're forecasting 6% year-over-year distribution growth in 2011, and we think the distribution growth rate will be even higher in 2012. That is very competitive compared to average MLP distribution growth of 4% to 5%.

TER: You've got a $90 target on EV Energy Partners, and it's currently trading around $75. You've hiked the price target twice over the past month. Where does this optimism come from? My understanding is that currently there is really no accurate valuation available due to lack of visibility with regard to its Chesapeake Energy Corp. (CHK:NYSE) joint venture. What's the low end and what's the high end on this partnership?

KS: EV Energy Partners is a little bit more higher-risk/higher-rate of return investment versus its upstream MLP peer group. I would argue that close to $20 is in the stock price already on its undeveloped Utica Shale acreage, hence the low yield. But we're seeing fairly good visibility on ranges of what the partnership's acreage could be worth and very bullish comments coming from the industry.

If the Utica play doesn't work at all, I think EV Energy Partners is close to a $50 stock. But a lot of acreage value is being derisked by extremely bullish comments we've heard about the results from different management teams, namely Chesapeake's. We expect a lot of derisking as production results come out over the next 60 days or so, as well as potential monetization events for year-end. As that materializes, we expect EVEP to continue to move up.

TER: Your target price on VOC Energy is $27. Currently the price is just under $22. You seem to place a lot of emphasis on the experienced and highly motivated sponsorship.

KS: Yes. This is a management team that participated in MV Oil Trust (MVO:NYSE) and has done a phenomenal job of maintaining production and offsetting declines. And because it's a relatively new issuer, it still has quite a bit of its production hedged at high prices. VOC Energy has hedged roughly 50% of its oil at a price that's a little over $100. This brings a lot of stability to its cash flow in the next several years, as well as its current valuation, which is extremely attractive. I think that people are going to be impressed and surprised to see the upside when VOC Energy announces its quarterly distributions.

TER: Two of these three companies that you mentioned, EV Energy and VOC Energy, seem to have very high relative strength, particularly EV Energy, which is up 18% in the last three months, and has doubled in price over the past year. That's amazing in this kind of environment.

KS: Absolutely. That's not something you necessarily expect out of the upstream MLP space or a yield-oriented vehicle. It speaks to the nature of how accretive some of these undeveloped acreage properties can be when you've only valued the proven, developed and producing assets, but then happen to get some undeveloped acreage upside for free. That's what EV Energy has essentially done, and it will be able to monetize this acreage and then flip it into proven and producing properties, which are going to have a significant impact on its cash flow. This is not something you can plan on or something that you can predict, but it's a big upside.

TER: Do you have any other trusts or MLPs you wanted to mention?

KS: We like Legacy Reserves, L.P. (LGCY:NASDAQ) a lot. I would like to mention it because of Legacy's reliable and disciplined business model of acquiring working interests in the Permian Basin, as well as its Wolfberry drilling results. Legacy had a really strong second quarter, and it was too bad that the greater market turmoil didn't allow for significant focus on its drilling results. Legacy is expected to deliver 4%–5% distribution growth this year. We think it is in the position to grow its distribution sequentially for the rest of the year, and so we expect strong things out of Legacy.

TER: What about the integrated gas names?

KS: Our favorite in that space is National Fuel Gas Company (NFG:NYSE). It is one of the larger acreage owners in the Marcellus, with 745,000 net acres, the vast majority on which it owns the mineral rights. That acreage position is not yet fully reflected in its stock price. We're expecting a lot of good things. It's delivering 40% year-over-year production growth in 2011, and we're expecting north of 30% next year. As they derisk some of their acreage, the valuation should show up in its stock price.

TER: National Fuel Gas is down about 18% over the past 12 weeks. Do you think of it has a value?

KS: I do. Some of that price decline was based on the fact that National Fuel Gas decided not to bring in a joint-venture partner. Because of that decision, a lot of the fast money moved out of the stock. I expect the same sort of value creation, but it's going to take a little longer to materialize than if it had brought in a partner to develop some of their acreage.

We also like El Paso Corporation (EP:NYSE). We like what it's doing with the dropdowns to El Paso Pipeline Partners L.P. (EPB:NYSE). That's going to be highly accretive and makes for a wonderful financing opportunity. Its E&P assets have improved significantly over the last 24 months, and it has a very strong organic growth base.

TER: You tend to be conservative in your valuations and not build in premium target pricing above net asset value into your models. Is this due to the uncertain market climate?

KS: Yes. We are in uncertain times. It's not unprecedented, but we're seeing extreme volatility in oil and gas prices. That lends itself to more conservative valuations. But we try to be realistic about where we expect the stock prices be within the next 12 months.

TER: I've enjoyed meeting you. It's been a pleasure.

KS: Thank you very much.

For the past four years, E&P Associate Analyst Kevin Smith has been with Raymond James & Associates, where he follows upstream master limited partnerships and U.S. royalty trusts. Previously he was with Wells Fargo & Company in its E&P Corporate Lending group in Houston, where he was responsible for credit analysis of mid- and large-cap E&P companies. Kevin was also a power trader at Reliant Resources for three years. He holds a BBA from Baylor University and an MBA from Texas A&M University.

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DISCLOSURE:
1) George Mack of The Energy Report conducted this interview. He personally and/or his family own shares of the following companies mentioned in this interview: None.
2) The following companies mentioned in the interview are sponsors of The Energy Report: LINN Energy LLC.
3) Kevin Smith: I personally and/or my family own shares of the following companies mentioned in this interview: None. I personally and/or my family am paid by the following companies mentioned in this interview: None.
4) Regulatory Disclosures:
EV Energy Partners L.P.:
Raymond James & Associates lead-managed a follow-on offering of EV Energy Partners L.P. shares in March 2011.
Raymond James & Associates makes a NASDAQ market in shares of EV Energy Partners L.P.
Raymond James & Associates received non-investment banking securities-related compensation from EV Energy Partners L.P. within the past 12 months.

Legacy Reserves L.P.:
Raymond James & Associates lead-managed a follow-on offering of Legacy Reserves L.P. shares in November 2010.
Raymond James & Associates makes a NASDAQ market in shares of Legacy Reserves L.P.

LINN Energy LLC:
Raymond James & Associates lead-managed a follow-on offering of LINN Energy, LLC shares in December 2010 and co-managed a follow-on offering of LINN Energy LLC shares in March 2011.
Raymond James & Associates makes a NASDAQ market in shares of LINN Energy LLC.