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posted on 02 December 2015

Upstream Still Getting Creamed

by Robert Rapier, Investing Daily

Investing Daily Article of the Week

A year ago this week OPEC met and made a decision that ultimately obliterated the master limited partnerships involved in oil production.

These upstream MLPs were hit extremely hard after the oil exporters' group decided to defend market share instead of cutting production quotas.

OPEC's reasoning was that production cuts would only help shale oil producers grow market share by allowing them to maintain high margins. The bottom fell out of the oil market after that OPEC meeting, and cash flow turned solidly negative for nearly all oil producers.

Natural gas prices have been depressed for other reasons, namely that the success of shale gas production in the U.S. continues to oversupply the market, despite demand that continues to grow.

As a result, oil and gas producers have been near the bottom of the lagging energy sector this year.

The natural gas market will tighten up over the next few years. There will be many new sources of demand developing, even as many of the shale gas basins are seeing gas production slow or decline. But the immediate future looks bearish as natural gas inventories just hit the 4 trillion cubic feet mark for the first time ever. It's hard to believe that only a year ago natural gas inventories were still dangerously low:


That brings us to the oil market. U.S. shale oil production has begun to decline in response to lower oil prices, but crude oil inventories remain high. It is likely to be a few more months before supply drops and demand rises enough to reverse the rising tide of inventories. Thus, there is a risk of soft prices for a few more months.

Enter OPEC once again. Its next meeting is on Dec. 4. Many OPEC members have been vocal about making necessary moves to push prices back up to $70/bbl or higher. Just this week, Venezuelan Oil Minister Eulogio Del Pino warned that oil could fall to $20/bbl if his colleagues failed to act. "We cannot allow that the market continue controlling the price. The principles of OPEC were to act on the price of the crude oil, and we need to go back to the principles of OPEC," he said.

The strategy OPEC adopted a year ago hasn't worked very well thus far, and the group certainly didn't anticipate an extended period of sub-$50 oil. But Saudi Arabia - the most influential member of the group - has shown no signs that it's prepared to change course. Should OPEC act decisively to cut production quotas at the December meeting, prices are likely to move up to $60/bbl relatively quickly. If it instead continues the course of the past year, prices may very well drop below the $40/bbl support level in the short term.

In any case, it would seem that we are close to the bottom of the oil cycle. Prices may fall a bit more, but they are already at unsustainably low levels. Prices will need to rise if production is going to continue to meet global demand. The upstream MLPs that have been hit so hard should rally once that happens - assuming they survive that long.

According to the Master Limited Partnership Association (formerly the National Association of Publicly Traded Partnerships), there are 14 upstream oil and gas MLPs. One of these partnerships is New Source Energy Partners (OTC: NSLP), which currently trades at $0.11/unit. Another, Dorchester Minerals (NASDAQ: DMLP), reported no oil or gas production for the most recent quarter. Here is a look at the remaining dozen, along with some important metrics, in order of descending enterprise value:


  • EV = Enterprise value in billions as of Nov. 20

  • EBITDA = Earnings before interest, tax, depreciation and amortization for the trailing 12 months (TTM), in billions

  • Debt/EBITDA = Net debt at the end of Q3 divided by TTM EBITDA

  • FCF = Levered free cash flow for the TTM in millions

  • Tot Production = Average daily production of oil, natural gas, and natural gas liquids for Q3 in thousands of barrels of oil equivalent (BOE) per day

  • Reserves = Total proved reserves in million BOE at year-end 2014

  • Gas = percentage of reserves classified as natural gas

  • YTD = Total year-to-date return

This table gives an idea of the size of the various upstream partnerships. Despite well-documented troubles that have shaved 75% off its value this year, Linn Energy (NASDAQ: LINE) remains by far the largest of the upstream MLPs. The average return of this group has been -56% year-to-date, but 9 of the 12 are down at least 60% on the year. Also note that one of the top three performers in the group, Blackstone Minerals (NYSE: BSM), had its IPO near the end of April.

Also note that Blackstone and Viper Energy Partners (NASDAQ: VNOM) operate on the basis of mineral interests, so their financial metrics aren't a perfect apples-to-apples comparison with the others in the group that produce their own oil and gas.

Are any of these worth owning? While some among this group are likely to see big gains as oil prices recover, the downside risk will continue to be high. Bankruptcy threatens for some, and others will likely be consolidated. It's not a sector for the squeamish, but join us at MLP Profits for up-to-date advice on emerging opportunities in this sector.

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