It’s a tough time to be an oil and gas exploration and production company. The steep drop in oil and gas prices over the past year has weighed heavily on these upstream companies because their profitability and cash flow are almost entirely reliant on supportive commodity prices.
Indeed, the carnage sweeping across this corner of the energy sector is clear. Stock prices have collapsed, and distributions to investors have been cut to save as much cash as possible.
But while everything in the rearview mirror looks extremely bad, the damage is done, and there may finally be light at the end of the tunnel. For this reason, I’d suggest income investors take a closer look at Breitburn Energy (NASDAQ: BBEP).
Breitburn’s operating strategy for several years was to purchase high-quality acreage and aggressively increase production in these areas. Breitburn has a foothold in the best production regions of the United States: 18% of its proved reserves are in the Permian Basin, 13% in the Mid-Continent region including Oklahoma, and another 7% in California.
This high-quality asset focus allowed Breitburn’s proved reserves to grow 23% per year from 2009 to 2014. Production was up 17% per year in the same time frame.
Of course, the downside to this ramp-up in production is that, when commodity prices fall, profits collapse. This is exactly what transpired over the past year, and the rest is history. Breitburn has already cut its distribution twice because of this — by 52% and 49% over the past year.
Assessing the Risks for This Oil MLP
To be sure, Breitburn’s aggressive production strategy means the stock carries some risks. If oil and gas prices go back to their 2015 low, or even lower, Breitburn’s sky-high distribution may be in danger of another painful cut. The company has a significant debt position, and in the capital structure, debt holders get paid first and foremost.
Plus, the company’s hedges are set to roll off over the next several years, as it dictated in a recent presentation at the 2015 GHS 100 Energy Conference. Breitburn is effectively hedged at 73% of total oil and gas production this year, at $93 per barrel for oil and $4.98 per million British thermal units for natural gas.
But looking further out, Breitburn’s total production is only hedged 61% next year at $89 oil and $4.25 natural gas, and 37% in 2017 at $85 oil and $4.33 natural gas. From this, it’s clear that a prolonged downturn in oil and gas prices will have a meaningful effect on Breitburn’s finances.
This all certainly looks bad, but if oil and gas prices have found a floor, Breitburn’s huge 9% distribution may have as well. Therein lies the potential opportunity.
Indeed, there has been a stealth rally in commodities that few investors or analysts are appreciating. Crude oil is back up above $60 per barrel in the United States, after falling all the way to $45 per barrel at the 2015 low. This is a sneaky 33% rally that could not have come at a better time for upstream MLPs.
This is why Breitburn’s fundamentals improved greatly last quarter. Last quarter, Breitburn covered its $0.50 annualized per-unit distribution by more than 2.2 times with underlying cash flow. This is a great sign that, at long last, Breitburn’s distribution is finally covered by internally-generated cash flow.
Moreover, Breitburn is taking the necessary steps to shore up its financial position, by cutting spending: lease operating expenses fell 9% per barrel of oil equivalent, quarter over quarter.
Furthermore, Breitburn has received some much-needed capital to boost its liquidity, including a $1 billion investment led by EIG Global Energy Partners. Proceeds were used to reduce debt under Breitburn’s credit facility. Separately, Breitburn also raised $252 million by issuing 14 million units last October. In all, these initiatives strengthened Breitburn’s balance sheet and provided liquidity at a critical time.
To summarize, viewing Breitburn based on the recent past paints a very ugly picture. Units have lost approximately three-quarters of their value over the past year, due to the brutal collapse in commodity prices.
But for investors looking ahead, oil and gas MLPs could be a massive opportunity, if commodities have found a bottom. The energy sector is completely unloved right now, but could offer the best buying opportunities.
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