MLPs That Hedge Commodity Risk

Elliott Gue Editor and Publisher, Energy and Income Advisor and Capitalist Times

Master limited partnerships have flown high of late, but Elliott Gue shares a couple of names that have potential to continue climbing.

We're talking MLPs with Elliott Gue. Elliott, so MLPs have been extremely popular recently as everybody dives into income. Could you explain what MLPs you like, what sectors, and why you like them?

Well, most publicly traded Master Limited Partnerships are actually involved in the midstream energy business-basically transporting and storing oil and natural gas-but there are a few that are actually involved in the upstream energy business, actually producing oil and gas and selling it. Two of my favorites there are Linn Energy (LINE) and Vanguard Natural Resources (VNR).

Vanguard has nothing to do with Vanguard Mutual Funds.

No, no.

It's entirely different.

It's an entirely different organization. I'm not sure why they chose that name. I know they have been talking about changing the name at one point, but they have no affiliation whatsoever.

Linn yields about 7%, Vanguard yields over 8%, almost 8.5% right now. Both are involved in basically the same business: They own basically mature oil and gas wells. They produce oil and gas from those wells and they sell it.

But the key thing for MLPs is they typically hedge all their production or most of their production for years into the future. In the case of Linn, they traditionally hedge 100% of their output in both oil and gas for at least five years. Right now, they've actually hedged gas out well past that 100%.

So even though they're oil and gas producers, they really don't have a lot of exposure to commodity prices. So if oil goes up in the short term it's not much of a boost, but if it goes down, it really won't harm their ability to keep paying distributions. And right now is a great environment for them, because they're able to go out and actually make acquisitions, in particular, of gas-producing properties. Gas prices are really low right now, so properties are available at really fire-sale prices.

Earlier this year, Linn Energy actually made two big gas-focused acquisitions, two $1 billion-plus acquisitions from BP (BP). BP is obviously trying to raise cash to help fund the spill recovery. And Linn made these two big acquisitions at such low prices that even though gas prices are kind of low, they can still make money. And they're able to lock in a profit margin for seven years in the future by hedging.

So, this is a really easy way to grow in the current environment, and it takes advantage of the fact that so many gas properties are available for sale at really low prices.

Right, because it's very difficult for most gas companies to operate at the levels that gas is right now.

Absolutely, and if you bought that acreage a couple of years ago at sky-high leasing prices, and you're trying to make money with those costs. It's a very different scenario than if you're able to buy that property on the cheap, you know, for pennies on the dollar of what it would have traded for a few years ago, you can still make money even at low gas prices.

The other thing is if you look at the futures market for gas, it's a little esoteric, but the near-month futures, the futures expiring over the next few months are really depressed. But if I go out a year or two in the future, they're trading $4 or $5 per million BTUs, which is a healthy price. Linn can make a lot of money at that kind of a price, and they're able to lock in those prices using hedges. So just a couple of years in the future, they're going to earn even more money from these hedges.

And what's Vanguard's story?

Vanguard's story is very much the same. Vanguard is a little bit like a baby limb. It's smaller and it's a little bit riskier...they don't hedge on 100% of their output. They hedge a lot, but not 100%, and they are involved in the same basic strategy right now.

They made a $440 million acquisition, which is smaller than Linn's, but it's a much smaller firm. It's actually 93% natural gas-producing properties, and they're doing exactly the same thing, hedging all of that production from that particular play for using the futures market.

Another strategy to look at in the future is that right now gas prices are low. So these fields already have wells in them, they're producing gas from these existing wells, and they're not going to drill anymore. They'll keep maintaining them, but not drill aggressively.

If gas prices do go up in three or four or five years, they could certainly drill additional wells, they have dozens of potential drilling locations, increase their production, and still take advantage of higher gas prices. So, it's basically locked-in margins now and some options if gas prices go up in the future.

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