What to Buy: BreitBurn Energy Partners LP (NSDQ: BBEP) < USD18

Why Now: BreitBurn Energy Partners LP (NSDQ: BBEP) is a master limited partnership (MLP) that produces oil and natural gas and is squarely focused on paying high and consistent dividends to its unitholders. Following its release of third quarter 2011 earnings, the company raised its distribution–as MLP dividends are called–by 3 percent, the sixth consecutive quarterly boost.

The stock, however, has dropped 6 percent since the announcement and currently yields well over 10 percent. It also sells for well below the value of its oil and gas reserves and at just 72 percent of listed book value.

The primary reason is continuing investor fears about a reprise of the 2008-09 crash. But BreitBurn management has done a nice job reducing exposure to the vicissitude of energy commodity markets. In fact, it’s locked in significant revenue five years out by locking in prices for future output of oil and gas.

The upshot is BreitBurn is a high-yield stock where investor perception of risk is way out of whack with reality. Those who buy now get a huge, growing and tax advantaged dividend, as well as the potential for real upside when today’s wide-eyed volatility diminishes.

The Story

There wasn’t much debate about this month’s target once BreitBurn Energy Partners LP (NSDQ: BBEP) released third-quarter numbers and boosted its distribution for the sixth consecutive quarter. Our overall coverage universe–spanning Utility Forecaster, Canadian Edge, MLP Profits and now Australian Edge–includes well more than 500 stocks, many of which are now priced for double-digit yields. The goal here, however, is to identify those that are well equipped as businesses to stick around long enough for the market to realize its mispricing ways.

These types of adventures entail a great deal more risk than we usually take on with portfolio recommendations for the various advisories. BreitBurn, however, embodies just about every quality we’re looking for, and management is back to doing what it says it’s going to do. The market either hasn’t realized this yet or wants more proof. We’ll happily speculate on BreitBurn’s ability to win back the support of the broader market, particularly with a 10 percent yield and a rising distribution stream.

Roger: First of all, David, I think we ought to say a few words about some of our previous recommendations in Big Yield Hunting. I think we’ve been pretty up front with people about what kind of stocks these are, and that we’re taking calculated risks by recommending them.

Mainly, we’re betting the market is pricing in too much risk, and the companies will prevail in holding their dividends. Sometimes they work out big, but some of them don’t work out so well.

David: Well, one that has worked out pretty well so far is last month’s pick PetroBakken Energy Ltd (TSX: PBN, OTC: PBKEF). In fact, at one point it went pretty far past our buy target, though I see it’s fallen back in the last week or so.

Roger: Yeah, good point. You really don’t want to chase anything in this market, particularly anything like this. The only reason you buy any stock with above average risk is if the potential return is off the chart. That was the case with PetroBakken when we wrote it up last month.

Since then we’ve seen third-quarter numbers that indicate management is getting the company’s production challenges under control, and guidance was favorable as well. I especially like the very strong distribution coverage and the fact that they’ve made some moves to reduce debt maturity risk.

But we’re also now up more than 25 percent from the initial recommendation, and I don’t think anyone should pay more than USD10 for PetroBakken.

David: And one very good reason not to is a little-known master limited partnership that you and I have been discussing the past couple weeks: Oil and gas producer BreitBurn Energy Partners LP (NSDQ: BBEP). It actually just increased its dividend and still yields more than 10 percent.

Roger: That’s a combination you only see when investors are really over-pricing risk.

There are plenty of companies with high dividends that are having trouble maintaining them. But dividend increases only happen when companies are growing–which is the best and only real guarantee a dividend is safe. It’s clear investors are ignoring BreitBurn’s boost because they’re deathly worried about the big picture, mainly a reprise of 2008 and a crash in energy prices.

As you know, I’m not buying that scenario. But even if energy prices did come down, BreitBurn’s a lot better protected than most.

David: As you always say, you buy the business. But let’s talk a bit about the company and its third-quarter numbers.

Production of oil and natural gas is rising, but not nearly as much as PetroBakken. Third-quarter output was 1.681 million barrels of oil equivalent (boe), or 18,273 barrels of oil equivalent per day (boe/d). That was up about 1 percent sequentially from the second quarter thanks to acquisitions. They now have output up to 23,300 boe/d thanks to making even more purchases.

Roger: That’s not big growth, but it is growth. More important for me, the numbers are coming on right in line with management’s 2011 guidance. That along with energy prices and drilling costs is what producers set their dividends on. As long as they’re meeting guidance, it means the assumptions on which they’ve based the payout are intact, and the dividend is safe.

In fact, this is very likely the number that gave management the most confidence to raise their dividend. It’s bullish.

David: Production is very balanced, with about 49 percent of output coming from oil and natural gas liquids (NGLs). The focus has been to invest more heavily in oil and liquids, which are priced by global markets and therefore are much more favorably priced than natural gas, which is still basically trapped in North America.

Roger: Another good point. Focus on liquids isn’t unique to BreitBurn. But being able to shift and keep a strong balance sheet and increase dividends is a major point in their favor. And management has indicated this will remain the case going forward.

David: Does it bother you that production from BreitBurn’s Eastern division, concentrated in Michigan, Indiana and Kentucky and focused on natural gas, was down 3 percent sequentially? Lower production means higher costs per unit of output, so it cuts into margins both ways.

Roger: I’d be a lot more bothered if I saw this as a company wide trend. But again, they’re increasing production overall. And they’re spending money to keep that going. In the East, they spent USD6 million to drill 16 wells, complete 14 rigs and optimize a facility, adding about 3 million cubic feet equivalent per day to production.

Meanwhile, they spent USD15.7 million in the Western division, and oil focused production rose 8 percent there. Third-quarter capital spending was USD22.3 million, down from USD28.1 million the second quarter. But that appears to be more due to seasonal factors and the timing of certain activity to get output up sooner.

Moreover, management still plans to spend about USD80 million all told in 2011, including the two acquisitions. So they’re right on target with expectations.

David: Just a few more numbers. Revenue, including realized gains on commodity derivative instruments, was up 13 percent sequentially. Lease operating expenses and processing fees excluding transportation expenses increased to USD21.61 per boe, from USD18.41 per boe. That appears to be due to maintenance work on facilities, which is a lot easier to do in the company’s northern properties in summer than in winter.

It looks like they really benefitted from high crude oil prices, though that may have pushed up costs for materials and services 10 to 15 percent during the course of 2011. That kind of bothered me. CEO Hal Washburn in the conference call said he expects to report better fourth-quarter numbers on this count and meet full-year guidance. But he also said “Our lease operating expenses were above the high end of the guidance range due to the seasonal nature of our well-servicing, maintenance and work-over activities.” If this is all “seasonal” activity, doesn’t that imply that it’s recurring? And if so, shouldn’t management have a better handle on this before it issues guidance? Am I making too much of this?

Roger: Maybe, maybe not. I think he’s hedging a bit that there might be other factors that push up costs and cause them to miss guidance. As you know, weather can have a huge impact on drilling and producing oil and gas, particularly in areas when the mercury is about to drop big time.

Washburn’s most important statement on guidance, however, was the distribution increase. And keep in mind that cash flow thus far–really the bottom line for master limited partnerships–is actually at the high end of management’s full-year 2011 guidance.

David: Management also made a statement with the earnings release that it has hedged a great deal of oil and production forward to lock in prices. That has the impact of safeguarding cash flows. But it does make the numbers more complicated when there are realized and unrealized gains on commodity derivative instruments.

For example, in the third quarter, they made USD8.1 million, but in the second quarter they had a USD1.8 million realized loss.

Roger: That may be why some investors have a hard time believing BreitBurn’s distribution is safe. But if you look at the kind of prices they’ve locked in for future production, you have to be impressed with their discipline and acumen.

David: I agree. Realized natural gas prices averaged USD6.72 per million cubic feet (Mcf) compared to a New York Mercantile Exchange (NYMEX) average natural gas price of USD4.06 per Mcf. Realized crude and liquids prices averaged USD81.50 per BOE, while NYMEX crude averaged USD89.49.

The company also has “adjusted” hedges that are based on the higher price of Brent crude rather than West Texas Intermediate Crude. That’s because BreitBurn’s oil production is concentrated in California and the pipes flow west. Assuming the midpoint of 2011 production guidance has held flat and based on previously announced production levels for the two recent acquisitions, BreitBurn’s production is hedged at approximately 73 percent for the fourth quarter of 2011, 70 percent in 2012, 68 percent in 2013, 46 percent in 2014 and 36 percent in 2015. Average annual prices for the period range between USD80.84 and USD101 per barrel of oil and USD5.43 and USD7.47 per million British thermal units of gas.

Roger: Those are good prices and very solid percentages. If energy prices fall, so will cash flow. But there’s plenty of cushion to protect the distribution as well as make acquisitions of properties from owners who would be truly distressed if energy prices really dropped. And they can also pick up some serious cash flow gains if prices rise as well.

That’s a formula that in my mind provides a pretty strong assurance that dividends will not only hold going forward but will likely rise.

David: They’re also not slowing down acquisitions. They completed two in the Rocky Mountain region totaling USD340 million during the quarter. That was a USD57 million deal in eastern Wyoming and a USD283 million deal in southwestern Wyoming. The southwestern Wyoming Evanston and Green River Basin gas and oil assets are long-lived, predictable and low-decline properties.

Roger: And management is obviously contemplating more deals, as they’ve done consistently for years. But what’s even more impressive is the way they’ve systematically locked in sales contracts after completing each deal, essentially for an amount equal to the purchase price.

They don’t sacrifice upside but they do pretty much eliminate the financial risk.

David: And some of these deals have been in natural gas. Washburn says “acquisition economics are strong based on the current gas strip” and “we think natural gas is attractively valued relative to oil.”

Roger: I won’t second-guess him. But in any case I think he’s controlling risk, which is really my bottom line. There is a higher level of debt that you might find in other MLPs, with about USD511 million net debt. They have USD211 million drawn on a USD850 million revolving facility; it matures May 9, 2016, so that gives them plenty of time to refinance or rollover.

The facility’s rate is variable and resets quarterly, actually rising when the company draws out more money. That could be a problem if interest rates really moved up but it’s not now and the company has USD345 million of undrawn capacity to make more acquisitions.

David: The third-quarter distribution was raised 3 percent from the second-quarter level. But it’s up 11.5 percent increase over the third-quarter 2010 distribution, and it’s the sixth consecutive quarterly distribution increase since May 2010.

Can they possibly sustain it?

Roger: That depends on energy prices in my opinion. But the point is they have done a lot to ensure the current rate holds. And that alone should be enough to ensure a big total return from income and the stock price going a lot higher.

David: The only thing I can think of to gainsay that is that this company does have something of a checkered past. It was once part of Provident Energy Ltd (TSX: PVE, NYSE: PVX), and there was a huge battle between that company and Quicksilver Resources Inc (NYSE: KWK) in the courts. It was apparently resolved, but I wonder if there are residual issues we’re not aware of.

Roger: That’s a good question. Unfortunately, energy is literally a dirty business, and there are always legal, regulatory and environmental issues. Some you can get forewarning of by reading the 10-K. Some you can’t.

I also worry about any energy company operating in California, as BreitBurn is, or that relies on such mature fields to increase production. This is why we have to watch all companies every single quarter for signs of weakening and we have to be ready to exit when warranted.

That’s the nature of a calculated risk, and it’s why Big Yield Hunting stocks aren’t as safe as portfolio stocks in our other advisories. But for those who are prepared to take the risk, this is a great shot. And we could really see some huge gains if energy prices head higher going forward as I expect.

David: OK, and as for MLP taxation, here’s a brief primer. Master limited partnerships such as BreitBurn are taxed differently from common stocks. A portion is return of capital (ROC), which isn’t taxed when received. Rather, ROC is subtracted from your cost basis and is taxed as a capital gain when you sell the MLP.

A portion of MLP distributions may be classified as “unrelated taxable business income,” or UBTI, which is technically taxable even if you hold the MLP in an IRA. From a practical standpoint, however, unless you have total UBTI from all MLPs in an IRA that adds up to more than $1,000, you won’t owe tax. Having that much UBTI requires an institution-sized account.

The net impact of MLP taxation is you pay less than you would on a common stock dividend. It is more complex. Mainly, you receive a Form K-1 rather than a 1099. Many K-1s can be downloaded directly on TurboTax, however, and any competent accountant should be able to file them correctly without charging an arm and a leg.

Roger: Thanks for getting that out of the way.

David: Thanks, Rog. Buy BreitBurn Energy Partners up to USD18. And note, too, that the buy-under price for October’s pick, PetroBakken, is now USD10.

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• March 17, 2011: Chorus Aviation Inc (TSX: CHR/A, OTC: CHRVF)–Buy < USD5.50
• April 21, 2011: Superior Plus Corp (TSX: SPB, OTC: SUUIF)–Buy < USD11.60
• May 19, 2011: The DATA Group Income Fund (TSX: DGI-U, OTC: DGPIF)–Buy < USD6
• June 16, 2011: FP Newspapers Inc (TSX: FP, OTC: FPNUF)–Buy < USD5.60
• July 22, 2011: France Telecom (France: FTE, NYSE: FTE)–Buy < EUR16, USD23
• August 31, 2011: Zargon Oil & Gas Ltd (TSX: ZAR, OTC: ZARFF)–Buy < CAD17.50, USD18
• September 15, 2011: Alaska Communications (NSDQ: ALSK)–Buy < USD8
• October 21, 2011: PetroBakken Energy (TSX: PBN, OTC: PBKEF)–Buy < CAD10.30, USD10
• November 18, 2011: BreitBurn Energy Partners LP (NSDQ: BBEP)–Buy < USD18

• August 19, 2010: New Flyer Industries (TSX: NFI-U, OTC: NFYIF)–SELL (06/16/11)
• November 18, 2010: Telstra Corp Ltd (Australia: TLS, OTC: TLSYY)–SELL (06/16/11)
• January 20, 2011: Cellcom Israel Ltd (Israel: CEL, NYSE: CEL)–SELL (08/18/11)
• February 22, 2011: DUET Group (Australia: DUE, OTC: DUETF)–SELL (08/18/11)