“The Incredible Secret of the 9%-Yieldin’ ‘Tulsa Surprise'” (Roger Conrad)

by Travis Johnson, Stock Gumshoe | September 28, 2012 11:55 am

Friday File look at a new MLP Profits teaser

Here’s how the latest teaser ad that I’ve been asked about from the folks at Investing Daily starts:

“Limited Distribution… Do Not Forward… Do Not Share

“BUSTED!

“The Incredible Secret of the 9%-Yieldin’ ‘Tulsa Surprise'”

And whenever you put that in your ad … well, you can pretty much guarantee that your friendly neighborhood Gumshoe is going to feel an overpowering urge to sniff out the answers and share ’em with the world. Or, since it’s Friday, with the best part of the world: the delightful Stock Gumshoe Irregulars (that’s you!)

So what are they talking about? Well, in case you’re not excited enough to care yet, read on for more of the intro:

“Stage is Set for Massive Run-Up:

“BREAKING NEWS: An Influential Insider Just Went on a Massive Buying Spree. Act Fast and You Could Become ‘Insider Rich,’ Too.”

OK, now do you wanna know? Me too. So what’s the deal? Here’s some more background in Roger Conrad’s words:

“… back in February I alerted readers to a little-known oil and gas upstart I call the “Tulsa Surprise”… barely two months after it went public.

“Fundamentals were solid. Momentum was surging. But talk about hitting the jackpot…

“Yesterday, they announced 2nd-quarter results showing revenue topping $29 million. That’s nearly TRIPLE the $10.7 million in sales during the same quarter last year….

“But I just snooped out a KILLER SECRET…

“While trolling through SEC filings, I noticed a rash of insider buying by one of the company’s most influential directors. Not just one buy… or two… BUT 8 SEPARATE BUYS TOTALING $399,510 SINCE APRIL 17th!”

OK, so … high yield, high growth, big insider buying … sounds good so far. What about some clues about what the company actually does?

“Here’s the crux of the matter… and why the Tulsa Surprise has a major leg up on the competition. For years, they’ve used a remarkable technique to enhance production from flagging wells. They inject water around the edges of a field to restore reservoir pressure and push oil toward wells.

“Incredibly, they can then pump out as much oil in the second phase as their competitors generate in their first.

“They have this ‘squeezing maneuver’ down to a science… they’re beating the competition to the punch… and it’s working like gangbusters.

“Get this: More than 90 percent of the Tulsa Surprise’s 272 wells use waterflooding to bump up production. In 2011, they were getting 1,343 barrels of oil equivalent per day—up 100% from the year before. (Management attributes about 75 percent of this production growth to water flooding.)

“Remember, these are boring old ‘spent’ wells that many other operators would have given up on.”

And apparently this stock has essentially no exposure to natural gas (which is good these days — lots of natural gas wells that seemed like a great idea five yeaers ago are unprofitable at current depressed prices), and hedges well — Conrad says he thinks we’re preparing for oil to spike back above the last peak of about $145 before too long, but that this pick, with its 9% yield, is safer than just buying exposure to oil. Here’s the last bit for you:

“SWEET! Zero Exposure to Depressed Natural Gas Prices… and Hedged In at $100 Per Barrel in Oil

“To insulate the Tulsa Surprise from fluctuations in commodity prices, management aims to hedge about 2/3 of production. Right now, they’ve hedged about 53 percent of 2012’s production and 30 percent of 2013’s—locking in prices of about $100 per barrel.”

Hedging means you’re essentially pre-selling your oil on the futures markets — so you know that at least 30% of the oil you sell in 2013 will be at $100 a barrel, no matter whether the spot price at the time is $35 or $200 or whatever may come. That gives some predictability, which is particularly important for companies like this that aim to have large and regular distributions to shareholders.

So which pick is Conrad teasing? Well, since this is for the MLP Profits newsletter we can bet that it’s almost certainly a master limited partnership (MLP). And it’s a new one, we’re told, went public just this past Winter … and a producing one, which narrows the list still more (most MLPs have historically been in the midstream or pipeline space — predictable, toll-based businesses … MLPs who actually explore for and produce oil or gas or do other stuff aside from operating processing plants and pipelines are rarer).

So we toss all that into the Mighty, Mighty Thinkolator, give the crank a good whirl, and out comes our answer: Mid-Con Energy Partners (MCEP)

Which is indeed a new MLP, it started operations about a year ago and went public last Winter, though apparently it was venture-backed under a different name for seven or eight years before that before becoming a partnership — it looks like there are various entities called Mid-Con Energy (including the current Mid-Con Energy III and Mid-Con Energy IV) who are operators and developers that are then designed to “drop down” producing assets to the MLP, which would pay for the producing assets either wish cash or with new units. And it does yield almost 9% — actually 8.4% at the current price, but it looks like this teaser ad was written about a month ago, following the second quarter results. That’s just taking the current quarterly payout and annualizing it, since they haven’t been public long enough to pay out a full year’s distributions yet … though presumably, like other MLPs, they will focus on increasing the distribution over time.

They did also post that $29 million number in their last quarter[1] — though it looks like a big chunk of that was an unrealized gain from commodities contracts. Cash flow is covering the distribution, which is usually what matters most to MLP investors, and their projections say they’ll have enough distributable cash flow to cover the dividend with a 20% cushion for the next two quarters — probably longer if their operations continue to do well, given their continued push to hedge more than half of their production.

And they really have seen a pretty decent dose of insider buying since they went public — which is a little bit unusual for a new IPO. Usually companies go public in part because they have to have a way to compensate employees who have earned stock options over the years, and those employees tend to be sellers, not buyers, after the stock reaches the open markets (after lockup periods expire, at least), but that’s not what has happened in this case. This was a venture-backed IPO, from Yorktown Energy Partners, and Yorktown funds still own a large stake in the neighborhood of 50%, with the only other institutional holders of consequence being the MLP-focused folks like Kayne Anderson and Cushing. It’s still a very small MLP, with a market cap of less than $400 million. I would assume that the Yorktown funds would want to gradually sell down their stake, as most venture investors do, but it might be that with a strong yield on their initial investment they just want to hold on.

The prominent director who’s been buying shares, as teased by Conrad, is Robert W. Berry, who has a long history in the Texas/Oklahoma oil patch, and another director, Peter Adamson III, has been buying as well — the insider buying has not been among the “C-suite” executives, which is generally the best kind of insider buying to see (the assumption is that CEO, CFO, COO etc. know more about how the company is doing than does the board of directors, and C-suite insider buying is more likely to lead to a gain in price over the ensuing year or so). Adamson is a local investment manager, but Berry is enough of an oil patch insider that I can see why Conrad would give his buying extra weight.

There are several other producing MLPs that have been teased or covered in this space in recent years, with the most prominent among them being the stalwart Linn Energy (LINE)[2], but other names to consider if you’re looking for an MLP with a high yield that actually produces oil and gas and appears to have at least a somewhat sustainable and hedged future might be Legacy Reserves (LGCY), Breitburn Energy Partners (BBEP), or Vanguard Natural Resources (VNR). There are a few others, too, including two that are also recent startups that have higher yields and, one presumes, probably carry more risk than LGCY, LINE or MCEP — the “babies” with double digit yields that I’ve noticed are QR Energy (QRE) and LRR Energy (LRE), I haven’t checked them at all but I usually presume that the higher-yielding producing MLPs either have less hedging, lower reserves, or more natural gas exposure.

In general, I do like the well-run producing MLPs as an alternative to the oil and gas trusts — the trusts have been resurgent as well, with some new ones coming public in recent years, but I like that MLPs have much more flexibility. A trust has its portion of an oil field’s production but has no flexibility to go out and buy more assets, or to invest in the field to increase returns, they have to be passive … but MLPs can be much more active — issuing new units to buy more fields, or investing in the fields to raise production levels (as with the waterflooding that MCEP is doing), etc. They’re almost certainly going to be more volatile than and riskier than the big pipeline operators, who run toll businesses that are much less dependent on the production of any one oil field or on the pricing of the actual commodity, but that’s why they pay higher yields.

There’s plenty to like about MLPs in general in a low-yield environment — they don’t have to pay much interest on their debt, and even the big, stable pipeline-operators and midstream companies pay out pretty enticing yields of 4-5% still, which sounds good next to most bonds, particularly if you like the tax deferral features and don’t mind dealing with the K-1 filings. Of course, they’ve also continued to get more and more attention from investors, too, including this latest piece from Barron’s today[3].

So is MCEP one for you? Well, it doesn’t have much of a track record, and I would expect that it will probably be a bit riskier than bigger players like LGCY and LINE who are similarly producing oil from long-lived, slow decline fields — but with a market cap of only $400 million it’s also going to be far, far easier for MCEP to boost returns by adding a few new assets or getting better than expected results from a few wells. It takes lot less to move the needle with a small cap player like this than it does for the $8 billion LINE or even the $1.4 billion LGCY, for example … and MCEP has the additional bonus of having relatively low debt, so they could probably juice returns by levering up a bit more if they wished to do so.

And yes, if their success with waterflooding continues they should be in quite good shape — they have now hedged about half of their 2014 production at $94, so that’s a good indication that if their performance in the field is as they expect then they should be able to maintain distributions quite nicely for the next couple years even if the price of oil falls. The flip side, of course, is that if oil goes to $250 a barrel they’ll do substantially worse than oil producers who haven’t hedged — but if you’re buying into these kinds of producing MLPs you need to have the expectation that they will be sustaining and gradually increasing the distribution, not that they will give you exposure to spikes in the price of oil. If we get a crazy price spike and MCEP (or one of the other hedged MLP producers) doubles because the oil price doubles, you probably want to sell MCEP before everyone realizes that their distributions won’t go up as fast as the price of oil.

With insiders controlling the general partnership shares, and with the founding private equity investors controlling the company, you won’t get any say in how the company operates or dilutes unitholders or anything else … so it’s reasonable that these shares should trade at some discount because of the fact that they could come up with ways to be unusually generous to themselves … but frankly, if you thought you were getting much input into any other company you own you’re probably deluding yourself, anyway. Substantial insider ownership does at least give the directors and executives motivation to maintain the value of the units, which for a MLP really just means maintaining and growing the unitholder distributions.

You can see the company’s investor presentation here[4], they give a pretty good rundown of their hedging, their strategy, and their success so far in substantially increasing production with waterflooding. I haven’t spent a lot of time examining their reserves or the structure of the partnership, but I do give Conrad credit for generally doing a good job with picking solid performers in the oil patch, including some picks I’ve bought in the past. I don’t particularly want to add a producing MLP to my portfolio, but if I did I would probably diversify a bit by buying sector leader LINE along with one of the smaller, higher-yielding picks, perhaps like MCEP or one of the other younger players.

Endnotes:
  1. their last quarter: http://ir.midconenergypartners.com/releasedetail.cfm?ReleaseID=698996
  2. Linn Energy (LINE): http://stockgumshoe.com/tag/linn-energy/
  3. latest piece from Barron’s today: http://online.barrons.com/article/SB50001424053111904414004578022772151614246.html
  4. see the company’s investor presentation here: http://files.shareholder.com/downloads/AMDA-KNI1T/2090767865x0x590833/4f3d3ff4-5af4-4efa-8f11-de0eeceaf26a/MCEP_Investor%20Presentation_08.08.12.vF.pdf

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