Sounds like an oxymoron, safe dividends and speculative upside. How could that be possible?
Oil has fallen over 70% over the last year due to declining projections of future oil demand. While I have argued that long oil exposure is a prudent and wise move for any portfolio, there’s no better time than today to be adding long oil exposure given the potential upside available. It’s hard to argue that, despite increased focus on alternative energies and alternative fuels, these new technologies will not likely affect oil demand in any significant manner over the next decade. The first American electric car will not reach production until the end of 2010 and will take years before wide spread adoption changes consumer behavior. New power plants also take between 2 and 5 years to complete and truly efficient new technologies such as solar power could take at least another two to three years before they become competitive with current oil prices.
But, despite the 240% upside should oil reach back towards its $150 high, it’s hard to predict just when oil might rebound. As such, I’ve been looking for oil stocks that pay dividends. One in particular, Linn Energy, has been on my radar for months.
Linn Energy (LINE) is an exploration and production MLP. An MLP is a publicly traded vehicle that is structured as a limited partnerhsip. As a result, “dividends” are actually classified as distributions and treated as a return of principal. As a result, there are some additional tax complications, but ultimately provide an opportunity to gain the advantage of having your distributions taxed as capital gains as opposed to ordinary income.
Investment Strengths and Weaknesses
Linn Energy produces and sells oil and gas in the Western and Mid-Continent regions of the U.S. What separates Linn from its competitors is an aggressive hedging program for which they have hedged current production levels through 2011 at prices in excess of $80/barrel of oil and $7/Mcf of natural gas. Even more savvy, the Company uses puts on 40% of its hedging to allow it to take advantage of any upside price action.
The worry for Linn and other MLPs is that frozen credit markets will limit their ability to grow through acquisition. Linn, however, has demonstrated an ability to grow proved reserves organically and maintains $440 million in borrowing capacity, enough to selectively target new assets.
Valuation
Linn currently pays $2.52/share in distributions a year. Strong hedging through 2011 should provide at least three years of security even without continued growth through acquisition. If the Company were truly unable to grow its proven reserve assets, it could still produce at current levels for 21 years. Assuming oil and gas prices were never to rebound from current levels, one might assume that the dividend would be halved from 2012 and onwards. Applying a 10% discount rate, the NPV of these dividends alone would be $14.63, a 12% premium to current prices.
Full Disclosure: Author is long shares of LINE at the time of writing.
