The United States shale revolution has been a godsend for master limited partnerships as a direct result of what the Internal Revenue Service defines as ‘qualifying sources’ of income.
According to the IRS, a partnership must generate at least 90 percent of its income from qualifying sources to meet MLP requirements. Luckily for energy investors, these sources are generally produced in the natural resource industry.
Principal industries for MLPs include, but are not limited to, transmission pipelines, oil, natural gas, refining, and midstream units. With the rise of shale production in the U.S., midstreams have seen great yield recently.
MLPs hold tax-exempt status on the corporate level, which allows the partnerships to pay higher distributions to investors. Instead of paying corporate taxes, MLPs distribute the extra money to investors on a quarterly basis.
And if that’s not enough, the income received from distributions is tax free until investors receive back the full amount of their original investment.
Companies like Kinder Morgan (NYSE: KMP), Plains All American Pipeline (NYSE: PAA), and Markwest Energy (NYSE: MWE) have all benefited from MLP status, and other companies are looking to hop on board.
A New MLP
Devon Energy Corporation’s (NYSE: DVN) board of directors just announced a plan to form a publicly traded midstream MLP. The partnership will own a minority interest in Devon’s United States midstream business, which includes natural gas extraction and processing throughout Texas, Wyoming, and Oklahoma.
Devon has significant midstream assets, with over 300 compressor units, 8 gas processing plants, and 6,500 miles of pipeline.
The MLP is expected to register with the Securities and Exchange Commission in the third quarter of 2013, with an offering of publicly traded MLP units following registration.
Devon will own a majority of the MLP units as well as incentive distribution rights. The company plans to use the additional cash flow collected from unit purchases to fund current operations.
Now, I wouldn’t be quick to jump on the Devon MLP train right away – MLP investors stand to make most of their income through consistently high profits, not growth potential, and Devon fits much better in the latter category. The move is more likely to pose benefits to current Devon shareholders.
Operating cash-flow has been a concern for analysts looking at Devon, and funds received from incoming unit purchases should alleviate some of these doubts.
In addition, Devon is currently coming out of a transition period that poses a potential upside for what could be an undervalued stock.
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Transition Period
Beginning in late 2009, Devon Energy began to sell off close to $10 billion in assets in order to shift focus from offshore international activity to production in North America. Considering the 23 percent year-over-year increase Devon has seen in production rates, this was a good move.
However, the market doesn’t seem to agree – Devon’s shares have dropped nearly 50 percent in the past five years, which is pretty shameful when compared to major energy indexes.
But a drop in price is only unwelcome to those already invested. For everyone else, this simply means opportunity.
It is very possible that Devon is currently undervalued. The company is trading relatively low against 5-year performance, and its price to book ratio is 0.6 lower than the industry average.
The transition to onshore and domestic drilling has likely been turning off investors for the past few years (the stock took a major dive surrounding the 2009 asset sales). But patience is a virtue, and these things take time.
Considering Devon’s acreage holding in the Permian Basin, production growth is more than promising. The Permian Basin contains the Cline formation, which holds an estimated 30 billion barrels of recoverable oil, and Devon holds 389,000 acres in the play.
Devon plans to drill 30 wells in the area this year, further establishing its footprint in onshore shale plays.
In addition, the company recently announced a quarterly cash dividend of 22 cents a share, which is a 10 percent increase over its prior dividend.
As long as the Cline continues to meet expectations, Devon is looking at substantial growth opportunity in the near future.
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