3 Reasons Wall Street is Dead Wrong About KNOT Offshore Partners

Source:  Knot Offshore Partners

A sky high-yield can often be a red flag that a company's payout may be too good to be true. Then again the worst oil crash in decades can also create immense long-term income generating opportunities. Learn three reasons why Knot Offshore Partners (KNOP 1.13%) is one such opportunity and more importantly, how Wall Street's mistake can greatly benefit your diversified dividend portfolio in the years to come even if oil prices remain in the toilet.

Super stable and growing earnings

Source: Knot Offshore Partners earnings presentation.

As you can see Knot Offshore Partners had a great quarter. Three drop downs over the past year increased its fleet size 43% over the past year fueling strong growth in sales, profit, and most importantly, the DCF that funds the quarterly distribution. 

On October 15th Knot Offshore purchased the Ingrid Knutsen, its 10th tanker, from its sponsor for $115 million. The vessel is charted by a subsidiary of ExxonMobil (XOM -1.67%) through Q1 of 2024 with two options to extend that to 2029. This latest drop down adds $238 million to Knot Offshore's backlog which has grown to $863 million with an average charter contract duration of 5.8 years.

Payout is far safer than Wall Street believes
Income investors need to look at three aspects of any investment: yield, payout security, and realistic long-term growth prospects.  Arguably distribution sustainability is the most important part of a distribution profile for investors to consider, since unit prices typically rise or fall alongside an MLP's payout. Based on Knot Offshore's 15% yield investors have very little confidence in the MLP's ability to sustain its distribution or grow it in the future.

However such assumptions are incorrect. Knot Offshore operates both in the oil and shipping industries which are some of Wall Street's most hated sectors right now. However, its business model is in no way like that of struggling oil producers or dry goods shippers that have seen prices for their products or services collapse catastrophically in recent years. The fact is that Knot Offshore Partners is, In the words of CEO John Costain, "in essence, a midstream mobile pipeline business with fully contracted revenue streams...There is, therefore, no commodity risk."

Source: Knot Offshore Partners.

Excellent growth prospects

Source: Knot Offshore Partners.

As you can see Knot Offshore's cash flow is ultra secure, backed by long-term fixed rate contracts with some of the largest oil companies in the world such as ExxonMobil, Statoil (EQNR -2.13%), and BG Group, which will soon be owned by Royal Dutch Shell (RDS.A). The same holds true for the future drop down pipeline of tankers which provide the opportunity to grow its fleet 50%.

Despite the worst oil crash in a generation big oil companies continue to invest in the most attractive offshore opportunities and that means continued strong demand for this niche midstream sector. For example BG group is currently investing heavily in offshore Brazilian oil exploration where break even prices remain below $40 per barrel.

Similarly Statoil continues to drill and invest North sea oil production. In fact Statoil recently decided to invest over $7 billion in the Mariner oil field and is considering investing in the Bressay field as well. Combined the Mariner and Bressay projects would likely result in 195,000 barrels per day of production and generate demand for five shuttle tankers.

Risks to be aware of
Should oil prices remain low for several years than shuttle tanker charter rates will continue to decline as they are slowly doing now. For example Repsol, a subsidiary of Sinopec, recently extended its contract for one of Knot's tankers by five years to 2023 in exchange for a 6.2% reduction in charter rate.

Meanwhile Knot Offshore's current unit price is potentially too low to raise equity growth capital in order to buy the five drop down candidates from its sponsor without excess dilution that could lower future distribution growth.   

Bottom line: Wall Street has Knot Offshore Partners' business model all wrong
In my opinion there is no justifiable reason that Knot Offshore Partners should be trading at a 15% yield. Yes plunging oil prices have had a small negative effect on shuttle tanker charter rates. However based on: the small magnitude of these declines thus far, Knot Offshores' long-term contracted, fixed-fee midstream business model, and its sustainable coverage ratio, I think the probability of a distribution cut over the next few years is far lower than what Wall Street is currently pricing into the MLP.

What's more its sponsor's drop down pipeline means that Knot Offshore Partners has a very clear growth catalyst should Wall Street realize its mistake and price this MLP's units correctly.