Source: KNOT Offshore Partners
Oil prices recenty hit an 11 year low which has resulted in many energy stocks, including shuttle tanker operator KNOT Offshore Partners (KNOP 1.13%) falling to all time lows and sending its yield to a sky-high 15.5%.
Yet such periodic market crashes can offer superb long-term income investing opportunities if the underlying business model of a company can continue to generate strong and predictable cash flows that results in a sustainable payout.
To illustrate three reasons why this is likely the case with KNOT Offshore Partners let's take a look at a few key management comments from the company's most recent earnings call to see why this MLP could prove to be one of the best high-yield dividend stocks of 2016 and beyond.
Wall Street is overly pessimistic about shuttle tanker industry
"Investor perception seems to be that the shuttle tanker demand will vary with crude oil prices and the resulting appetite for offshore drilling. They perceive charter rates will come under pressure, if the low oil price persists. Perception is not reality."-John Costain, CEO
While true that low oil prices could hurt global offshore drilling demand in the long-term should they remain very low for many years, investors fears regarding short-medium-term charter rates for this niche tanker market fails to take into account once important fact.
Deep sea oil projects take several years to bring online, and despite oil companies slashing their capital budgets in 2015 and 2016, new offshore projects -- for which investments have largely been completed or who have attractively low break even prices -- are likely to continue driving strong demand for shuttle tankers over the next few years.
In the North Sea, where 40% of KNOT Offshore's tankers operate, Statoil (EQNR -2.13%) is continuing with a $7 billion oil project and considering a second. Together these two projects have the potential to employ five additional shuttle tankers alone, each under lucrative, long-term contracts.
Meanwhile, offshore Brazilian oil projects have a breakeven price of around $40 per barrel. That's low enough for BG Group -- which is being acquired by Royal Dutch Shell (RDS.A) -- which has signed long-term contracts for three of KNOT Offshore's five potential drop down candidates.
Midstream MLP business model
"KNOT Offshore Partners LP is, in essence, a midstream mobile pipeline business, with fully contracted revenue streams and...before ordering a new vessel, KNOT Offshore will always agree a long-term employment contract for the vessel. There is no speculative ordering, so our MLP will yield both stable and sustainable revenues." -John Costain
Source: KNOT Offshore Partners investor presentation
KNOT Offshore's current yield implies a substantial short-term threat of a distribution cut yet its distribution coverage ratio of 1.07 shows that its actually sustainable. What's more its distributable cash flow or DCF-- which funds the payout -- is secured by contracts with an average remaining length, including extension options, of 8.3 years.
In addition the companies KNOT Offshore does business with are hardly some fly-by-night operations but instead some of the world's largest oil giants, such as Statoil, ExxonMobil, and Shell. The strength of these counter parties means that contract defaults are very unlikely and yet another reason that this MLP's high yield is, in my opinion, unjustified.
Continued growth potential despite low oil prices
"On the October 13, 2015, we were pleased to announce the purchase of Ingrid Knutsen from our sponsor for $115 million. The vessel is on a 10-year time charter to...subsidiary of ExxonMobil...We financed the acquisition by the assumption of $104.5 million of outstanding indebtedness and cash in hand...We have an aggregate of $77.5 million of secured debt related to Ingrid Knutsen."-John Costain
I point out this quote to highlight the importance of debt funding to KNOT Offshore's continued growth. With the unit price so low debt funding is pretty much the only funding source for the MLP to acquire the five drop down candidates in its sponsor's drop down pipeline.
However, just because an MLP has continued access to debt markets doesn't mean its balance sheet is strong enough to support continued borrowing until a recovery in oil prices raises the value of its equity high enough to allow for the selling of additional units to fund accretive growth.
Luckily KNOT Offshore Partners' current debt load of $619 million is entirely in the form of senior secured term loans, and not from a revolving credit facility whose debt covenants could limit its ability to continue tapping growth funding.
In addition, the MLP's cash balance of $67 million is large enough to cover the cost of the $64.5 million in debt coming due through 2016 meaning that the KNOT Offshore shouldn't have any problems servicing its debts.
Bottom line:
The simple fact is that KNOT Offshore's long-term, fixed-price contracts grant it a midstream business model that means its DCF is largely immune from short-medium term oil prices. This is why, in my opinion Wall Streets absurd valuation of this MLP makes it one of the best hidden long-term income opportunities of 2016.
