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Radnor, Pennsylvania-based Penn Virginia Resource Partners, L.P. (PVR) is a master limited partnership engaged primarily in coal-royalty leasing activities and gathering and processing natural gas. The partnership's coal properties are located in the Appalachian, Illionois, and San Juan basins (Virginia, West Virginia, eastern Kentucky, southern Illinois, and New Mexico). The partnership's natural gas midstream business was acquired in March of 2005 and has assets in both Oklahoma and Texas.
As of the end of 2006 Penn Virginia LP controlled approximately 765 million tons of proved and probable reserves (approximately 87% steam coal, 13% metallurgical). Approximately 73% of the coal produced from the partnership's properties comes from underground mines. PVR made three coal acquisitions in 2006, adding 96 million tons of coal reserves. Also, in the first half of 06 the partnership purchased additional pipeline assets to complement its current natural gas midstream business. More recently, the company has expanded into both timber assets and oil & gas royalty lands.
MLP status explained
Penn Virginia Resource Partners operates as a master limited partnership or MLP. In adopting this corporate structure, the company is limited in that 90% of its income must be generated through natural resource type operations. Typically, the company will purchase steady cash flowing assets such as royalty interests or transportation pipelines. By maintaining this focus, the government allows MLP's an exemption from both federal and state taxes at the corporate level. This allows companies such as PVR and larger MLP's such as Kinder Morgan LP (NYSE: KMP) to hold income generating assets that deliver cash directly to investors. Once distributed, the income is claimed by the individual investor and taxed at his or her ordinary rate.
There are a few key points to consider before purchasing MLP units as investments. First, they can complicate year-end tax filing complexities. An investor may need to file additional forms and may be required to file in each of the various states where the MLP does business. Second, MLP's may not be suitable for tax deferred accounts such as an IRA, Roth-IRA, or 401K. Investor's are advised to consult their tax advisor regarding this matter. Finally, as a positive for MLP's, most of a given distribution is non-taxable due to depreciation and depletion write-offs. An investor will typically pay tax on less than 20% of the distributed amount. The investor's tax-basis on the units however, will be reduced.
Bull Story
PVR's status as a coal-royalty MLP reduces its exposure to the inherent risks in the coal production business, such as environmental, labor, and permit-related risks. Since the partnership does not operate any mines itself, it has low operating costs, generates stable cash flows, and has very little maintenance capital expenditure requirements. The partnership s MLP structure exempts it from federal taxes and this gives the business a capital advantage when purchasing energy assets. We believe its growth through acquisiton strategy offers long-term upside to unitholders. PVR units are appropriate for investor s seeking income along with upside to domestic coal markets. At its current distribution rate of $1.76 per unit, PVR units are yielding a relatively safe 7.8%. The other main source of revenue comes from PVR s midstream natural gas processing and gathering services. This is another source of relatively consistant cash flows with little operational risk. Although the midstream industry has been notorious for its "frac spead" volatility, PVR has done a good job at mitigating this uncertainty by hedging nearly 50% of its throughput for 2008.
Concurrent with their mantra of growth organically and via acquisitions, the partnership is the process of constructing two new processing facilities in Texas which are scheduled to be operational in the first quarter of 2008. Together these facilities will be able to process up to 140 MMcf/d. This should allow PVR to expand its footprint into new markets with the ability to gain a bigger customer base that it once didn't have the capacity to handle. Between coal production and the natural gas midstream operation, the latter should be the largest growth platform in 2008, forecasted to grow 20% from 2007 MMcf/d levels.
Bear Story
The growth engine of PVR needs a constant supply of acquisition opportunities. Management however has noted that acquisition pricing is very competitive in the current market. For this reason, we see only moderate growth coming from acquisitions in the near-term. Other growth avenues will come primarily from increases in coal pricing, total tonnage mined, and total midstream margins. While spot pricing for Appalachian Basin coal has improved substancially from early '07 pricing, the shift of production to the midwest and western basins where coal trades at a discount to eastern coal will put downward pressure on royalties per ton in 2008. Further, while the midstream business is experiencing high margins currently, the results can swing significantly based on "frac spread" volatility. As restated from above, PVR currently has 50% of its midstream throughput exposed to unfavorable price swings in 2008. With our view of a U.S. recession in 2008, a decrease in electricity demand will slow production even further in the Appalachian Basin, the key to having favorable royalty per ton figures. Another downside risk to PVR is that two customers account for 49% of their midstream gas revenue. With this area being their largest growth vehicle, a failure to sustain these customers could prove to be fatal.
Finally, the partnership's payouts have reached the higher split levels, meaning the general partner will receive half of all incremental distribution growth going forward. Specifically, the GP is entitled to 50% of distributable cash above $0.375 per quarter (calculated based on total cash distributed). For reference, the last announced distribution was $0.43 per unit. Overall, while we believe the partnership offers a relatively safe yield, we are willing to wait for more attractive unit pricing.
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