Vanguard Natural Resources LLC
Vanguard Natural Resources LLC at National Association of Publicly Traded Partnerships MLP Investor
May 22, 2013 9:00 a.m. ET
Richard Robert – EVP, CFO, Secretary
Kevin Smith – Raymond James
All right, good morning. We're going to go ahead and start with our next presentation. Next up, we have Richard Robert speaking on behalf of Vanguard Natural Resources, the CFO, and talking about their nice outlook, as well as their robust organic drilling program that’s kicking out. And with that?
Thank you, Kevin. Good morning, everyone. Thank you for taking the time to come listen to the Vanguard story.
There are two principal things I’d like – that I hope you get out of this presentation.
The first being that we’re not a typical upstream company. We’re very different than your typical C-Corp resource player. And the second thing – I hope you get out of this presentation – is that a growth-via-acquisition strategy is a viable strategy. And with that, I’ll get started.
We are an upstream MLP. We call ourselves an MLP, but, actually, we are structured as an LLC. The difference, essentially, is that we do not have a General Partner. And, as such, we don't have incentive distribution rights.
And so, that’s a very important concept, when you're considering cost of capital. And down the road, we won't have those cost of capital constraints that a lot of the midstreams you see are having. Ones that have been successful and have raised their distributions, a lot of them are having to buy in their GPs because they can't be competitive anymore.
That’s not the case for us. And we’re also – our governance is also much more like a C-Corp, where our unit holders elect a Board of Directors each year.
When we started back in '07, a little over five years ago, we had an enterprise value of a little over $240 million. Today, we’re about $3.3 billion, so a fair amount of growth over this five-year period.
And I would suggest that that growth, if anything, is going to accelerate. Like a lot of things, the first billion is your hardest billion. Now, that we have access to the high-yield market and sellers are aware of our name, the deal flow has improved and, more importantly, the quality of the deal flow has improved.
We’re having to – we’re participating in a lot less auctions and more in kind of seller direct dialog. They know that we’re in the area; they know that we’re going to pay a fair price. And I think we’ve got a reputation, as being a company that is pretty reasonable in terms of negotiation, so I think we’re becoming a preferred buyer on a lot of these assets.
Something we did recently is go to a monthly distribution. We are the first – and not the only anymore, but we are the first company, MLP, that went to a monthly distribution. We did it as a response to investor comments that they like MLPs, but the cash flow is very – it’s not consistent. Four months out of the year when they get their MLP distributions they felt very wealthy. And the other eight months, they were trying to manage their checkbooks. So, we thought we would take care of that and start providing monthly distributions. And I think the response on the retail investor side has been quite good.
We identified five specific areas that we thought were very important to creating a successful upstream MLP. First and foremost is you have to buy the right assets. You might remember the oil and gas partnerships of the '80s didn't fare very well for two reasons.
One, because of the pricing; everyone remembers what happened from a price perspective; the prices collapsed, and hedging wasn't available at that time, so they took it in the chin.
But they also didn't necessarily buy the right assets. We look for some very specific characteristics, being long-life reserves. We want high R-over-P ratios. We want stable production profiles. We want stable operating costs. And we want a high percentage of producing properties, when we buy these assets. Typically, 60% or more of the properties need to be producing such that it can be accretive on day one.
Second thing is discipline. Know when things fit. Step aside when they don't fit. We evaluate upwards of 150 transactions on an annual basis. We’re introduced to two, three, four new deals every week. But they don't all fit, and we call those out pretty quickly.
If they don't have those characteristics that I just suggested, we typically won't go to the next step. But when we do go to the next step, we do a full evaluation, we use realistic assumptions, and we bid, based on those assumptions.
We lose most of the time. We have to get very used to losing on transactions. We probably bid 50 transactions and we may complete three, four, five transactions in a given year. So, we just have to be very mindful that the assumptions have to be realistic and we have to continue to be disciplined. We all want to grow, but we want to grow wisely.
And I think that one of the things I forget to mention sometimes is we’re very proud of the growth aspect, going from $200 million-plus to $3.3 billion. But what we’re most proud of is over the course of time, we’ve raised our distribution 45%. So, I think that is a testament to making good transactions. Even in volatile commodity markets and in volatile financial markets, we’ve been able to find a way to grow and continue to raise our distribution on a consistent basis.
An active hedging program, as I mentioned. That’s really the difference between the partnerships of the '80s and the partnerships of today. That’s what allows this upstream model to work.
We use a very active – we have a very active hedging program. There’s probably – there’s not a week that goes by that Scott and I and our treasurer look at our hedge book and look for ways to optimize and put in new hedges. And you’ll see in our quarterly press releases, we always have a section, where we say all the new hedges that we put in place that quarter; so it just shows you that we’re continuously adding new hedges.
Strong credit profile. Clearly we need liquidity to prosecute this acquisition strategy. We want to make sure that we have the funds available. Sellers like to see liquidity on your balance sheet, before you put in the bid, so it’s important that we continue to have a good credit profile.
And finally, like any other company, you want a management team that has some experience. And as you can see from this next slide, there’s a lot of years of experience on the right there. I am the baby at 25 years. A lot of gray hairs. And we’re very fortunate that we’ve been able to pick up a lot of these people over the course of time.
When we started this Company we had four employees; Scott and I being two of them, so we’ve come a long way and added some very good talent.
Where we started; Appalachia. We were essentially a one-trick pony; all gas, all Appalachia. But we told our investors not to worry; we were going to diversify geographically as well as commodity-wise. And sure enough, here we are today operating out of nine different basins, very diverse set of assets.
A lot of operated. We operate about 60% of our cash flow, which is important, we feel. We don't mind getting into non-operated interests, but we want to make sure that we do it with partners that – number one, we feel are very competent; and, number two, have a similar view on how to spend capital and the rates of returns that are required to spend that capital.
We did have a significant shift in our reserve mix from the end of 2011 to the end of 2012. As you can see, at the end of '11, we were much oilier on a reserve basis than we are at the end of '12. That was a specific plan that we put in place, and I’ll get into a little bit more on another slide.
But what didn't change is a high percentage of PDP. Proved developed producing assets still is the bulk of our production – bulk of our reserves.
So, to the point that we are not a typical C-Corp. It’s a very important distinction because you invest in these companies for entirely different reasons, and I want to make sure our investor base understands that.
We don't invest a lot in acreage. Like I said, we want a high percentage of PDP, so we’re not buying a lot of undeveloped acreage that we’re going to have to spend a lot of money to develop. As such, we don't out spend our cash flow. In fact, we couldn't, if we want to make a distribution. So, it’s important that we buy the right assets.
And finally, we don't take commodity price exposure, which is, typically, a lot of the C-Corps that’s what their investors want. That’s why they buy certain companies because they have a view on where oil or gas is going to go and they want to ride that wave.
We are a much different story; we’re about yield, we're about stable, consistent cash flow generation. We don't want to buy properties that require a significant amount of capital.
We are the only upstream MLP now that doesn't have growth capital in their capital structure. All of our – all of the drilling capital that we spend is considered maintenance capital.
And when we derived what our maintenance capital is, it’s a very specific – it is a very formulaic number. We look at the decline that’s expected on our existing assets. We look at the cash flow decline that’s a result of that production decline. And then, we go through all of our undeveloped acreage and we determine which projects that we are going to do to replace that cash flow.
It‘s not necessarily production. It’s cash flow. We can see natural gas declines. And as long as you’re replacing that with some oil, you can see on a BOE basis your production go down and your cash flow stay the same. So, we're really not focused on production, which is another difference between the C-Corps; they typically focus on production and not necessarily cash flow, it seems.
As you can see from this slide, this is 2012 capital programs. On the left-hand side there, the resource players. The red represents how much they spent in drilling. The blue represents how much cash flow was generated by that entity.
As you can see there’s a big gap. And that gap is reversed on the upstream side. Even those upstreams that have a capital program or growth capital programs, they continue to have more cash flow than their capital programs.
But the C-Corps, that gap has to be filled. And that gap is typically filled through M&A. They sell assets. And that’s how – they sell their mature assets to reinvest in higher-growth assets.
And that’s why in this acquisition – this growth-through-acquisition strategy is viable because these C-Corps outspend their cash flow year over year over year, and that allows there to be a lot of opportunities for people like us to buy the assets that they no longer value. They’ve gotten the returns. They’ve developed these properties. They’ve gotten good returns. They’re now in kind of a terminal decline, where it’s a very slow, shallow decline. That’s when we want to buy it.
So, there are a lot of assets come to market, and that’s really the difference between the midstream pipeline market and the upstream market. The midstreams grow through organic growth. They add to existing capacity. They build new pipelines. It’s a fairly visible growth strategy.
Ours, obviously, is less visible. It’s less certain, which clearly is why the upstreams trade at a higher yield than some of the midstream folks. But until you understand how large the M&A side is, I guess, you don't understand how viable it is to actually grow through this strategy.
I mean if you look at all the upstream MLPs that have been out there, we’ve all grown substantially in the five, six years that we’ve been in existence. And there’s really no reason to think that it’s going to slow down. In fact, my premise is that it will accelerate. And the reason it will accelerate is because of the shale revolution.
To put it in perspective, a lot of people hear about the shale revolution; it’s talked about a lot. But not everyone understands dynamics of how big the numbers are. Yes. When – pre-shale – we thought we had a 12-year life of gas. Today, post-shale, it’s a 100-year life. You know that’s a significant step change in reserves.
On the oil side not quite as dramatic, but still fairly dramatic. We thought we had 20 billion barrels of reserves. We now think we have 100 billion barrels of reserves.
These numbers keep getting revised, as well. I was told – these are January numbers; I have heard the numbers are even actually higher now than they were back then. So – and these are not our numbers. This was an investment firm, investment company that did some analysis. So, these aren't numbers that I'm just pulling out of nowhere.
So, the same firm did an analysis on what kind of capital is going to have to be spent to develop the reserves that we know about today. And they suggested that over the next 30 years, the midstream sector, the pipelines, are going to have to spend about $250 billion. That pales in comparison to the $1.8 trillion that’s going to have to be spent by the upstream companies, the C-Corp resource players.
That’s a lot of capital, and they’re going to have to finance that somehow. And if you look at, historically, how they’ve financed it, they’ve done it through selling assets; assets that no longer fit their strategy. And those are the assets that we like.
So, it’s a very symbiotic relationship. The C-Corps have recognized the upstream MLP, as a financing vehicle for themselves, essentially, and it’s one that they will continue to utilize because they don't view us as competitors, so they like to sell to us.
I told you about our reserve change. We went from gas to oil then back to gas. Well, back in the middle of 2009, gas was trading in the $9, $10, $11 range and oil was trading, I think, in the $50, $60 range. And Scott and I looked at each other and said, “You know I think there’s probably going to be better opportunities on the oil side over the next several years.”
And so, sure enough, for the next two years, we focused on oily transactions, and 10 of the next 11 transactions were oily. Well, it was nice to be right. We all saw what happened to gas prices and we’ve seen what has happened to oil prices.
Well, we kind of had the reverse epiphany at the end of '11; we had gas at $2; we had oil at $100. And we looked at each other and said, ”You know what? I think it’s time to start looking at gas.”
And sure enough, in 2012, that’s what we focused on, and we completed two large transactions in 2012. And, hence, our reserve mix has become much more gassy. That doesn't mean our cash flow is gassy; it means our reserve mix is. And I think it bodes well for the future. We did very good transactions based on existing pricing. But really the optionality that we purchased for nothing is really significant and I think will benefit our unit holders in the long run.
We'll talk about these transactions briefly. The Range Permian acquisition is a $275 million acquisition we closed on April 1st. Excited about this.
You’ll notice an R-over-P ratio of about 20 years – a little over 20 years, actually. That’s the type of asset we like. It had a good mix in terms of production – about 40% gas; 30% oil; 30% NGLs; so a good mix in product as well.
But what really interested us about this – excites us about this project is the behind-pipe opportunities. These were conventional wells, vertical wells that were producing out of one zone typically. And they actually had sometimes four, five, six different formations above the existing producing formation that were not producing at the moment.
So, all that we propose to do is to go downhole, perforate other zones, and commingle the production. We’re talking about a very small capital cost; somewhere in the $200,000 to $250,000 range, and you are bringing on several other zones of production. That’s a very economical way of bringing in other production, when the vertical hole is already drilled.
So, we modeled that transaction doing two of those per month – two of those types of re-drills per month. And we have a four- to five-year inventory of locations to do, so it’s a good project. We’ve finally a – we just hired an engineer, who’s going to do nothing but prosecute that plan.
The Barrett acquisition; it was a transaction that we closed on December 31st. It was a $375 million transaction, as I recall.
A lot of acreage, where we took over operations in the Wind River and the Powder River areas, and got two field offices there. And we ‘re prosecuting our plans up there.
But there isn't a lot to do in these areas because gas drilling doesn't work very well, and certainly not in our acquisition model. When prices were in the $3 range, drilling didn't work. And so, the good news is all the undeveloped acreage that came along with this transaction, it had no value, so we didn't pay for it. So, we got an option for nothing, essentially.
It had a very nice hedge book attached to this production, and we continue to hedge these properties for four or five years.
But what made this interesting is the profile didn't necessarily work for us very well. Barrett had spent, in excess of $100 million for the last few years in the Piceance Basin in particular. They really liked that area.
And so, they had declines. They had new wells that were declining pretty hard. So, the decline rate in this area was 18% to 20%, which is not the model we like.
So, we had to figure a way to make it work. And so, what we decided to do was to escalate the working interest in that area each year. They didn't want to sell their entire interest in the area; they only sold us a small part. We started at 18% this first year; then we go to 21% the following year; 24%; and then finally 26%.
And that, combined with a hedge book that escalates every year, you know the contango gas market, and so we were able to hedge a higher price each successive year. So, even with that high decline, we’re able to keep our cash flow essentially stable with no capital expenditures. So, that was – it's a very nice transaction. That’s the MLP nirvana; no capital and keeps stable cash flow.
And 2016 was an important year. We only escalated through 2016, because we think by 2016 we will have sustainable $4.50 type pricing, which makes drilling in this area economical again. So, that’s how we modeled this transaction.
This is a transaction that we closed – this is a $445 million transaction that we closed in June of last year. Again, a very prolific area, the Arkoma Basin. Woodford had most of the value. We really didn't give a lot of value to the Fayetteville area, and yet, we are seeing a lot of drilling in that Fayetteville.
So, another situation, where we – because of pricing, we didn't foresee a lot of activity in that area. But I can tell you, we’ve already gotten about 50 AFEs this year already in that area. Southwestern is very active, and is the leader and knows how to drill that area.
In the Woodford, this is an area that we thought was going to be very active. And given the right gas price, could be prolific for us.
When we made this acquisition, even at the depressed pricing, NGL and gas, there were 180 drilling locations that were economical. And those are the only ones who gave any value to. And that was based on a $4.7 million AFE to drill these wells.
Well, we just finished drilling our first five wells in the area at an average cost of about $3.75 million, so that is a significant change in capital costs. That improves your IRR considerably in this area. And in terms of drilling locations, at a – we said at a $4.50 price, there were about another 1,100 proved locations to be drilled.
So, at a $3.75 million AFE, I imagine that number is smaller than $4.50 or lower than $4.50. And this is an area that we expect to do great things for us. And if we ever did do a growth capital budget, this is the area we would start with.
Again, hedge book, this was an area that – or Anterra had done a great job putting on hedges at fairly high values. And we were tempted to leave those hedges in place as is. They’re averaged about $6.35. We would have had great cash flow for three years.
But I didn't think we were going to be able to replace that cash flow at $6.35, so we were facing a cash flow cliff, which is not good in our industry. That’s what we try to avoid at all costs.
So, instead of just maintaining those hedges we actually restructured them, extended the tenor for two years to make them five-year hedges, so they go in 2017. And we increased the amount of production that was hedged under those contracts.
So, essentially what we did is we hedged 100% of the gas for an extended period of time; and that brought that hedge price down to $5.00.
Well, we’re hopeful that by 2017, we will see $5 sustainable gas again. With all the demand that we expect to occur over the next five years, we think that is realistic.
So, discipline, from a financial perspective, is clearly very important in our structure. When we’re distributing a lot of cash flow, we need to maintain discipline in everything we do. These are just a few of the ways we do it.
And I’ll mention that our bank syndicate is a very supportive one. We started with two banks in our credit facility. We now have 24 banks. We have a $1.3 billion facility with about $600 million of availability today, so we do have some very nice liquidity to prosecute transactions.
But risk mitigation occurs in many different ways, and I just want to make sure that people understand; we do look at it in all the ways we can. We often leverage other people's expertise. When we know they have more expertise in an area than we do, we’re happy to let other people drill wells.
For example, in the Bakken, where they’re drilling $10 million, $15 million wells, 40-stage fracs, that’s not our expertise. So, we’re happy to sell down our interest and let Oasis or Continental or SM Energy drill those wells, and we take a smaller interest, reduce our risk in any single well.
We’ve done the same thing in the Arkoma, by the way. That’s one of the ways we got our costs down as low as they are is we went to another operator in that area, who we respected and showed them our drilling plan. And they said, “No. That is not the way we would do it; this is how we would do it.” And as a result, we saved $1 million per well.
So, we have to be able to – we have to put our ego aside and recognize when other people have expertise that we don't. But we do it in all the other things we do as well.
Hedging; can't say enough about it. It’s not unusual anymore. But when we started two and a half years ago, we wanted to hedge these transactions, as soon as we signed the purchase sale agreement. The banks weren't necessarily supportive of that, because you don't own the assets, but we finally convinced them.
And so, now, we actually put these hedges in place when we sign the purchase sale agreement. When we’ve agreed to a price, we put those hedges in place immediately.
So, as a result, our hedge book on the gas side looks very good because we’ve done some significant transactions. Our oil hedge book looks good from a pricing perspective, but less robust because we haven't done as many oil transactions but we will solve that soon.
And when you're putting these hedges in place, you’re creating margin. Red line depicts, where we bought the reserves; blue line depicts, where we were able to hedge the production. Creating that margin allows us to pay a healthy distribution.
Probably one of the more important slides – how much sensitivity do we have? We're not 100% hedged on our production. We are susceptible to basis differentials.
What – under what kind of scenario would we have concerns in terms of pricing? But you can see in any kind of reasonable commodity price environment, we are above a one times coverage.
And it is not a mistake. We actually make more money when gas prices are lower, because we are so heavily hedged. It has to do with severance taxes. We don't pay severance taxes on our hedge gains, so we actually retain more cash flow, when we make more money on hedges.
Obviously, with acquisitions, you have nice charts like this. But the one that’s most important, I think, is the one on the bottom there; distribution growth. Again, through very difficult commodity price environments, through difficult capital markets environments, we’ve maintained or we’ve managed to grow our distribution year-over-year.
And at 45%, we’re kind of – since our IPO, we’re the leader in the clubhouse over that time period, and our yield somewhat reflects that. I think there’s – I think we’re still somewhat of a value, considering our track record. And I think I’m hopeful that we will continue to see some improvement in our unit price, as we continue to prosecute and grow our distribution.
So. I’ve run out of time. I’m happy to take a few questions but I don't – and then, we’ll certainly take more in the breakout room, in the Alder room. But are there any questions I can take? I guess we’ll do. Oh, go ahead.
How do we differentiate ourselves from Lynn via – in terms of our hedging strategy? Well, you can see, on our gas side all, of our hedging there is swaps; we do not use any puts in our hedging strategy on the gas side.
On the oil side, the – there are some puts, but there aren't standalone puts.
A collar is essentially a put and a call. But we typically have not paid for our hedging. We sometimes do in a small way on three-ways. If the bottom doesn't quite fulfill all the premium require, we paid a little bit.
But certainly, it is not our policy to pay a lot of money for puts. So, that’s essentially how we differentiate ourselves.
Any other questions? Yes, Sir?
The natural gas hedges go through the first half of 2017.
Yes. And I’m very hopeful that by 2017 there will be – there’ll have been enough demand catalysts occur that you’re going to see supply and demand come more into balance, and you're going to see a sustainable $5 gas by 2017, I’m hopeful.
When do you think we will get $4 in 2016?
2016, we had expected $4.50 type gas. Obviously you're seeing that today. I am not quite sure how sustainable that is.
Supply response is going to be significant when you get over $4. We have seen it in the AFEs that we are getting from other active gas drillers. When you put that much supply, you’re going to have a price response and you're going to see pricing come down.
Yes, I mean, if you look – one of the things I like about our hedging, if you look at the pricing of our hedging, it’s consistent every year – $4.60, $4.58, $4.60, $4.69, I mean, there is no cash flow cliff there.
And it’s also at a level that I think is going to be repeatable. It’s not like we have $8 hedges in place and we have to replace the $8 hedges to maintain the cash flow we do today. To replace $4.50, $4.60 type gas hedges I think is very doable.
Over this time period, it is 85%. But you can see it is 94% this year, 86% the next year, 93% the next year. So, a significant amount of production is hedged.
And then in your oil?
Oil, less so. Pricing is fairly consistent year-over-year but you can see it does decline. This is what our gas hedge book looked like at the end of 2011 because we’d focused on oily transactions and we put on a lot of oily hedges at that time.
Over the last two years, we’ve done a lot of gas transactions, and so you’ll see it reverse. As soon as we do an oil transaction you’ll see this hedge book changed dramatically.
Do you basically have about half your (inaudible)?
About half of your (inaudible).
Well, this year we are at 100%. Next year, we’re at 88%. And then, it declines significantly, 36% for 2015.
Yes. I mean we put on new hedges every quarter, and that was my point. If you look at our quarterly press release, you’ll see we put in there all the new hedges we put in place just that quarter. And you’ll see, we continuously add new hedges.
Well, the hedging makes our bottom line very volatile from a GAAP net income perspective, because you have to mark-to-market your hedge book every quarter. So, changes in commodity prices significantly impact our net income on a GAAP basis.
And that’s why we always tell people – unfortunately it is not a very relevant metric for us because of that mark-to-market change. That’s why we, obviously, focus on adjusted EBITDA, to try and take out some of that non-cash impact.
Well, it makes it very consistent in terms of our cash flow.
Well, not necessarily. I mean right now, I mean gas – oil prices are in the $92, $95 range, so our oil hedges are at around, where oil prices are trading. So, it has a fairly minimal impact on our cash flow, actually.
On the gas side, we do generate a fair amount of cash flow from our hedge book because at $4.60 average – gas prices are at $4.60 today on average.
$4.60 is our average this year.
And so, we’re making money on our gas hedges today.
What do you think gas will be at (inaudible)?
Crystal ball. Yes, I think it's going to be pretty range-bound, because I think we’ll be fairly range-bound between $3.50 and $4.50. I don't see it getting much above that.
But, obviously, weather still plays a large part in where prices go. If we have a cool versus hot summer, that could affect pricing.
So, storage is obviously an important factor. Right now we have a lot of storage to fill, and so prices are remaining fairly high. But if we have a cool summer and we’re not utilizing a lot of gas or if our economy goes into doldrums and industry is not using a lot of gas, you can see a pretty quick response to gas prices coming down.
I think we need to get to the Alder room. If you have any more questions, please join us there.
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