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Executives

Carol Coale – IR, DRG&E

Scott Smith – President and CEO

Richard Robert – EVP and CFO

Analysts

Michael Blum – Wells Fargo Securities

Joel Havard – Hilliard Lyons

Subash Chandra – Jefferies & Company

Richard Dearnly – Longport Partners

Ian Sinnott – Kayne Anderson Capital Advisors

Richard Roy – Citigroup

Vanguard Natural Resources, LLC (VNR) Q2 2009 Earnings Call Transcript July 30, 2009 11:00 AM ET

Operator

Good morning ladies and gentlemen and thank you for standing by. Welcome to the Vanguard Natural Resources second quarter earnings conference call. During today’s presentation, all parties will be in a listen-only mode. Following the presentation, the conference will be opened for questions. (Operator instructions). As a reminder, this conference is being recorded today Thursday, July 30, 2009.

I would now like to turn the conference over to Carol Coale. Please go ahead ma’am.

Carol Coale

Thank you, Natch. Good morning, everyone and I appreciate you joining us today. Before we turn the call over to management let us go over a few items.

If you would like to be on our e-mail distribution list to receive future news releases or if you experience a technical problem and did not get one this morning, please call us at 713-529-6600. If you would like to listen to a replay of today’s call, it will be available via webcast by going to the Investor Relations section of the company’s website, at www.vnrllc.com or via recorded into replay until August 6, 2009.

Information was also provided in this morning’s earnings release. Information reported on this call speaks only as of today July 30, 2009 and therefore you are advised that time sensitive information may no longer be accurate as of the time of any replay. Before we get started, please note that some of the comments today could be considered forward-looking statements and are based on certain assumptions and expectations of management. For detailed list of all the risk factors associated with our business, please refer to the 2008 10-K which is available on our website under the Investor Relations tab or on EDGAR.

Now, I would like to turn the call over to Scott Smith, President and CEO of Vanguard Natural Resources. Scott?

Scott Smith

Thanks, Carol and thanks all of you for joining us this morning to review our 2009 second quarter results. As always, I am joined today by Richard Robert, our Executive Vice President and Chief Financial Officer as well as Britt Pence, our Vice President of Operations. This morning, I’ll start with some highlights of the second quarter then move on to a brief discussion of operations and then Richard will take you through a review of the financials. Then we will open the line up for Q&A.

First of all, our strategy to preserve capital and temporarily suspend our development drilling program, given the low commodity price environment, resulted in a record high Distributable Cash Flow and distribution coverage for the second consecutive quarter.

Second, the key aspect of our business model was to add long lived oil and gas assets to our portfolio, we are very pleased to announce subsequent to the end of the quarter that we have agreed to purchase approximately 27 Bcfe of producing oil and gas reserves in South Texas from an affiliate of Lewis Energy. This is our second South Texas acquisition from Lewis. These properties are located in Weasel County [ph] and feature a long lived predominantly rich natural gas production from approximately 114 producing wells. Based on current production of $5 million a day of wet or unprocessed gas the ‘r’ over ‘p’ for these assets is approximately 15 years. If you refer to our press release issued on Tuesday, July 21 there is much more detail about this transaction.

Third, we continue to benefit from the hedging program we put in place last year. Our favorable hedge positions on our expected oil and gas production helped to mitigate the volatility of energy prices and protect our cash flows. Including the hedges that we assumed and added with the Lewis transactions, we expect that approximately 92% our estimated natural gas production from producing wells is hedged through 2011 at a base price of 818 per MMBtu. For the balance of ‘09, we have hedged approximately 95% of our expected natural gas production at a minimum average price of 855 per MMBtu and 78% of our expected oil production at a minimum average price of $89.40 a barrel. You will find much more detail on our hedge positions in this morning’s earnings release and in the 10-Q we expect to file on July 31st. It’s important to remember that a substantial portion of our gas production has a high Btu content. So our reported pricing on a Mcf basis will be approximately 15 to 20% higher than the 855 floor price referred to previously.

Our hedge positions support our ability to maintain our distribution payments and as we announced last week the company will pay a second quarter cash distribution of $0.50 per unit payable on August 14th to unitholders of record on July 31st. This payment is unchanged from what we paid in the first quarter of ’09 and represents a 12% increase over the 0.445 distribution we paid in the first quarter of 2008. Our annualized $2 distribution equates to approximately a 14% tax deferred yield to new investors based on yesterday’s closing price of $14.18. The rise in commodity prices we experienced between the first and second quarter however had the effect of reducing the value of our hedged positions which resulted in unrealized or noncash loss of $14.1 million during the quarter. This loss is merely the change in the value of the oil and gas hedges from the end of the first quarter to the end of the second quarter.

During the second quarter we realized $8 million of gains on our commodity derivatives, which represents cash settlements of $8.7 million which were then offset by amortization of premiums paid on those settled derivatives. It appears we may have seen the bottom in commodity part markets, however it is hard to get too excited about natural gas prices when we are looking at record storage levels heading into the ’09, ’10 winter season. Fortunately we are well positioned to make it through this period with a hedge program that supports our cash flows and distributions. We hope that the economy rebounds, the commodity markets, in particular the natural gas market, will improve and we will be looking for opportunities to layer additional hedges in the 2011 through 2013 timeframe. We are always looking to add hedges when we see attractive pricing that is sufficient to ensure desired cash flows during those periods.

Now with respect to our operating results. During the second quarter our average daily production rose a 11% to 17, 629 million Mcfe from the 15, 888 Mcfe we produced in the second quarter of ’08. We declined about 1% sequentially from the first quarter. We did not drill any new wells on operated properties and there was a limited drilling on the nonoperated properties as well. Including the positive impacts of our hedges in the second quarter we realized a net price of $10.71 per Mcf on our natural gas sales and just under $76 per barrel on sales of crude oil. In our largest operating area, the Appalachian basin, our oil production in the quarter increased 103% over the same period last year.

The natural gas production declined by approximately 12%. This net decline was about 5% on an Mcfe basis. A nice increase in oil production was primarily due to the completion of oil wells in the area. Our Appalachian operating partner, Vinland has been focusing their efforts on recompletion work to enhance oil production which typically involves installing pumping units, tank batteries in order to accommodate the oil production. This program has obviously been very successful. We continue to work with them and to identify additional wells that are candidates to recomplete a work over, with a goal of maximizing production from those existing well inventory at a nominal investment. Together we believe this the best operating strategy in this environment.

In the Permian basin during the quarter, we produced about 70 million cubic feet of gas and just under 57,000 barrels of oil which represents a total decline of about 14% on Mcf basis from the same period last year. In South Texas, we produced about 271 million cubic feet equivalent of gas or just under 3 million a day equivalent. During this quarter we did not drill again. We did not drill any wells in South Texas or in the Permian.

In summary, as evidenced by the Lewis Energy transaction we announced, we will continue to look for attractive opportunities to acquire high quality reserves that will be accretive to near term cash flows and produce stable production volumes to support our distributions in the future. We intend to move forward our development drilling program when market conditions improve and allow us to draw an adequate return on our drilling investment.

Thanks again everybody for joining us this morning and I will now turn the call over to Richard for the financial review.

Richard Robert

Thanks Scott and good morning. During the 2009 second quarter we reported a net loss of $6.8 million compared to a net loss of $47 million in the 2008 second quarter. The recent quarter included $13.1 million of non-cash unrealized net losses in our commodity and interest rate derivative contracts and $1 million non-cash compensation charge for the change in the unrealized fair value phantom units granted to management. Please keep in mind these are non-cash items. Excluding the net impact of these items, our adjusted net income was $7.3 million in the second quarter of 2009 or $0.58 per unit as compared to adjusted net income of $5.2 million or $0.46 per unit in the second quarter of 2008. Another important measure of our financial performance is our adjusted EBITDA. Our adjusted EBITDA rose 11% in the 2009 second quarter to $13.3 million compared to the $11.9 million achieved in the second quarter of 2008 and increased approximately 5% over the $12.7 million recorded in the first quarter of 2009. We generated Distributable Cash Flow of $11.3 million end of 2009 second quarter after $652,000 in capital expenditures and $1.4 million in interest costs. This represented an 88% increase over the $6 million in Distributable Cash Flow generated in the same period last year and a 12% increase over the $10 million in Distributable Cash Flow generated in the first quarter of 2009.

This quarter’s cash flow resulted in a distribution covered ratio of approximately $1.8 times and more importantly the strong coverage ratio is also seen for the six months ended June 2009 as our coverage ratio was approximately 1.7 times for the first half of the year. This puts us ahead of the guidance that we have previously disclosed for the 2009 year. We contribute much of our success this year to our hedging strategy as we have disclosed and discussed at length every time if someone is willing to listen. Our hedging strategy and resulting hedges that have been put in place has inflated our cash flows from significant variations despite volatile commodity prices.

We believe that this is absolutely essential when our unitholders are expecting a consistent cash distribution quarter after quarter. Our hedging program is designed to protect our cash flow and support our distribution in any commodity price environment. It also helps us stay well within our debt covenants for the foreseeable future.

Now I would like to take a look at our expenses during the quarter. Our lease operating expenses increased by $500,000 to $2.8 million for the three months ended June 30, 2009 over last year's second quarter but decreased on a Mcf equivalent basis. Most of the dollar increase was related to costs incurred in the South Texas acquisition that was not in the 2008 quarter. However our production and other taxes decreased by $0.5 million during the 2009 second quarter as compared to the same period in ’08 because of the significant drop in oil and gas sales revenue as a result of the drop in commodity prices. Depreciation, depletion, and amortization decreased to approximately $2.6 million during the quarter from approximately $2.3 million in the same period last year primarily due to lower amortization costs related to the full cost and permit write down we took at the end of 2008 and in the first quarter of this year.

As I did in last quarter’s call, I need to take a minute to discuss the increase in our SG&A which rose $1.3 million in the recent quarter from the second quarter of 2008, due to stock-based incentive compensation. In both periods, ending June 30, 2009 and 2008, there were non-cash compensation charges totaling $1.8 million and $1 million respectively. A large portion of these charges are related to the amortization of the value of grants of restricted Class B units granted to employees prior to our IPO. Accounting rules require us to value the grant at the time the grant was given and then recognize the value of that grant as an expense over the investing period. In addition some of the non-cash expense recognized relates to restrictive common units granted to employees and directors in addition to phantom units granted to officers.

Majority of the difference between what was recognized this year versus last year is the phantom units granted to management pursuant to their employment agreements had some realized value associated with them this year. Value is based on the price depreciation of our units since the beginning of the year and because our units substantially appreciated in value over the quarter an unrealized expense was recognized. Please keep in mind that each quarter the value of these units will be recalculated until the final value is determined at the end of the year.

I would like to shift my discussion to our leverage and liquidity. At the end of the second quarter we had indebtedness under our reserve-based credit facility totaling $132.5 million and had $21.5 million available for borrowing under our reserve based credit facility. We also had $3.7 million in cash on our balance sheet. This debt level represents a $4 million reduction from March 31, 2009; in addition, we improved our cash position by almost $1 million in that same period. Subsequent to June 30th, we have continued to utilize our excess cash flow to reduce debt and we currently have a $129 million drawn on our reserve based credit facility even after consideration of a $2.6 million deposit that was made on the recently announced Lewis acquisition agreement.

On May 29, 2009 we announced that in conjunction with our scheduled spring borrowing base redetermination the borrowing base on our reserve based credit facility had been reduced to $154 million principally due to the lower commodity price tags used by the banks to value our reserves. The borrowing base was previously set at $175 million. As part of the Lewis acquisition we have filed $300 million universal shelf registration statement which is not effective currently but we are working diligently with the SEC and hope to have the S3 effective in the near future. In addition we are in the process of amending our existing credit facility as part of this amendment we expect to extend the term of the credit facility and expect that our borrowing base will increase as a result of the new assets pledged from the Lewis acquisition.

As Scott discussed we have built a high quality portfolio of assets through acquisitions with specific characteristics. Those characteristics include mature stable production profiles with low declined rates, long life reserves, reasonably predictable operating expenses and the ability to effectively hedge commodity price exposure including any basis differential. This strategy has served Vanguard well as evidenced by our strong operating results over the last few quarters despite significantly lower natural gas and oil prices. We are dedicated to continuing this strategy but we will not be so focused on acquisitions to forget that our success is also depended on our ability to maximize the productivity of our existing assets. We feel that staying focused on a patient, conservative business strategy will ultimately reap rewards for our unitholders. This concludes my comments and we will be happy to take any questions you might have.

Question-and-Answer Session

Operator

(Operator instructions) Our first question comes from the line of Michael Blum with Wells Fargo Securities. Go ahead please.

Michael Blum -- Wells Fargo Securities

Thanks. Good morning.

Scott Smith

Hey Michael.

Richard Robert

Good morning.

Michael Blum -- Wells Fargo Securities

Couple of questions. One, I guess just in terms of the guidance I think you referenced it by – am I to infer because there is no update to the guidance that the prior guidance stands, obviously excluding the impact of the recent acquisition?

Scott Smith

Yes, I mean we are not going to typically update our guidance in the middle of the year absent an acquisition but I would expect after we close this acquisition that we will publish some additional guidance.

Michael Blum -- Wells Fargo Securities

Okay, and in terms of amending the credit facility and extending it you will be started at new pricing terms and what do you think those all look like?

Richard Robert

Yes, we will. We do anticipate an increase in pricing. Yes, I would expect somewhere in the neighborhood of 75 basis point increase in oil pricing.

Michael Blum -- Wells Fargo Securities

Okay. And then as it relates to the acquisition – oh, I am sorry, that is one and a follow up, I will get back in queue.

Richard Robert

Okay.

Operator

Thank you. (Operator instructions) Our next question comes from the line of Joel Havard with Hilliard Lyons. Go ahead, please.

Joel Havard -- Hilliard Lyons

Thank you. Good morning everybody.

Richard Robert

Good morning.

Scott Smith

Good morning.

Joel Havard -- Hilliard Lyons

Briefly, the recomplete activity in Appalachian, about how many wells would that have affected and what do you think the schedule looks like the rest of the year?

Britt Pence

This is Britt Pence and in Appalachian we then completed a couple of wells, there were truly recompletions and we have also done a lot of work where we have added pumping units to some wells that had oil production to unload the wells and that has been effective. So, you had a combination, different types of walkovers. We probably – I do not know the exact number of pumping units we installed but it has probably been in the neighborhood of about 15 maybe and we have seen some nice oil production from doing that, and in fact it looks like it is roughly about 100 barrels a day net to us that we have seen from doing those activities. So, that has been encouraging. We have also had plans to do eight recompletions for the remainder of the year. We are going to start on four of them hopefully next week and then we will follow up with four more kind of contingent on those results.

Joel Havard -- Hilliard Lyons

Okay and if that did not count as my follow on I would like to also ask if there is still the possibility or maybe the shifting more toward likelihood that post transaction there would some activity in South Texas?

Scott Smith

I think we have had a lot of discussions with Lewis and believe me they volunteered, they said look if you guys want to drill we will go ahead, and I think it still makes sense for us to basically put and leave everything on hold and really start focusing on in 2010.

Joel Havard -- Hilliard Lyons

Okay, alright guys. Thanks. Best of Luck.

Scott Smith

Thank you.

Operator

Thank you and our next question comes from the line of Subash Chandra with Jefferies & Company. Go ahead, please.

Subash Chandra Jefferies & Company

Yes, hi good morning. First I guess a broad question how are you sort of handicapping new derivates, legislation and is there a look through on your part on if you think there is going to be a big deal or not, do you think you, if it does pass here do you think you know picks up the slack and you know along those lines?

Scott Smith

I mean, we are handicapping it, that is obviously a hard thing to do. I do not think I am knowledgeable enough to handicap it but I have concerns about it for certain because right now we only do our hedging through our bank group which means that we do not have to post any collateral and the banks effectively limit the amount of hedging we can do so we are already subject to some of the restrictions that the government wants to impose on other people. So I am hopeful that somehow there will be a carve out for situations like ours where we are already restricted and we have a situation where we do not have post collaterals. So, I would hate to have to start posting collateral for our positions that would obviously increase our cost of doing business. I am hopeful that and I know from discussions with it might be a AA, etc, they are talking to the politicians to ensure that I have wrote a letter and hopefully that will continue to talk on our behalf and make sure they understand our situation.

Subash Chandra Jefferies & Company

Okay and a follow up. Do you get from the Lewis deal – they I think they have a lot of acreage so, a, is there the potential for more transactions and b, do you get to look at the Eagleford and do you intend to participate there at all?

Scott Smith

You are correct in that Lewis, they are, they have a huge acreage position in excess of 400,000 acres down net this trend much of which that Eagleford underlies. We are not getting Eagleford rights. Again the Eagleford, those are the resource plays because we have seen by pretty much all the people at work and those are cash eaters and really do not work well for our model. With respect to other drop downs I think a lot of that will depend on how Lewis’ efforts in the Eagleford turn out. If they are very successful and Mr. Lewis decides that he is going to put the paddle to the medal in the development of Eagleford Shale and their base cash flow would not support that level I think you know if that is the decision and they know what our appetite is, obviously this is our second transaction, there is a good degree of trust in how we deal with each other. We really think they are great operators and great partners and we think that they appreciate us as well. So, I would hope that, you know we will see what circumstances bring but if I think there is a some – at least a possibility of another drop in.

Subash Chandra Jefferies & Company

Thanks. I will get back in the queue.

Scott Smith

Thanks.

Operator

Thank you. (Operator instructions) Our next question comes from the line of Richard Dearnly with Longport Partners. Go ahead, please.

Richard Dearnly – Longport Partners

Good morning. Would you discuss how you came to the pricing on the South Texas acquisition? How did you get to $1.94 million and as part b, how much of the value would you impute to the existing hedge position that you inherited?

Scott Smith

Okay, I mean, I think $1.94 million is just simply a take the purchase price and divide it by the 27 Bcfe equivalent.

Richard Dearnly – Longport Partners

Why a $1.94 million as opposed to a $1.64 million or $2.34 million or any other number?

Scott Smith

Well, we basically run the acquisition on a price tag that proximate the strip at the time and that layer in the hedges on top of that. So you come up with a PV value that we are willing to pay and in this case it was a very attractive PV value. Pick the only way you consider the NGL’s that are being produced on this property which does not necessarily get factored into the reserve calculation. It is, because it is very rich gas, like it is processed and a large part of the economics comes from those NGL processing revenues.

Richard Dearnly – Longport Partners

And how important where the existing hedges? How much of the value would you say that was?

Scott Smith

About $5 million was the value of those hedges.

Richard Dearnly – Longport Partners

Okay, thank you.

Scott Smith

You are welcome.

Operator

Thank you and our next question comes from the line of Ian Sinnott with Kayne Anderson Capital Advisors. Go ahead, please.

Ian Sinnott -- Kayne Anderson Capital Advisors

Hey guys. A couple of questions. First, on the deal of the hedges you guys mentioned that you put on some costless collars but then you say it costs you $3.1 million, just confused did you pay for them or not or will you pay for them?

Scott Smith

We did a – the structure we used then was deferred premium. We will pay for them – currently they will settle when those hedges settle you pay the deferred premium item. So, you are right. That was a miscue on our part.

Ian Sinnott -- Kayne Anderson Capital Advisors

And is that included in the $52.25 million or that is an additional amount?

Scott Smith

That will be on top of that. That is an additional amount.

Ian Sinnott -- Kayne Anderson Capital Advisors

And then the second question is in terms of paying for the deal are you going to fill up the borrowing base, you know with the additional amount that you get or because you know at $52.25 million you have what $30 million some left which means if you get $20 million or $20 or so million in additions you will pretty much fall a lot? Are you willing to give that or?

Scott Smith

No, I mean, clearly we would be fully drawn at that point and we do not want to operate on a fully drawn basis, so clearly the intent would be to raise some additional capital.

Ian Sinnott -- Kayne Anderson Capital Advisors

Alright. Okay, thanks guys. I will let someone else ask.

Scott Smith

Appreciated. Thanks.

Operator

Thank you and our next question is a follow up from Subash Chandra. Go ahead, please.

Subash Chandra Jefferies & Company

Thanks. What is the market right now appetite to use your units to do acquisitions directly with the seller?

Scott Smith

Oh, I think it obviously depends on the seller, you know in this particular transaction with Mr. Lewis he is already at a little over 10% so we did not have a – well, we are trying to get more units out not concentrate in any more one person. So, and again they were looking to generate cash, units are fine but it does not stand when they are trying to drill wells. So, they were looking at a cash transaction as well. So, I think there are other parties that would consider it but we have not been pressing that and did not want to press that on this transaction.

Richard Robert

As Scott mentioned our ultimate goal is to have more flowed out there so having a large block concentrated in someone’s hands is not where we would prefer to go, does not mean we would not go there, just we prefer not to.

Subash Chandra Jefferies & Company

And, the final one from me. In Q3, or I guess upcoming bank redeterminations, as far as sort of how the banks might be feeling about it relative to maybe the April redeterminations, any feeling there on if maybe the confidence levels have returned and what kind of strip pricing they might be comfortable with?

Scott Smith

I think the majority of the banks have lowered their price tags to levels that are commensurate with where pricing is and certainly below where the strip is on the out years. So, I do not expect a significant change in their price tags, you know we certainly feel confident that once we have raised some additional capital we will have more than enough liquidity to again, to guard against any subsequent declines that they may come up with.

Subash Chandra - Jefferies & Company

Got it. Okay, thank you.

Operator

(Operator instructions) Our next question comes from the line of Richard Roy with Citigroup. Go ahead, please.

Richard Roy – Citigroup

Thank you. Hi guys.

Scott Smith

Hi.

Richard Roy – Citigroup

You mentioned that you are in the process of amending the credit facility, could you just give us some parameters on how to think about what potential increase in the borrowing base that will get to from the acquisition?

Scott Smith

We are anticipating an increase in the $30 million to $35 million range.

Richard Roy – Citigroup

Perfect. And do you have a timeline as when you expect that to be finalized?

Scott Smith

Certainly in the third quarter.

Richard Roy – Citigroup

Got it. Alright. Perfect, thank you.

Operator

Thank you and we have no further audio questions at this time. I would like to turn the conference back over to management for any closing statements.

Scott Smith

Again, thanks everyone for joining us today. Again, it is a pleasure to be able to tell our story and report good results and again if anybody has any questions obviously, feel free to contact Richard or myself anytime. So, and again thanks for joining us.

Operator

Ladies and gentlemen, this concludes the Vanguard Natural Resources second quarter earnings conference call.

This conference will be available for replay after 1:00 p.m. Eastern Time today through August 13, 2009 at midnight Eastern Time. You may access the replay at anytime by dialing 1-303-590-3030 and entering the access code of 4106192. Thank you for your participation and you may now disconnect.

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