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Vanguard Natural Resources LLC (NASDAQ:VNR)

Q3 2009 Earnings Call

November 04, 2009 11:00 am ET

Executives

Scott Smith - President & Chief Executive Officer

Richard Robert - Executive Vice President & Chief Financial Officer

Carol Coale - Investor Relations, DRG&E

Analysts

Joel Havard - Hilliard Lyons

Ethan Bellamy - Wunderlich Securities

Eli Cantor - Jeffries

Richard Dearnly - Longport Partners

Operator

Ladies and gentlemen thanks for standing by. Welcome to the Vanguard Natural Resources third 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)

I would now like to turn the conference over to our host Sheila Stuewe, please go ahead.

Sheila Stuewe

Good morning everyone, and thanks and welcome to the Vanguard Natural Resources, LLC third quarter 2009 earnings conference call. We appreciate you joining us today. Before I turn the call over to management I have a few items to go over.

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 instant replay until November 18, 2009.

This information was also provided in this morning’s earnings release. Information reported on this call speaks only as of today, November 4, 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 Smith

Thank you Sheila, and thanks everyone for joining us this morning to review our third quarter results. As usual, I am joined 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 third quarter, then move on to a brief discussion of operations and then Richard will take you through a review of the financials, and then we will open the line up for Q-and-A.

First of all, I am very pleased to report we achieved another consecutive quarter of record high distributable cash flow, production levels and distribution coverage. With respect to coverage, this primarily reflects our ongoing strategy of preserving capital and suspending drilling activities during this period of low natural gas pricing.

While we haven’t been active with drilling, we have been screening and evaluating many properties for possible acquisition, in the Lewis transaction we closed this quarter with a direct result of the effort on behalf of the team. From our perspective probably the most encouraging sign we saw last quarter was the ability of the upstream MLT companies to access reasonably priced capital through the issuance of equity and secondary offerings.

In order to execute our long-term growth strategy successfully, we need to have the ability to find accretive acquisitions with equity proceeds in conjunction with our bank funding and our credit facility. It’s also important to note that the evaluations of the upstream MLT group have continued to improve as the market recognizes the distributions are secure, and investors continue to look for attractive yielding stocks.

Obviously we hope yield compression continues and our unit holder’s benefit from a higher unit price going forward. An added benefit of our recent equity offerings is a very large increase in daily trading volumes we have seen, with an average trading volume over the last three months of approximately 237,000 units per day compared to approximately 72,000 per day in the second quarter before the equity offering. Hopefully this increased liquidity provide larger investors with confidence, they can invest best in Vanguard units going forward.

As we mentioned in our last call, the properties we acquired from Lewis Energy added significant producing oil and gas reserves in South Texas. Sun TSH field, which is located in La Salle County features long lived, predominantly rich natural gas production for approximately 112 producing wells.

Based on current production of approximately 6.2 million cubic feet per day, equivalent on a process basis, R over P of these assets is approximately 16 years. Current market is very favorable for processing, and we benefit from the spread between oil and liquid prices and the price in natural gas. During the quarter we realized approximately $0.82 a gallon from the sale of our natural gas sector.

We also continue to benefit from the hedging program that’s the key component of our business model. Our favorable hedge positions on our expected oil and gas production mitigate the volatility of energy prices, and protect the cash flows and our ability to make distributions. Including the hedges that we assumed and added with the Lewis transactions, we expect that approximately 93% of our estimated natural gas productions from existing producing wells is hedged through 2011 at a minimum price of 813 per Mbtu.

Please keep in mind when we hedge our natural gas, we also include our expected natural gas liquids because as we have elected to hedge the BTU’s associated with NGL production through natural gas hedge, because there really isn’t a much of a liquid market for hedging natural gas liquids all the time. With respect to oil production, we expect that approximately 69% of our estimated oil production from existing producing wells is hedged through 2011 at a price of about $86.14 a barrel.

In the last quarter of 2009, we currently have hedges on approximately 95% of our estimated natural gas production, at a minimum average price of 853 per MMBtu, 78% of our expected oil production at a minimum price of about 8944 barrel. You will find much more detail on our hedge positions in this mornings earnings release and in the 10-Q we expect to file later today.

It’s important to remember that a substantial portion of our gas production does have a high Btu content, though our reported pricing on our Mcf basis will be approximately 15% to 20% higher than the 853 floor price, floor price I referred to previously.

Now we have been able to pay a third quarter distribution of $0.50 per unit payable on November 13th to unit holders of record on the six. This payment is unchanged from what we paid in the second quarter of ‘09 and a current $2 distribution equates to approximately 11% tax deferred yields to new investors, based on yesterday’s closing price of $17.82.

Although oil and gas prices are well below the levels we saw in 2008, the rising commodity prices we experienced during the second and third quarter of ‘09 have effects of reducing the value of our hedge positions, which resulted in unrealized or non-cash losses of $21.2 million during the quarter. This loss is merely the change in the value of the natural gas and oil hedges from the end of the second quarter to the end of the third quarter.

Now, briefly review our operating results. During the quarter our average daily production rose sequentially to 20.396 million cubic feet equivalent per day up from 17.629 million cubic feet equivalent, we produced in the second quarter of ‘09. This included about six weeks of incremental production from the Sun TSH properties.

On our existing properties we didn’t drill any new wells on our operated properties, and there was limited drilling activity on the non-operating properties. Including the positive impact of our hedges in the third quarter, we realized a net price of $11.12 per Mcf on our natural gas sales, and $77.15 per barrel on sales of crude oil. And as mentioned earlier we averaged $0.82 a gallon or $34.44 per barrel on our NGL’s during the quarter.

In the Appalachian basin, our oil production in the quarter increased to 129% over the same period last year, but natural gas production declined approximately 16%. This net decline was about 6% on MCFE basis. A nice increase we saw in oil production is due to the completion of additional oil wells in the area.

We and our operating partner Vinland have been focusing our efforts on re-completion work to enhance oil production, which typically involves installing pumping units and tank batteries in order to accommodate the oil production. This program has obviously been very successful, and we continue to work together to identify additional wells that are candidates to re-complete our work over in order to continue this progress. Together we believe this is an excellent strategy in the environment we are currently in.

In the Permian Basin during the quarter, we produced approximately 57 million cubic feet of gas, 58,000 barrels of oil and 105 gallons of natural gas liquids, which represents an increase of about 27% on our Mcfe basis from the same period last year.

In South Texas comparisons are a little less meaningful because we closed the first Lewis transaction on July 28, 2008 and then we closed the second Lewis transaction on August 17 of this year. So the results from last year and this year include partial periods for each acquisition.

During the quarter we produced about 335 million cubic feet equivalent of gas, which included a 139 million from the Sun TSH deal. Last year we produced approximately 160 million cubic feet of gas in South Texas in the third quarter. Again, during the recent quarter we didn’t drill any wells in South Texas or in the Permian basin.

In closing I am very optimistic about the prospects we see going forward and some of the upstream MLT market in general. With the reopening of the capital markets, we’re positioned to execute the growth strategy we ambition, we took the company public two years ago.

We are beginning to see many interesting acquisitions opportunities, and are confident this trend will continue and accelerate in 2010 as the larger companies including some of the majors continue to look to streamline their asset bases and the shale driven company’s continue to look to monetize mature fields in order to fund their high returns, but very capital intensive exploitation programs.

Our focus continues to be on the acquisition of high-quality, long life reserves that will be accretive to cash flow and produce stable production volume that support our distributions going forward.

Now, I will turn the call over to Richard for our financial review.

Richard Robert

Thanks Scott, and good morning. For the third quarter of 2009 we reported net income for the quarter of $701,000 or $0.05 per unit, compared to reported net income of $71.8 million or $5.90 per unit in the third quarter of 2008. Both quarters include special items.

The recent quarter included $12.8 million of non-cash unrealized net losses in our commodity and interest rate derivative contracts, and an $800,000 non-cash compensation charge for the change in unrealized fair value of phantom units granted to officers, offset by $5.9 million gain on the acquisition of natural gas and oil properties in the Lewis transaction, which was recorded based on a new fair value accounting rule.

Going forward, investors can expect to see a non-cash gain or loss each time we make an acquisition unless we saw on the purchase and sale agreement on the same day that we closed the acquisition. Please keep in mind that all of these items are non-cash. For comparison, the 2008 third-quarter results included a $65.9 million unrealized net gain in our commodity interest-rate contracts.

Excluding the net impact of these non-cash items, our adjusted net income which is a non-GAAP financial measure was $8.4 million or $0.58 per unit. This compares to our adjusted net income of $5.9 million or $0.48 per unit in the third quarter of last year.

Another important measure of our financial performance is our adjusted EBITDA. Our adjusted EBITDA rose 13% in the 2009 third quarter to $15.6 million compared to the $13.8 million achieved in the third quarter of 2008, an increase of approximately 17% over the $13.3 million recorded in the second quarter of this year.

We generated record distributable cash flow of $13 million in the 2009 third quarter after approximately $1 million in capital expenditures, and $1.5 million in interest cost. This represented a 130% increase over the $5.6 million in distributable cash flow generated in the same period last year, and a 15% increase over the $11.3 million in distributable cash flow generated in the second quarter of 2009.

However as Scott previously mentioned, much of the increase in our distributable cash flow this year can be attributed to our decision to not drill new wells in the slow natural gas price environment.

Assuming that we spent the fair amount of capital for expect capital expenditures as we did in the same period last year, we would still show at 30% increase in our distributable cash flow for the third quarter and a 26% increase for the nine months. I believe this is a testament to the low decline of rate of our properties, the remedial work done on existing properties this year, and confirmation that our hedges are working as planned.

That being said, based on our awaited average units outstanding during the quarter, this quarter’s cash flow resulted in the distribution coverage ratio of approximately 1.8 times and our coverage ratio of the first nine months of this year was approximately 1.73 times. This puts up slightly ahead of the guidance that we have previously disclosed in the 2009 year.

We continue to contribute much of our success this year to our hedging strategy. As we have disclosed and discussed at length every time someone is willing to listen, our hedging strategy and resulting hedges that have been put in place has insulated our cash flows from significant variations despite volatile commodity prices.

We believe that this is absolutely essential when our unit holders 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 while within our debt covenants for the foreseeable future.

I would like to take a look at our expenses during the quarter. Our least operating expenses declined slightly to $3.3 million from $3.5 million from last years third quarter reflecting an average decrease on an Mcf equivalent basis to a $1.77 from $2.24.

Our production and other taxes also decreased to $974,000 from $1.3 million from the same period last year because of the significant drop in oil and gas sales revenue resulting from lower commodity prices, which in turn reduces the amount of severance taxes due.

Depreciation, depletion, and amortization decreased to approximately $3.3 million for the quarter from approximately $4.2 million in the 2008 third quarter, primarily due to lower amortization costs related to the full cost of impairment write downs 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 37% to $2.1 million in the recent quarter from the third quarter of last year. Our SG&A can be divided into three categories, cash expenses, non-cash unit base incentive compensation and finally phantom unit incentive compensation.

Now I’ll discuss each separately. Cash G&A expenses for the quarter at $800,000 were unchanged from those of the comparable period last year. For the nine months however cash G&A expenses this year are approximately $800,000 higher than last year, due primarily the increased insurance cost, increased legal and professional fees and increased salaries if you do for employers, all of which can be attributed to the growth in our business.

Non-cash unit based compensation of $500,000 and $2.3 million for the three and nine months period in 2009 respectively were comparable to the amounts reflected in 2008. These amounts relate to divesting of grants of restricted class per units to employees prior to our IPO, as well as divesting of unit grants director’s employee is given each year.

Accounting rules require us to value the grants at a time the grant is give, and then recognize the value of that grant as an expense over divesting period. Majority of the difference between SG&A expense this year versus last year is the phantom units granted offers pursuant to our employment agreements. They have some unrealized value associated with them this year and had no value associated with them last year.

Value is based on the price depreciation of our unit since the beginning of the year, and because our units substantially appreciated in value over the third quarter and over 2009, and unrealized expense of approximately $800,000 was recognized in the third quarter and approximately $3 million for the nine months. Let’s keep in mind that the value of these units will be recalculated at December 31, 2009 when the final value will be known and either cash or units will be paid to the officers at their election as incentive compensation.

Now I’d like to shift my discussion to our leverage and liquidity. At the end of the third quarter we had indebtedness under our reserve base credit facility totaling $123.5 million, this debt level represents an approximately $11.5 million reduction from December 31, 2008 and more importantly a $9 million reduction from June our 30, 2009 level.

In addition since September 30 we have paid down the facility an additional $5.5 million, which leaves our current availability under our credit facility at $52 million. In all our liquidity has improved approximately $29 million since the end of the second quarter.

During the third quarter, we amended our reserve base credit facility, as part of the amendment we pleasure on assets from the recent Lewis acquisition, term of our facility was extended from March 2011 to October 2012, borrowing base was increased from a $154 million to a $175 million. Our interest margins were increased by approximately 75 basis points and we added two new lenders under the facility.

Last month pursuant to the regularly scheduled follow borrowing base re-determination, our borrowing base was reduced $5 million to $170 million and the definition of majority letters was changed from 75% to 66.6%. No other terms under the facility were changed. We are very pleased with the support showed by our banks during this process, and we are hopeful that they will continue to show their support as we grow.

As Scott discussed, we have built a high-quality portfolio of assets through acquisitions with specific characteristics. Those characteristics include mature, stable production profiles that low decline rates, long life reserves, reasonably predictable operating expenses and the ability to effectively hedge commodity price exposure.

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 the strategy, and now that the capital markets have reopened we feel optimistic about our ability to grow this company.

This concludes my comments. We are happy to take any questions you might have.

Question-and-Answer-Session

Operator

Thank you. We will now begin the question and answer session. (Operator instructions). Our first question comes from the line of Joel Havard - Hilliard Lyons. Please go ahead.

Joel Havard - Hilliard Lyons

Thank you. Good morning everybody, good work. First of all I want to backup and get a better handle on the new operations in South Texas, Lewis field. How many net wells was that, and what drilling are you obligated for if any in Q4 and through 2010 and then I’ll hold my follow-up question for afterwards.

Scott Smith

In that, the Lewis acquisition, we basically picked up 100% working interest in all of those 112 wells. With respect to drilling we set that up contractually, that we aren’t going to start drilling until 2010, and I believe that’s about 7 wells per year and that would go through 2015.

Joel Havard - Hilliard Lyons

And separately follow-up, lease operating expense dynamics, what’s going on there? Listening to some of the earlier calls over the last few days, no sign of cost pressure yet. I wondered if that’s true for you all, and then more specifically sort of on a by operating region basis anything you are seeing?

Scott Smith

I don’t think that we’re seeing a whole lot of cost pressure yet, one thing about our production specifically like addressed Appalachia, the lion share of our cost are fixed transportation costs. In other words we’ve got transportation contracts that cover certain volumes and since our volumes have remained relatively flat and the costs are fixed by the local transportation company, that really doesn’t change very much.

The same thing with our overhead in transport and well service costs are all fixed. So those costs pretty much remains fixed on a per unit basis. South Texas, the biggest cost there is probably the gathering fee and the well overhead, but again these are small volume gas wells that don’t take a lot of cost. We are not seeing a lot of upward pressure.

Joel Havard - Hilliard Lyons

Okay good. Thanks, I will get back in line and thank you guys, good luck.

Scott Smith

Okay. Thanks Joel.

Operator

Thank you. Our next question comes from the line of Ethan Bellamy with Wunderlich Securities. Please go ahead.

Ethan Bellamy - Wunderlich Securities

Hey guys, good quarter. A couple of questions; first you mentioned the low decline rate on assets, could you give us an update on what you expect the sort of weighted average decline rates pro forma for the acquisition is for all the assets?

Richard Robert

Well, on the decline what we’re seeing is something less than 10%. Most of our production here is from wells that are mature and long life. What you see on the newer wells is a steep decline, because we haven’t had a lot of drilling, we have done basically no drilling this year. The production decline is going to be probably in the neighborhood of 70%. This is going to pretty low because we just haven’t added the new wells to the production profile.

Ethan Bellamy - Wunderlich Securities

Okay, that’s helpful, thank you. In the release you say that you will return to drilling when the returns are appropriate. Could you give us a sense for what the gas prices are to stimulate drilling on your properties?

Richard Robert

I think it’s somewhere going to be north of $5. I will say we are fizzing both with the Vinland and the Lewis people, later this quarter with the idea of, okay, where our current AFE is at for drilling in light with the current gas market to make sure and see where the returns are. We are maybe a little bit premature, but we’re hoping that the cost have come down enough, and again at a plus $5 type number for 2010, hopefully that’s going to be sufficient to start the rigs backup.

Ethan Bellamy - Wunderlich Securities

Okay, thanks. Last question.

Richard Robert

But at the same time, I think we’re probably more focused on acquiring production as to creating new supply. I mean because that’s just is adding to the problem that we currently have, it’s too much supply.

Ethan Bellamy - Wunderlich Securities

Sure. Okay. Last question, in the release you stated that you’re going to use excess free cash flow to de-lever for the balance of the year. At what point do you get comfortable with the leverage and the withdrawn amount in the revolver, and is that just the function of where you are going in terms of M&A?

Richard Robert

Yes, I mean certainly, I mean de-levering gives us the ability to draw that facility, to help support our M&A initiative. When we acquire new properties we’d like to have the option to draw down on that facility, and obviously the more liquidity we have and the more availability we have, the larger the transactions we can do.

That’s certainly important to us, but we want to run this company on a fairly conservative basis. We’ve said since the IPO that we would prefer to run this on a debt to EBITDA level of somewhere in the 1.5 times range, on a normalized basis, and so we are just trying to get back there, and with the uncertainty amongst the banks and uncertainty commodity prices and where they are going to set price tax, we just think it’s prudent to have as much flexibility as possible.

Ethan Bellamy - Wunderlich Securities

Thanks Richard, I appreciate it.

Richard Robert

Thanks Ethan.

Operator

Thank you. Our next question comes from the line of Eli Cantor [ph] with Jefferies. Please go ahead.

Eli Cantor - Jeffries

Good morning guys. Just one quick question on acquisitions. I wanted to get your thoughts on the acquisition market going forward, what your outlook is and whether we should expect additional acquisitions on the year to come?

Scott Smith

Well, again I think as we expressed in the call, I mean I think the acquisition market continues to get better for acquirers that are looking for the type assets where it fits in our profile. You’ve seen plenty of announcements of the major, ConocoPhillips is probably the largest one of $10 million, a lot of that’s going to be domestic US.

Again mature assets that began, there’s not a whole lot upside left, but that’s exactly what we are looking for. We are starting to see some of the larger independence, look to monetize again assets that have good cash flow, but again they need that cash to redeploy, even for the Marcellus Haynes or whatever it might be, but I think that trend is just going to keep going and we’ll probably accelerate as we go into 2010.

There has been discussion with lot of the broker types that we visit with all the time. They think that it’s just, again, going to continue to increase. Again, as people need cash to develop these shale plays, they just need a lot of cash.

Richard Robert

Yes, and I think a lot of it has to do with our ability to raise equity at reasonable levels too, and unfortunately we’re at a point where we can do accretive acquisitions, again based on where our unit price is trailing. I think we’re very hopeful that there will more acquisitions.

Eli Cantor - Jeffries

Got you, and then I guess just one more question on capital spending for next year; directionally do you expect to be spending more or less or around flattish for 2010?

Scott Smith

For our capital spending, again I think it depends on the analysis that we do and after we sat down Vinland and Lewis and confirm what the AFE’s are to drill these wells and depending on that if we have a better utilization. I mean, if the acquisition market is as good as we think it might be, we might be better served not to drilling the wells again, and just use the cash flow to buy new properties.

So I think it just depends on what kind of opportunities we see and we’re going to obviously invest the capital in the highest return projects, which may or may not be developing new wells, maybe acquiring existing properties.

Eli Cantor - Jeffries

Got it, thanks very much.

Operator

(Operator Instructions) Our next question comes from the line of Richard Dearnly with Longport Partners. Please go ahead.

Richard Dearnly - Longport Partners

Good morning. What would you estimate your CapEx is given your portfolio and necessary to offset that 7% natural decline curve in today’s market?

Scott Smith

I can tell you we have approximately $40 million of capital in our forecast to do that.

Richard Dearnly - Longport Partners

That’s kind of in your long term plan?

Scott Smith

Yes.

Richard Dearnly - Longport Partners

But you said, well of course in ‘09 you are well short of that, and it sounds like in ‘10 you are going to be focused on acquisitions, and it would seem like given the cost that the 14 million is probably a question, the service businesses and drilling and what not, has that come down any?

Scott Smith

Yes, come down quite a bit.

Richard Dearnly - Longport Partners

Is the 14 the new number or the old number?

Scott Smith

I think the 14 probably stays about the same, maybe we were able to drill a few more wells. Like I said those are the kind of the issues we are trying to refine with the operating partners to really get a better handle on where we think things are, can we term up rigs at certain cost to get a feel for exactly what, how much banks for the dollar we might be able to get.

Richard Robert

Frankly it also depends on what kind of technology we choose to employ in our drilling. If we chose to go more horizontal, the economics change. And the $14 million is based on a lot of vertical wells that we have planned on drilling. But we are certainly looking at more horizontal applications in there as we are.

Richard Dearnly - Longport Partners

It seems that the EMP industry has largely already figured out that at current prices and or scripts that CapEx is highly productive and are quickly ramping up their CapEx plans. You all seem to be sort of behind the net thinking.

Scott Smith

I think it’s sort of an apples-and-oranges comparison, I mean, again you are looking at, I think, the guys are ramping up the CapEx program probably in a lot of cases are people with shale play. And if you run strip pricing at the average pricing let’s say 650 or whatever, the returns on those huge investments that they make in those horizontal wells is probably pretty attractive. Again, that’s not our assets.

Richard Dearnly - Longport Partners

Not sure?

Scott Smith

Well, again, we have to give our unit holders the lion share of our cash flow. So we have to be judicious in the wells we drill. And again the asset base we have doesn’t really lend itself, our growth to a lot of accelerated type of drilling, huge drilling programs, it’s very measured unit, the way it’s designed is again the idea is to try to maintain our production at current levels.

Richard Dearnly - Longport Partners

Right, okay. Thank you.

Scott Smith

Thank you.

Operator

(Operator Instructions) I am not showing any further questions at this time. I would now like to turn it back over to management for any closing remarks. Please go ahead.

Scott Smith

Thank you Marissa, and thanks to everybody for joining us today. Again we think we have got a great quarter, the future is pretty bright and we’re very optimistic around here, we think there is going to be a lot of opportunities for Vanguard to grow going forward, and we look forward to taking advantage of the opportunities we see out there. So thanks again for joining us, and please give either Richard or I call if anybody has any questions. Thanks. Bye.

Operator

Thank you. Ladies and gentlemen, this concludes the Vanguard Natural Resources third quarter earnings conference call. If you’d like to listen to the replay of today’s conference please dial 303-590-3030, using the access code 4168639. We would like to thank you for your participation, you may now disconnect.

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