On December 30, Vanguard Natural Resources (VNR) announced a huge $581M acquisition of mostly natural gas properties in Southwestern Wyoming. A few days later, on January 2, Vanguard Natural Resources held a conference call which clarified some of the uncertainties related to the transaction as well as added details related to its economics. The company also explained its rationale for shifting some of its capex to growth, which marks a first for the company. Vanguard Natural Resources is an upstream, or E&P, MLP with a high monthly distribution. At current prices, the stock yields about 8.50%.
A look at the new production and its economics
Below is a breakdown of the key stats for quick reference
Purchase price: $581M
Current production: 113.4 MCFE/D
Production mix: 80% natural gas, 16% NGLs, 4% oil
Proved Reserves: 847 BCFE with an estimated reserve life of 20 years
Cost of proved reserves: $0.69 per MCFE
Cost of production: around $5000 per flowing MCFE ($30,000 per flowing BOE)
As I noted in my previous article, this appears to be a very attractively priced transaction for Vanguard Natural Resources. The seller was previously undisclosed, but according to the filed 8-K, it now appears to be Anadarko E&P onshore llc, a subsidiary of Anadarko Petroleum (APC).
These assets fit Vanguard Natural Resources profile of low risk production with low decline rates and consistent returns. It is also a big bet on natural gas for the company as it boosts reserves by nearly 80% and production by 55%. The company is acquiring about 2,000 producing wells with over 970 proved undeveloped drilling locations. Also included are 5,200 additional locations not being booked due to the SEC five-year rule. These are 100% non-operated properties with Vanguard Natural Resources working interest being around 10%. The two major operating partners will be Ultra Petroleum Corp. (UPL) and QEP Resources, Inc (QEP).
Vanguard Natural Resources made it clear in its conference call that it expects to have little issues with moving this new production. There are already agreements in place with Western Gas Resources and Enterprise for the movement of gas to Western Gas's Grainger Gas processing plant and or the Enterprise Pioneer gas plant. Processing will be done at Western Gas Grainger plant with any spillover being handled by the Enterprise Pioneer gas plant.
During the conference call, the company noted that it is paying roughly 5 times expected 2014 cash flow. This seems like a fair valuation when coupled with the production being priced at $5,000 per flowing MCFE and reserves at $0.69 per MCFE. Furthermore, the company mentioned that the purchase price also put a $100M value on the undeveloped inventory. When adjusted for these factors, it appears as if Vanguard Natural Resources got a very good price.
It is also worth mentioning Vanguard Natural Resources' hedging policy. The company is planning to hedge between 70% to 90% of the expected production through 2017. Do note that none of the expected NGLs production will be hedged due to the very weak pricing environment. The hedges are expected to be layered on once the transaction is closed. As with its previous policy, Vanguard Natural Resources' hedges will be essentially costless, using fixed price swaps.
Vanguard Natural Resources noted a few interesting tidbits regarding how it plans to finance this acquisition. For starters, the transaction will be initially paid for with its revolver. After closing the company will still have over $500M available under its revolver once adjusted for the increased asset base.
The company does plan to eventually fund the transaction with a mixture of 50/50 equity and debt. However, it will NOT be doing an equity secondary. It will instead be issuing units via its new at-the-market, or ATM, program. The company will basically sell units into the open market, thus avoiding the fees, discount, and other costs related to a large equity offering. At current prices, Vanguard Natural Resources would need to issue about 10M units to fund the equity half of the transaction.
There are some downsides I see with Vanguard Natural Resources ATM program. Issuing units constantly will likely cap the upside on the unit price. Vanguard Natural Resources has been enjoying a recent bull rally and is now near its 52-week high. I suspect units to now trade flat until enough equity is raised. The other concern would be that Vanguard Natural Resources' debt-to-EBITDA ratio will remain elevated short-to-medium term, above its typical targets of around a 3x.
Vanguard Natural Resources moves towards growth
For the first time, Vanguard Natural Resources will be spending capital on growth. During the conference call, the company noted that this acquisition will add $90M to its 2014 capital budget of which $50M will be for growth.
The two major operators, Ultra and QEP, are expected to drill a total of 16 gross wells per month in 2014. Drilling costs are expected to range from $3.8M to $4.2M per well with Vanguard Natural Resources working interest estimated at 11%. Estimated total recovery from each well ranges from 4 to 6 BCFE. The company noted that these wells are estimated to have initial production of 7,500 MCFE per day. However, the first year decline rates will be about 20%.
In terms of costs, finding and development costs are about $1 per MCFE, lease operating expenses are estimated at $0.41 per MCF while gathering and transportation costs are estimated at $0.80 per MCF. Assuming $4.00 per MCF natural gas pricing and $28 per BBL NGLs prices, these wells have an anticipated rate of returns of between 30% to 60%.
Doing some back of the envelope estimates, these wells have a similar cost profile compared to Vanguard Natural Resources' legacy production. The company also noted that these wells are less sensitive to NGL prices compared to some of its other production. In addition, nearly all of the undeveloped drilling locations have similar cost profiles, which may further boost profits.
$50M is not a small amount for a company the size of Vanguard Natural Resources. However, production will see a sizeable boost as a result of the drilling program. The company noted that it expects to increase production by as much as 15% in 2014 and about 17% in the following year.
Proved undeveloped inventory to serve as an "insurance policy"
One of the most important parts of the conference call was when Vanguard Natural Resources was asked about the sustainability of its business model. Upstream MLPs have in the past been compared to "a house of cards," ready to collapse if financial markets freeze up. However, Vanguard Natural Resources and its distribution seem to be able to withstand quite a bit. The company has noted that, if energy prices remain at current levels, its current drilling inventory will allow it to maintain its distribution for over ten years.
In essence, Vanguard Natural Resources' proved undeveloped drilling inventory gives its distribution security during difficult times. The recent acquisition increased this inventory significantly, from 26% to over 39%. When coupled with its hedges, this makes Vanguard Natural Resources one of the more conservative upstream MLPs out there.
Overall, this transaction appears to be a good one for Vanguard Natural Resources. The company is likely to achieve sizeable accretion to its DCF per unit, likely resulting in an improved coverage ratio. This may lead to a potential distribution boost sometime after closing.
There are some concerns related to the shift to natural gas. However, the company is hedging out nearly all of the extra production. In addition, as production costs are so low, this production will remain profitable even if natural gas prices decline 25% from current levels.
Disclaimer: The opinions in this article are for informational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned. Please do your own due diligence before making any investment decision.