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Vanguard Natural Resources, LLC (NASDAQ:VNR)

Q4 2010 Earnings Call

March 1, 2011 11:00 AM ET

Executives

Lisa Godfrey – IR

Scott Smith – President and CEO

Richard Robert – EVP, CFO and Secretary

Britt Pence – SVP, Engineering

Analysts

Ethan Bellamy – Robert W. Baird

James Jampel – HITE Hedge Asset Management

Joel Havard – Hilliard Lyons

Chad Potter – RBC Capital Markets

Operator

Ladies and gentlemen, welcome to the Fourth Quarter and Year-End 2010 Earnings and 2011 Outlook Conference Call on Tuesday, 1st of March 2011. Throughout today’s recorded presentation, all participants will be in a listen-only mode. After the presentation, there will be opportunity to ask questions. (Operator Instructions)

I’ll hand the conference over to Lisa Godfrey of Investor Relations. Please go ahead.

Lisa Godfrey

Good morning, everyone and welcome to the Vanguard Natural Resources LLC fiscal year-end and fourth quarter 2010 earnings conference call. We appreciate you joining us today.

Before I introduce Scott Smith, our President and Chief Executive Officer, I have some brief information to provide you. If you would like to listen to a replay of today’s call, it will be available through April 3, 2011 and may be accessed by calling 303-590-3030 and using the passcode 4407127. A website archive will also be available on the Investor Relations page of the company’s website at www.vnrllc.com and will be accessible online for approximately 30 days.

For more information or if you would like to be on our email distribution list to receive future news releases, please contact me at 832-327-2234 or via email at lgodfrey@vnrllc.com. This information was also provided in this morning’s earnings release.

Please note, the information reported on this call speaks only as of today, March 1, 2011 and therefore, you’re 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 a detailed list of all the risk factors associated with our business, please refer to our 10-K that will be filed later this week and will be available on our website under the Investor Relations tab and on EDGAR.

In addition, please note that the Schedule K-1 will be available to download from our website on or about March 9th and mail to our unit holders on or about March 15th.

Now, I would like to turn the call over to Scott Smith, President and Chief Executive Officer of Vanguard Natural Resources.

Scott Smith

Thank you, Lisa. And welcome everyone and thanks for joining us today on this conference call to review our accomplishments and results for 2010 along with our outlook for 2011. Joining me on the call today are Richard Robert, our Executive Vice President and Chief Financial Officer, along with Britt Pence, our Senior Vice President of Operations.

This morning, I’ll start with the summary of our results for the year, briefly discuss our year-end results and operations and then I’ll turn the call over to Richard for financial review, then as always we’ll open up the call for Q&A.

2010 was an excellent year all respects for the company and our unit holders. Highlights for the year include, we posted record adjusted EBITDA production and reserves which I’ll go over briefly each point. In 2010, our adjusted EBITDA was $80.4 million, up 43% over 2009 levels. With respect to production, our average daily production averaged 4,721 barrels of oil equivalent per day, again up 42% over the average of 3,335 barrels a day reported in 2009, primarily these are all result of the acquisitions we made during the year.

Please keep in mind, these production numbers don’t include any contribution from the Encore acquisition which we closed in December 31st of last year. With respect to our reserves, since we closed the Encore acquisition on December 31st, the Encore balance sheet and reserves are included in Vanguard’s year-end numbers.

With this in mind, Vanguard’s year-end 2010 total proved reserves were 69.3 million barrels of oil equivalent, up approximately 191% from our year-end 2009 numbers. But if you consider our year-end reserves with the contribution of our net ownership share in the Encore reserves, our year-end reserves will be approximately 47.5 million barrels of oil equivalent or approximately 100% greater than year-end 2009.

During the year, we continued our track record of growth by successfully completing two oil focused accretive acquisitions with the highlighting our acquisition of 100% of the general partner and a 46.7% limited partner owner – partnership position in Encore Energy Partners LP. With this acquisition, we dramatically expanded our operating platform as we now have assets in both the Williston and Big Horn Basins along with dramatically increasing our presence in the Permian Basin.

These acquisitions further our goal of putting together our quality portfolio of assets with the balanced commodity mix in geographic diversity. From a commodity perspective, our 2010 activities increased our exposure to oil and liquids from 42% of proved reserves to 63% of proved reserves. We’re pleased with this increase in liquids and our asset allocation mix which can be attributable primarily to the last three acquisitions we’ve made, Ward County’s Bone Spring acquisition in December of ‘09 and the Mississippi Parker Creek and the Encore acquisitions in 2010.

In addition, I’d point out that our percentage of proved producing reserves has increased substantially from 68% to 80% of total proved reserves. With the addition of the accretive acquisitions and associated increases in our cash flow, we will increase distribution 77% in 2010. And I point that our distribution growth has been approximately 32% since 2008. We’re very product of the fact that these increases represent the highest in our peer group all through the year and since 2008. Our current distribution currently stands at $2.24 per unit on an annual basis.

From an overall return perspective in 2010, we delivered a total return in excess of 44%. This performance can be attributed to our continued strategy of building the company through accretive acquisitions along with the continuation of the investment community getting a better understanding of the MLP structure and the benefits that can be derived from owning higher yield and equity securities.

Now I’ll provide a brief summary of the year-end production and capital spending. With respect – our average daily production for the fourth quarter of 2010 was just under 4,900 barrels of oil equivalent per day which was up 21% over the fourth quarter of 2009 levels. On a product basis, daily production was 2,664 barrels of oil and natural gas liquids per day and 13,328 Mcf per day. For the full year, average daily production was 4,721 barrels of oil equivalent per day. This represents a little over 2,400 barrels of oil and natural gas liquids per day and 13,672 Mcf of natural gas per day.

This production mix has become increasingly liquids based. Our production in 2009 was 38% oil in NGLs and 62% natural gas. In 2010, oil and natural gas production increased to 52% of total production and natural gas declined to 48%. The shift in commodity mix is attributable to both oil focused acquisitions as well as oil focused capital spending.

Speaking of the capital spending, the company invested $2.1 million in its development program during the fourth quarter of 2010. For the full year of 2010, the company invested approximately 15.3 million in its development program. This equates to an approximate 19% of EBITDA reinvestment rate in the asset base.

Now for our 2011 outlook. We’ve already begun several strategies that we’re confident will bring long-term value to our unit holders. Today, our engineers have reviewed the drilling prospects available from both the existing Vanguard property asset base and our newly acquired Encore assets and created a drilling and capital expenditure budget for 2011 that was approved by the Vanguard Board of Directors last week.

Our strategy for 2011 is to increase capital expenditures to approximately $27 million to $28.5 million excluding any acquisitions. This compares to the $15.3 million we spent this year – in 2010. This increase in capital expenditures reflects capital dollars to be spent on existing Vanguard assets and includes Vanguard’s approximate 47% Encore interest in Encore’s capital expenditure budget for 2011, which is estimated to be between $19.5 million to $20 million.

This capital spending program is focused on reducing the impact of natural declines in our oil and natural gas production based at both companies and includes new development drilling in the Elf Basin in Wyoming, additional development of the Parker Creek field in Mississippi, some new wells in the Permian Basin primarily the Bone Spring Play in Ward County, Texas.

We hope to begin drilling operations in all of these areas late in the second quarter of this year. We’re very pleased to report that Vanguard has completed the integration of all the operation and field employees, hired new engineering and accounting personnel if needed as well migrated to historical accounting information from Dan Barry on behalf of Vanguard’s new accounting system. Finally, on January 5th, we aligned our employee’s efforts working in the Encore and Vanguard assets by awarding them a restricting unit grant equal to one year of their salary. These grants have a four-year vesting schedule with 25% each year. We believe this incentive directly aligns our employee’s interest with our unit holders.

In summary, 2010 was an exceptional year for the company and its unit holders. We managed to achieve excellent results on all fronts. Our results are a reflection of the efforts of our employees and their hard work on behalf of the company to achieve its goals. We continue to access to the capital markets, we have the ability to continue the momentum of growth into 2011. We intend to remain active in the market it’s a discipline in our approach to acquisitions. With our structure and cost to capital, we feel like we can compete effectively for the right type of assets.

Now I’ll turn the call over to Richard for the financial review.

Richard Robert

Good morning. Let me start by reiterating that we’re excited about all the benefits we expect to see from the Encore acquisition. However, I’ll point out that Encore acquisition adds a layer of complexity when reviewing our financial results and our reserve and production information. Because we closed the transaction on the last day of 2010, the assets of Encore are consolidated into the Vanguard balance sheet at December 31st embedded a 53.3% ownership interest that we don’t control is backed out in one lump sum line and titled non-controlling interest.

This will also be the case for the income statement but since we only owned it for one day, the Vanguard income and production results do not include any contribution from the Encore operation. The result is that we show all the financing costs for the Encore acquisition on our balance sheet including the equity offering in October, the incremental debt on our reserve based credit facility and the new $175 million term loan with no associated income benefit from the Encore acquisition in 2010. Because of this, anyone calculating certain financial ratios such as return on equity and debt to EBITDA based on the December 31st financial statements will come up with some distorted numbers.

In summary, please keep in mind that the 2010 operating results do not include the benefit of Encore and any discussion related to 2011 does include the benefit of Encore. With those characterized in the mind, let me turn to our operating results.

Vanguard reported a net loss of $5.6 million for the fourth quarter of 2010 or $0.21 per unit as compared to a net loss of $39.7 million of fourth quarter of 2009 or $2.31 per unit. However, after excluding a variety of non-cash items as reflected in the reconciliation schedules attached to the press release, the adjusted net income for the fourth quarter of 2010 was $11.8 million or $0.45 per unit which represents 134% increase from the $5.1 million or $0.29 per unit earned in the fourth quarter of 2009.

We reported adjusted EBITDA of $20.6 million for the fourth quarter of 2010 representing a 14% increase from the $14.7 million reported in 2009. There are two items in the fourth quarter ‘10 that I would like to discuss. First you will note in the schedule attached to the press release, which reconciles net income or loss to adjusted EBITDA, we added a new line item labeled material transaction costs incurred on acquisitions. These costs are primarily made up as a fee paid to our financial advisor and legal costs on the Encore acquisition. We felt it was appropriate to separate these costs out due to their significance and as in back to arrive at adjusted EBITDA due to they’re being non-recurring costs.

The other item that I’d like to point out is that the company’s fourth quarter general and administrative expenses were much higher than normal, not only due to this non-recurring fee to our advisor and legal costs related to Encore, but also because we recorded a $1.6 million in cash bonuses to management and employees. This amount negatively impacted fourth quarter adjusted EBITDA and distributable cash flow.

Primarily I wanted to point this out so that the analysts who cover Vanguard will consider this bonus accrual when comparing our actual results with our guidance and their forecast. As we have not done in past, Vanguard does not include any potential bonus payments and give guidance numbers and so the analysts don’t have any potential bonus payouts in the forecast. Distributable cash flow totaled $16.9 million for the fourth quarter of 2010 which represents a 56% increase over the $10.8 million generated in fourth quarter of 2009.

Now let me turn to the full-year 2010 results. Vanguard reported net income of $21.9 million or $1 per unit for the year as compared to a net loss of $95.7 million or $6.74 per unit for 2009. However again, after excluding of our non-cash items as reflected in the reconciliation schedules, the adjusted net income for 2010 was $45.8 million or $2.09 per unit which represents a 75% increase from the $26.1 million earned in 2009 and a 14% increase on a per unit basis.

We reported adjusted EBITDA of $80.4 million for 2010 representing a 43% increase from the $56.2 million reported in 2009. This result compares favorably with our published guidance for the year. As stated earlier, we don’t include bonus payouts in our published guidance. So when we add the $1.6 million of bonuses back to adjusted EBITDA, we arrived at approximately $82 million in adjusted EBITDA for 2010 which compares to our published guidance range of $80.1 million to $82.7 million so it is at the higher end of the guidance range.

Finally, distributable cash flow totaled $57.5 million for 2010. Distributable cash flow increased 28% when compared to the $45.1 million generated in 2009 despite spending in incremental $10.3 million or 208% more in capital expenditures in 2010 than in 2009. One other cash flow item to consider is that Vanguard received $10.7 million in distributions in February 2011 profit investment in Encore which funded a large portion of Vanguard’s fourth quarter distribution of $16.8 million also made in February.

Now let me turn to our outlook for 2011. We are expecting some very good results in 2011 but before I get into the details let me reiterate as stated in the press release as a matter of cost that we do not attempt to provide guidance on a variety of items, but most notably, we do not include the impact of any potential future acquisitions, the impact of unrealized non-cash gains or losses from hedging instruments, or cash and stock bonuses to be paid in the future.

I’d like to point out that there is an error on press release on the 2011 guidance table which indicates that all the numbers include the non-controlling interest, but that is not the case. The projected production numbers in the guidance reflects Vanguard and Encore consolidated amounts not just Vanguard’s interest. On the other hand, all the other numbers in the guidance table reflects Vanguard’s net interest after removing the non-controlling interest. The numbers are being presented this way because that how we anticipate our results to be published according to Generally Accepted Accounting Principles.

Okay, now with the details. We are expecting our production to become more oil and NGL weighted with 65% of expected production to come from liquids in 2011 as compared to 52% in 2010. Based on average pricing in 2010 – based on averaged pricing in 2011 of $93.51 per barrel of oil or $27 per MMBtu for natural gas and an average composite natural gas liquids price of $42 per barrel or $1 per gallon, we expect to generate between 140 million and 147 million in adjusted EBITDA.

Vanguard’s standalone capital spending is expected to increase slightly from 2010 levels to between $17.9 million and $18.7 million from the $15.3 million spent in 2010. And as Scott mentioned, we’ll largely include oil focused drilling in our Bone Spring Play and the Permian – and our Hosston formation in Mississippi. The remaining $9.1 million to $9.8 million in our guidance represents our net interest in capital spending at Encore which as discussed on the Encore earnings call review we’ll focus primarily on oil drilling in the Big Horn Basin and variety of recompletion projects in the Permian Basin.

Vanguard’s standalone production is forecasted to modestly increase by approximately 3% from 2010 levels. But as mentioned, the more important factor is that it will be more oil weighted production which generates much better returns. We are anticipating a significant increase to our distributable cash flow primarily as a result of our investment in Encore, higher realized oil pricing and a larger production waiting in oil and NGL. Based on the numbers outlined in our guidance and based on our current distribution rate of $0.56 per unit or $2.24 annualized, we expect to generate a distribution coverage ratio of between 1.40 to 1.45 times.

We appreciate our investments continue to support and look forward to a great year. This concludes my comments. We’d be happy to answer any questions you may have at this time.

Question-and-Answer Session

Operator

(Operator Instructions) And your first question comes from Ethan Bellamy of Robert W. Baird. Please go ahead with your question.

Ethan Bellamy – Robert W. Baird

Hello gentlemen. With respect to guidance, does that include any negative impact in the first quarter for weather and if so how much?

Scott Smith

Yeah, I mean, we did anticipate some pre-swaps some slightly lower production in the first quarter and as a result of our drilling program and the pre-swaps, I think you’ll see our EBITDA increase gradually over the course of the year.

Ethan Bellamy – Robert W. Baird

Okay, thanks. The extensions in discoveries were a little bit lighter than what we were looking for, could you talk about the reserves, maybe for standalone Vanguard?

Britt Pence

Yeah, this is Britt. On the reserve for extensions, what those were, we did some – so to be in a reserve add it needs to be something where we’re not drilling puds. Most of our drilling activity was drilling proved reserves already, so this will now that ads and those are already booked is proved and so the only area where we had significant extensions is some of the drilling that we did in the Appalachia where we drilled some oil Maxim wells that were not booked as puds. And that’s why there’s such a low number for that category.

Ethan Bellamy – Robert W. Baird

Okay. Thanks, Britt.

Britt Pence

Yeah.

Operator

Thank you. Our next question comes from (inaudible) who is a private investor. Please go ahead with your question.

Unidentified Analyst

Good morning.

Scott Smith

Good morning.

Richard Robert

Good morning.

Unidentified Analyst

What was the coverage ratio last year?

Scott Smith

Well, again I mean it’s a matter of how you calculate the coverage ratio.

Unidentified Analyst

That was including ENP?

Scott Smith

Well. That’s – the point is that we derived a much of cash flow from ENP in the fourth quarter of 2010, which is why we felt comfortable increasing our distribution. So I mean if you calculate it on an annual basis, it’s somewhere in the 1.2 times range.

Unidentified Analyst

So if I understand correctly then based on that as a result of the ENP transaction, you project increasing your adjusted EBITDA by 75%, but the resulting impact on your distributable cash flow is effectively an increase of 20%?

Scott Smith

Well it’s a function of our capital spending as well. We have increased our capital spending at both entities.

Unidentified Analyst

And which ways you’re projected, sorry go ahead.

Scott Smith

...which affects your distributable cash flow.

Unidentified Analyst

Okay. What is your sort of goal for the coverage ratio long-term or you’d like to see it for the company?

Scott Smith

I think we’ve stated that we want to see the – we’re comfortable with the coverage ratio in the 1.2 to 1.3 times range.

Unidentified Analyst

Okay. And lastly what impact have you seen or do you see of the ongoing controversy about fracing and the environmental impacts on your operations?

Britt Pence

This is Britt. I don’t think that if that’s going to impact Vanguard, I don’t see that being a material issue. Where we are in Appalachia, it’s – we’re not in the Marcellus Play where a lot of that is being debated, we’re not in Barnett or (inaudible) announced so with the assets we have right now, it’s mostly oil lot deeper, it’s just on – we’re not in the areas that are I would consider it the hot bed areas for fracing issues.

Unidentified Analyst

Okay, thank you. This is all I have.

Operator

(Operator Instructions) Our next question comes from James Jampel of HITE Hedge Asset Management. Please go ahead with your question.

James Jampel – HITE Hedge Asset Management

Yeah. I guess I have to ask, how do, you look at the remainder of the Encore asset that you don’t own it. How should we think about when you guys might act to clean that up?

Scott Smith

Well, obviously as we made it pretty much crystal clear once as we made the acquisition, an eventual consolidation is something that, is something we’re definitely interested in. It’s something that we are constantly looking at running models on and it will something when the timing is right and we feel like in the best interest of the Vanguard unit holders, we’ll act accordingly.

James Jampel – HITE Hedge Asset Management

Have you gone through calculation of what you could save at the corporate level from a consolidation?

Richard Robert

Yeah. I mean we continue to look at those costs. Clearly we haven’t operated those at least for an extended period of time, so those numbers are still in flux, but we would anticipate some cost savings and not only just cost savings but also less distraction running two companies versus one or one company versus two rather.

James Jampel – HITE Hedge Asset Management

All right. Thank you.

Scott Smith

Thank you.

Operator

Thank you. And our next question comes from Joel Havard of Hilliard Lyons. Please go ahead with your question.

Joel Havard – Hilliard Lyons

Thank you. Good morning, everybody. Thanks. I wonder if you could give us just sort of a quick look back on any if there was recomplete work over effort in Q4 and maybe by number of proposed projects for 2011 or at least a proportion of the total CapEx budget?

Scott Smith

Okay. I’ll take a stab at this and I’ll let Britt to chime in as well. I know we have in our on, from the Vanguard’s perspective, we have half a dozen or so work over projects identified primarily up in the Appalachian area in more to develop some oil well. With respect to Encore, they probably have about 15 different opportunities, some gas, some oil, some of that we’ve already actually got started on the which we’re pleased with getting (inaudible) asset, we don’t have correct me if I’m wrong Britt, real dedicated group of identified recompletions other than just this handful of I just kind of mentioned.

Britt Pence

Right, in terms of capital spending, it doesn’t represent a large percentage of our capital budget.

Joel Havard – Hilliard Lyons

Britt you characterized that I mean is that 10% of the total budget and what I’m trying to back into what the number of new well projects might be this year. I know you’ll sort of hinted that in the prepared remarks covering a broad swap of the geography.

Britt Pence

Probably closer to about 5% roughly.

Joel Havard – Hilliard Lyons

Okay.

Britt Pence

I think dollars – the big dollars outstanding are drilling, it’s in these Mississippi – we have big working interest in the Word County and the Mississippi project and those are relatively expensive wells that’s where we get the hot, that’s where we get the better impact.

Joel Havard – Hilliard Lyons

Okay. So that’s 90%, 95% and the number despite I mean taking into consideration rather that those are more expensive projects is it, is it another 10 to 20 new wells this year?

Scott Smith

I think total on a gross basis, this is probably around 20 on a net basis, and it’s probably closer to 10.

Joel Havard – Hilliard Lyons

That’s perfect. Thanks guys.

Operator

Thank you. Our next question comes from Chad Potter of RBC Capital Markets. Please go ahead with your question. Thank you Mr. Potter your line is open, please go ahead.

Chad Potter – RBC Capital Markets

Sorry about that good morning, guys. Joel actually I think just asked most of my questions I was really just kind of trying to get how many Bone Spring wells you guys were planning in 2011.

Scott Smith

It’s probably about 1.5 net wells.

Chad Potter – RBC Capital Markets

So you still kind of maybe one every other quarter on a gross basis?

Scott Smith

Well we’re still looking at a couple of things but probably we’re looking at drilling anywhere from 100% wells to perhaps doing some joint wells with some of the offset operators. But I think somewhere around 1.5 net wells is probably about right. So that may – we may drill one 50-50 or some combination of wells that the idea we’re hopefully getting it started here in the second quarter.

Chad Potter – RBC Capital Markets

Right. So can I actually see...?

Scott Smith

But it’s a fact that it’d be done between the second and third quarters.

Chad Potter – RBC Capital Markets

So connectivity most of the new drilling activity is in necessity effect?

Scott Smith

Yes, on a well count basis, it’s in necessity. Correct.

Chad Potter – RBC Capital Markets

And as far as the breakout of those I mean that predominantly pud drilling or is there any new reserve activity potential?

Scott Smith

It’s just drilling puds.

Chad Potter – RBC Capital Markets

All right. Thanks guys.

Scott Smith

Thank you.

Operator

Thank you. We have no further questions at this time. Please continue with any further points you wish to rise.

Scott Smith

All right, well thank you everybody for joining us on the call today. Again 2010 was an excellent year for Vanguard and its unit holders. I think any unit holder should be very pleased as we delivered on all front. So we’re looking forward to a great 2011, there is a lot of opportunities out there, capital markets are obviously wide open and we’re looking forward to continuing to grow on their behalf. So again thanks so much and don’t hesitate to call Richard or I, if you have any questions.

Operator

Ladies and gentlemen, this concludes today’s fourth quarter and year-end 2010 earnings and 2011 outlook conference call. Thanks for participating. You may now disconnect.

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