Down Is Up - The Curious Case Of Memorial Production Partners And Its Hedges

| About: Memorial Production (MEMP)

Summary

Memorial Production Partners is the best-hedged upstream oil & gas company in the country for 2016 forward.

Crude hedges are at $80 and above, and gas hedges are at $4 and above.

The company will have positive pre-hedge cash flow even at Q4's dismal pricing.

Its hedge portfolio will allow the company to shore up the balance sheet by repurchasing debt or acquiring assets at attractive prices.

Memorial Production Partners (NASDAQ:MEMP) has the distinction of being the "best-hedged" oil & gas company for 2016 forward, with 81% of total production hedged through 2017 and 71% hedged through 2019 (according to the December 1, 2015 investor presentation). Not only does it have a large hedge book, but the hedges are at extremely attractive prices compared to the current market. All of the natural gas hedges are at $4 or above, and all crude hedges are at $80 or better.

Normally, hedges are intended to protect operators from the thinning of margins as prices fall. Now, instead of just thin, the operating margins are extremely lean or even negative, since operating costs are in many cases are higher than oil & gas cash prices. Therefore, the hedges have larger and larger value, and the companies are collecting cash each month from the settlement of these contracts, while ongoing production may be destroying that value as cash goes back out the door to pay lifting costs, G&A, and interest on debt.

From an income statement perspective, cash received from the settlement of MEMP's derivative contracts has begun to nearly match revenue from oil, gas and NGL sales. In Q3 2015, cash received from expired contracts totaled $64M, while revenue from the oil & gas operations was $87M. If we use realized pricing to estimate Q4 differentials, Q4 oil & gas sales revenue will be around $78MM, while cash from hedge settlements will be around $74MM.

If we break this down on a per-mcfe basis, we come up with the following:

(assuming the maintenance capex quoted by MEMP in the same presentation will be enough to keep production constant)

Q3 2015

Q4 2015

*** 2016

2017

2018

2019

Oil & gas sales revenue

$3.75

$3.36

$3.77

$4.12

$4.34

$4.52

Operating expenses **

$3.17

$3.17

$3.17

$3.17

$3.17

$3.17

Operating cash per mcfe

$0.58

$0.19

$0.60

$0.95

$1.17

$1.35

Maintenance capex

$1.35

$1.35

$1.35

$1.35

$1.35

$1.35

Interest expense

$1.33

$1.33

$1.33

$1.33

$1.33

$1.33

Income before hedges

-$2.10

-$2.49

-$2.08

-$1.73

-$1.51

-$1.33

Hedge settlement

$2.76

$3.18

$2.91

$2.22

$1.93

$1.19

Income per mcfe

$0.65

$0.69

$0.83

$0.49

$0.42

-$0.14

** Lease operating, G&A, gathering and transport, production taxes

Click to enlarge

*** Forward strip as of 12/31/15

Simply stated, because of its extremely aggressive hedging, MEMP will be operating in the black (excluding non-cash items like impairments and DD&A) until 2019. Enough to cover the distribution? Not quite. But management has already cut distributions once in the past year, and has expressed a willingness to continue to do so in the future to manage the company's cash prudently.

More interesting, however, is what happened to MEMP from a balance sheet perspective as commodity prices fell during the last quarter of 2015:

  1. A decrease in the value of reserves. We expect a hypothetical impairment of around 3-5%, based on the change in forward commodity prices and the company's reserve mix.
  2. An increase in the value of the hedge portfolio. Even after 2015 hedges are settled and roll off, the drop in forward prices, combined with the size of the forward hedge portfolio means a total increase in the value of the forward hedge book quarter on quarter.
  3. A decrease in the price of outstanding bonds. At the end of the year, MEMP's bonds were trading at around $0.30 on the dollar, down from $0.64 at the end of Q3.

So, interestingly, because of the strong hedge book and crash in bond prices, the company actually saw a benefit in Q4 due to falling commodity prices.

9/30/2015

12/31/2015

Book value impact

Reserves

$2470M

$2417M

-$124M

Hedge portfolio

$745M

$752M

$7M

Fair value of bonds**

$772M

$359M

$413M

Net change

$296M

** 2021 and 2022 senior notes with carrying value of 1.18B

Click to enlarge

Here's what the company's book value would look like on 12/31, with the outstanding bonds and hedge portfolio marked to market, and reserves discounted to account for the difference between the trailing 12-month measure and the forward curve:

Book Value of Reserves (less accumulated depreciation)

$1.9B

75% of Book Value of Reserves

$1.4B

Hedge Portfolio

$752M

Total Debt

$2.0B

Bond Discount

$822M

Adjusted Book Value

$1.0B

Adjusted Book Value per Unit

$12

Click to enlarge

Ultimately, Memorial's massive hedge portfolio gives management a huge amount of flexibility. They may choose to raise cash by: a) suspending the distribution; or b) liquidating some hedges, both of which management has expressed openness to in the last earnings call. The ability to liquidate hedges may be somewhat limited by covenants in the revolving credit facility, but it's not unimaginable that banks are amenable to making exceptions for moves that may reduce the debt/EBITDA ratio and shore up the balance sheet.

The company could then buy back a substantial amount of its outstanding bonds at a steep discount, and even be in a position to selectively acquire reserves from less-advantaged companies. It's impressive to see a firm with so many options when many peers are quickly running out of them.

Disclosure: I am/we are long MEMP.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.