Memorial Production Partners (NASDAQ:MEMP) is the last of the upstream MLPs to keep a meaningful distribution. (At least the last one I know of.) I believe that is about to come to an end, however, as Memorial Production Partners will likely struggle to generate cash flow in excess of the dividend in coming quarters. However, this partnership still has three years of comprehensive hedges by which to maintain its cash flow and either acquire or pay down debt. This article covers why I believe this partnership should, and will, cut imminently, and what Memorial might do going forward.
Cash flow and debt
The most important thing to understand about Memorial Production Partners is its terrific hedge book. Until the year 2019, over 80% of Memorial's crude oil and dry gas production is hedged, and even in 2019, a little over half of all production is hedged. Have a look.
Data courtesy of Memorial Production Partners Investor Relations.
While this hedge book is probably the best in its class of upstream MLPs, I believe the current distribution of thirty cents per share, per quarter, will be difficult to maintain. For example, back in November when Memorial cut its distribution by 40%, management expected WTI at strip level at that time, around $49. But right now, we're about $16 below that figure. Although higher dry gas prices will help a little, I believe that drop in realized WTI will be too much for the distribution.
Compounded on top of this is Memorial's cost management difficulties, which are significant. Last quarter, for example, Memorial could only reduce costs by a paltry 3%. Other companies have managed double-digit declines in lease operating expenses, thanks to falling oil prices. In the fourth quarter, Memorial will begin operating a saltwater disposal system that could bring additional cost savings.
Even with lower production costs, however, Memorial isn't going to be able to shell out its distribution. Last quarter, Memorial eked out a coverage ratio of 1.15 times. I suspect that next quarter's coverage ratio will drop to 1.0 times or maybe even lower, and I don't believe Memorial will maintain a coverage ratio below 1.0 times for long, if at all.
Of all the upstream MLPs, I still really like Memorial the best. Operational difficulties notwithstanding, Memorial enjoys a relatively low leverage ratio and plenty of excess capacity on its revolving line of credit. While Memorial does have a credit covenant on the revolver, the hedge book protects the company for the next four years.
Memorial carries a balance of about $700 million on the revolver, which comes due in March 2018. There is another $700 million senior note due in 2021, and another $400 million in 2022. I suspect that Memorial will soon work toward paying down its debt, starting with that revolving credit line.
According to the most recent quarterly report, Memorial generated $114 million in distributable cash flow in the first half of last year. If we assume that Memorial generates $220 million per year in DCF, then Memorial should be able to pay off over half of the revolver's balance. When the revolver comes due, Memorial should still have decent financial flexibility even in a worst-case scenario.
As things are right now, Memorial does need to prepare for the worst-case scenario, and I believe that it will do so at this time. Delevering is one way to ensure that Memorial will be able to carry on even if, heaven forbid, crude prices remain low for half a decade. At this point, I think E&Ps should not dismiss such a scenario.
If things start to get better, or if Memorial is able to keep some kind of revolving credit line after 2018, then the partnership will have a lot of flexibility by which to acquire. Management said they would like to extend their credit line beyond 2018, if that is possible.
As of right now, I wouldn't recommend any upstream MLP. Yes, Memorial's share price is very low, but it could easily get lower. If you want an oil and gas producer, I recommend looking at debt-free royalty trusts instead. However, I am still long Memorial and will continue to be.
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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.