Mid-Con Energy Partners - The Best Upstream E&P Company You've Never Heard Of

| About: Mid-Con Energy (MCEP)

Summary

At current strip pricing, Mid-Con is cash flow positive excluding hedges through 2018.

It will be a boring 18 to 24 months, with all free cash directed towards paying down debt.

Reinstatement of the distribution not likely until 2018.

Two major risk factors - April 2016 re-determination and 2017 Debt-to-EBITDA ratio exceeding 4, are overblown.

Overview

Mid-Con Energy Partners (NASDAQ:MCEP) is a small-cap upstream exploration and production company whose revenues are nearly all generated through the sale of oil. MCEP is by far and away the lowest-cost upstream E&P in its peer group. A summary of the company is provided in the table below:

Reserves 22.3 MMBoe
Proved Developed 68%
Units Outstanding 30.2MM
Debt Outstanding $173MM
Enterprise Value $227MM

MCEP is a small cap E&P company, with daily production of 4,772 BOE per day as of Q4 2015.

Q4 2015 Earnings

In what seems to be a consistent trend with MCEP over the last few quarters, MCEP delivered very strong results for Q4 2015. Highlights from the earnings include:

  • $15.5MM distributable cash flow (DCF) - Based on 30.2MM units outstanding, the DCF per share was $0.51. Considering that MCEP currently trades with a solid 1 handle, this implies an incredibly low multiple to share price.
  • flat production with lower capital expenditures - Production averaged 4,772 BOE per day for the quarter.
  • Reduced costs - Lease operating expenses were $18.90 per BOE, or a decrease of 3.6% quarter over quarter. G&A came in at $4.28 per BOE, or a decrease of 15% from the prior quarter.
  • Reduced debt - All free cash was directed towards paying down debt in the quarter. Debt was reduced by $14MM in the quarter, from $194MM outstanding at the end of Q3 2015 to $180MM outstanding at the end of Q4 2015. It should be noted that the decrease is consistent with free cash earned throughout the quarter. Moreover, the drop in debt will lower MCEPs annual interest expense by $0.42MM.
  • Net proved reserves - This metric came in at $191.4MM as of year end. It was noted further in the company's 10-K that

As of December 31, 2015, the mark-to-market value of our net derivative financial instruments totaled $25.6 million

A simple net asset value is then calculated as: [Net Proved Reserves]+[hedges]-[net debt]. Using the March 1, 2015 outstanding debt of $173MM yields a net asset value of $44MM, or $1.46. With oil at its current price of $38 per barrel, I believe that this number should serve as a floor to MCEPs stock price.

2016 Guidance

There were a bunch of good nuggets (and one disappointing one, in my opinion) coming from MCEP's 2016 guidance. These include:

  • A further decrease (based on the mid-point) in lease operating expenses to $18 per BOE
  • Full year DCF of $0.92 assuming 4,200 BOE per day in production and strip pricing of $36.5. The full guidance matrix of production change and oil price change is:
  • A disappointing production drop to ~4,200 BOE down about 11% from Q4 2015 production.

Cash Flow Forecasts

Using a simple model discussed here, I forecast distributable cash flow through 2018 with modifications made for current NYMEX strip pricing, and other assumptions as discussed below.

  1. Opex, G&A - Both operating expenses and G&A are assumed to decrease in 2016, and stay constant thereafter in 2017 and 2018. Lease operating expenses are assumed to be $17.4 per BOE. The motivation for this is based of the first bullet point of slide 9 of the Q4 investor presentation. G&A is assumed to be $4.0 per BOE consistent with the quarter-over-quarter decline rate in recent quarters coupled with the lowered production forecast.
  2. Commodity prices - The price assumptions by quarter are shown below for oil. The price data is based off of the most recent NYMEX future chain.
  3. Production - 2016 production is assumed to be 395 MBOE, or 4,389 BOE per day. This is consistent with, but towards the high-end, of management's production guidance.
  4. Hedges - The hedging assumptions, based on the latest investor presentation are provided below.
  5. Interest expense - The interest expense is comprised of $180MM outstanding on its credit facility at an annual rate of 2.9% for Q1 2016. Future interest expenses are re-calculated accordingly as all free cash flow is assumed to lower the outstanding balance.
  6. Production tax - The tax rate is assumed to be 5.3%, consistent with the mid-point of management's 2016 guidance.
  7. Capital expenditures - Per management's guidance, a value of $9MM per year or $2.25MM per quarter is used.
  8. Free cash flow - Assume all free cash flow is used to pay down the credit facility. In the subsequent quarter, the interest expense will update accordingly based on the decrease in borrowing base from the previous quarter.

The projected distributable cash flow, total outstanding debt, and debt-to-EBITDA are shown in figures below. For 2016, my forecast of annual DCF is a bit more optimistic than management's, coming in at $28.9MM per year, or $0.96 per share (compared to managements $0.92 per share). It is interesting to note that by 2018, MCEP is generating about ~$4.5MM per quarter in DCF, unhedged, with oil at ~$45 per barrel.

Risk Factors

There are two risk factors to my bullish thesis on MCEP. They are:

1. lenders and the borrowing base - As I had written previously, MCEP faces a $20MM problem by way of its borrowing base re-determination in May. In MCEPs 2015 10-K, they had this to say on the borrowing base problem:

"The non-conforming tranche matures May 1, 2016, requiring our outstanding debt balance to be paid down to $150.0 million at that time. As of December 31, 2015, the mark-to-market value of our net derivative financial instruments totaled $25.6 million . If necessary, the value of our net derivative financial instruments could be monetized and or combined with a portion of operating cash flows to satisfy debt maturities in 2016. Preliminary conversations with our lenders suggest the Partnership will not be compelled to monetize hedges to reduce debt during the upcoming spring 2016 bi-annual borrowing base redetermination. At this time, it appears more likely that the Partnership and its lenders will reach an accommodation comparable to the one reached by these same participant parties during our fall 2015 bi-annual borrowing base redetermination. "

My interpretation is that the lenders will likely give MCEP a pass on getting the borrowing base down to $150MM by May 2015. Rather, they will require MCEP to pay down debt by $15 to $20MM over the subsequent 6 months. The fall back option is to liquidate 2017 hedges, which given their current value, would allow MCEP to get below $150MM in outstanding debt if need be.

2. debt-to-EBITDA ratio - MCEPs 2015 10-K says this on the financial covenant on its borrowing base:

"At December 31, 2015, we had approximately $180.0 million of borrowings outstanding under our revolving credit facility. The facility requires us and our subsidiaries to maintain a leverage ratio of Consolidated Funded Indebtedness to Consolidated EBITDAX (as defined in the facility) of not more than 4.0 to 1.0"

As shown above, based on current NYMEX future chain, MCEP will likely exceed that covenant by 1Q 2017. Other upstream peer companies like Legacy Reserves LP (NASDAQ:LGCY) have received waivers or upward-revised covenants at the expense of a lower borrowing base. My belief is that MCEP will be required to continue paying down its borrowing base in exchange for a relaxation in its financial covenant.

Takeaway

Even at current strip pricing, MCEP is a very profitable company due to its low-cost producer status. Assuming oil prices follow current NYMEX futures, MCEP will generative significant positive distributable cash flow through 2018 all the while being able to reduce its borrowing base. Moreover, this distributable cash flow is sufficient to entirely fund its annual capital expenditures budget of $9MM per year without raising equity or debt. The risks factors are real, and an investor should be cognizant of them. However, I think both are resolvable even in today's low commodity price environment. Should oil prices rise, it only requires ~$50 oil for both risk factors to largely go away. Given my overall bullish thesis on crude oil, I am using MCEP as a way to play this position.

Disclosure: I am/we are long MCEP.

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.

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