In my previous article I discussed the key reasons why I felt Legacy Reserves (LGCY,LGCYO,LGCYP), deserved your attention as a potential or current investor. In that article I presented a 2016 WTI breakeven number but did not go into detail on the financials. This article will focus primarily on the numbers and hopefully help you understand not only why I am bullish on the name, but provide you with information that will allow you to draw some of your own conclusions as to their potential future profitability in a base, bull, bear, and mixed bull/bear commodity price scenarios. In addition to using these three cases, the 2017 fixed assumptions are adjusted based on likely events that management has guided for 2016 making this the most comprehensive analysis that I've seen published for this name.
For those looking for an investment vehicle in either Crude Oil or Natural Gas with a time horizon longer than one year, those currently invested in the United States Oil ETF (NYSEARCA:USO) or the United States Natural Gas ETF (NYSEARCA:UNG) looking for longer-term exposure without the decay, LGCYO makes an extremely compelling investment.
During the compilation of the data for this article, two things became clear:
- One small assumption can make a huge difference to the overall numbers and a few small assumptions can skew the data leading to incorrect conclusions
- Legacy makes it very difficult for the casual investor to complete a financial analysis based on the information they provide
Unfortunately there is no way to get around making some estimates in the analysis. An aversion to making estimates on prices by utilizing the strip fails to give investors a useful predictor of performance.
For all the scenarios I have used the following assumptions:
- Lease Operating Expenses (LOE) are $11.50 per barrel of oil equivalent (BOE)
- Production is 45,435 BOE per year. 26% is Crude Oil, 6% is Natural Gas Liquids (NGL) and 69% is Natural Gas (NG)
- Taxes are 8.2% of pre-hedge revenue
- Capital Expenditure ((capex)) is $37 million for 2016 onward
- G&A is $30,923,165 and excludes long-term incentive plan (LTIP) which is basically stock options issued to the executives
- Oil differentials are $4.71 per barrel, NGL differentials are 5% of spot price, and NGL price is 35% of Crude
- NG differentials are 0.14 per Bcf
- 1st lien revolver has $608 million outstanding at a rate of 2.9% for 2016
- $248 million of 2020 and $498 million of 2021 Senior Notes (bonds)
Aside from transparency, the reason I listed all of these out is that a change in any one of these numbers can make a huge difference to the outcome. Another published analysis I've seen assumed LOE of $10.50 per barrel which makes a huge positive impact to profitability. Another analysis I have seen appears to assume there are no differentials. Differentials are the difference between the spot price and the realized price and make a significant difference to the final numbers.
To illustrate my point, LOE of $10.50 (and not $11.50) increases free cash flow (FCF) by $16.5 million annually. Additionally, excluding differentials would add ~ $28 million to FCF. I am bullish, but I am also trying to build and maintain trust with my readers and want to make every effort to present the most realistic analysis possible.
2016/17 Cash Flow Estimates
While I believe the unhedged numbers are the most important for sustainability, the reality is that the current hedges protect Legacy from what is an unusually low commodity price environment in 2016.
The base case for oil in 2016 is $42.50 average WTI and $2.25 for NG.
In the base case we'll see $23 million positive free cash flow in 2016, great news. The hedges contribute approximately $40 million to that number. The bear case is pretty ugly and presents a good reminder why LGCYO, which has a par value of $25 is currently trading so low. You can see how quickly though that some reasonable improvement in commodity prices will improve the cash flow. Keep in mind that even in this bear case scenario, I find it unlikely that LGCY will declare bankruptcy due to the planned asset sales.
Per management guidance, 2016 asset sales should total $114.5 million in 2016 with a target for them to be completed in the first half of 2016. I'm going to assume that $50 million goes to the 1st lien revolving credit line and the other $50 million is used to buy back a mix of the 2020 and 2021 bonds at 50 cents in the dollar. I'll also assume the interest rate on the revolver increases by 0.5% for 2017 and a little pessimistically that LOE goes up to $12 per BOE.
While I'm pessimistic that oil services costs will stay low, I'm optimistic on 2017 commodity prices. In my model I assume a base case of $53 WTI and $3 NG.
For 2017 LGCY will flow $68 million of free cash with only $12 million coming from the hedges. In the bull case we see almost $146 million of free cash flow.
In the base case, I would imagine the distributions would resume on the preferred stock (LGCYO, LGCYP) but we'd likely not see the common distribution return for at least another year. The day the distributions resume on LGCYO/P is going to be a very nice day for holders of this equity.
All these numbers aside, commodity prices will decide the fate of Legacy. Let's start with NG. The price of NG has been volatile over the last five years. Below is a 5-year NG chart:
While production keeps setting new records, so does demand. NG is clearly winning the battle against coal for domestic power generation and there are several opportunities for exports to increase. If you believe that U.S. oil production is going to fall by 1 million bpd in 2016, the associated gas production from that oil production will also disappear. The biggest factor with NG however is weather. Seeking Alpha contributor Hedge Fund Insights has an excellent article here on why we are very likely to see weather over the next 1-2 years that will be very supportive of NG prices. These factors combined are the basis for my $3 spot NG price estimate for 2017. There are expectations that we'll see weather extremes in 2016 and 2017 that are likely to break records.
For my outlook on oil and the ten reasons I am bullish, check out my article here.
Sensitivity to each commodity price
In each model presented earlier it was assumed that Crude oil and NG both rise over the next 12-24 months. While I believe this to be the case, I want to show what would happen if only one commodity rises as it relates to my base case.
You can see that all Legacy needs to start generating some respectable FCF is one of the two commodity prices to make a solid upside move. This is one of the many reasons LGCY is such a compelling investment from my perspective. It doesn't have the decay of UNG or USO and it's not exposed directly to the fate of a single commodity.
In a "lower for longer" or "medium for longer" oil and gas price scenario, low cost is key. Hedges are temporary and I've covered in previous articles why they are nice little boost, but many have lost a lot of money basing their investment decisions on the names with the best hedges. Given that the hedges exist the following numbers are mostly academic, but if we see both oil and NG stay depressed beyond 2017 they'll matter.
So what WTI spot price do we need to see on average for LGCY to make money unhedged in 2016?
At $2 NG you'd need $54 WTI, at $2.5 NG you'll need $46.7 WTI, and at $3 NG you'd need only $39.25 WTI to be FCF break-even.
You can see from these numbers that LGCY is much better positioned that some of it's better covered peers. Other estimated numbers I've seen published put some of the unhedged breakeven for LGCY's peers in the $60-$80 range. Aside from the capital structure, this is the primary reason I've been so bearish on a recovery in Linn Energy (NASDAQ:LINE) and Breitburn Energy Partners (NASDAQ:BBEP).
There are several risks to investing in LGCY. They are covered in my previous article but I will attempt to summarize here:
- Commodity prices could stay low. The bear cases I present above show the commodity price scenarios in which the risk of owning LGCY increases exponentially
- One cannot assume that breakeven will be adequate and does not eliminate the risk of chapter 11. My personal opinion is that this is very unlikely unless commodity prices deteriorate significantly from here.
- The credit line could be subject to a significant further reduction. I also see this as unlikely as it was just reset at $725MM with only $608MM outstanding. It's also likely that at least 50% of the proceeds of the asset sales will got to this first lien debt (per the covenants)
- There are tax implications to holding LGCY, LGCYO and LGCYP that I covered in my previous article
- Due to the uncertainty of the market about the survival of LGCY, LGCYO and LGCYP are subject to wild price swings. If you choose to invest you must be prepared to feel like a true oilman and ride boom or bust until the base case eventually plays out. This takes nerves of steel and there is never any guarantee that bust will become boom. All the analysis in the world won't help if commodity prices stay really depressed.
The fundamentals of the LGCY business are quite strong. I recommend listening to the most recent conference call or checking out the transcript. Any significant uptick in the price of either NG or oil will see LGCY flowing respectable amounts of cash.
If you think there will be an appreciable rise in the price of Oil and Natural Gas over the next 12 to 24 months, I believe LGCYO (the preferred stock) is an excellent vehicle for taking advantage of that price appreciation and is currently where I have a significant long position. For a pure oil play, Mid-Con Energy partners (NASDAQ:MCEP) is another name worth a look alongside LGCY. MCEP is primarily oil while LGCY could benefit from improved pricing in either commodity.
Disclosure: I am/we are long LGCYO, LGCYP, 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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