Recently, Memorial Production Partners LP (NASDAQ:MEMP) announced that the credit line redetermination process was complete and that the company survived the redetermination process intact. While this accomplishment was a cause for celebration, if any process proves the fickleness of banks as lenders, this latest round of approval should be a poster child for that fickleness. In the future this company needs to do most of its financing in a way that does not involve banks, then a lot of what is now happening would not be such a threat to the company.
First, the bankers shrank the credit line to $925 million. That figure is suspiciously close to the value of the company's hedging program (but definitely not the value of the hedges). This is an important consideration because the hedges can be quickly turned into cash as needed. If indeed the loan amount bears some resemblance to the company's hedging program, than investors can expect reductions in the loan amount as the company monetizes its hedges when they come due. That process will continue until commodity prices rally significantly to restore faith of the lenders in the company or until operations show such significant improvement to restore the faith of lenders in the company.
The attitude of lenders has turned very hostile to oil and gas companies lately. Banks have demanded stronger financials than they were just a year ago. So its no surprise that the banks limited the company's ability to make distributions to unit holders. What is so frustrating about this is that back in February, on a previous article, it was noted that management was guiding toward a $.10 per unit each quarter as maintainable. If one were to believe that management did its due diligence on this, then the bankers saw that distribution before now and at least verbally gave it the ok. However, something changed since that time as the new agreement limits the maximum distribution to no more than about $.05 per unit each quarter. Anyone who thinks that this is a stable situation and the worst is over believes in the tooth fairy. These bankers are clearly nervous and they are nervous at the worst possible time for the company. Commodity prices did drop since that initial distribution rate guidance was given for the units, but those prices have also since rallied. However, the company lenders are acting as if commodity prices were still much lower than the current pricing.
So the company has two challenges. First it has to get its liquidity up from the current $131 million available borrowing plus cash. Management has not stated what they consider an adequate liquidity but before the current redetermination, the liquidity was closer to $400 million, though it did vary. The biggest problem here was this company never kept a large cash balance. Many kinds of partnerships have the habit of distributing their earnings to shareholders so cash on hand is usually limited. That is a huge disadvantage for the company to have at the bottom of a commodity market when seeking a credit line redetermination. Nothing reassures bankers like a ton of cash on hand whether the company needs it or not.
If repurchasing bonds at a discount will get the job done, than that should be the first priority, however, the bank line has a superior claim to the company assets, so that route is very unlikely to raise the company liquidity or reassure the lenders. Most likely, the company will have to find a new lenders for some of its first lien debt to free up its credit line. It may also have to swap some of its debt for equity, especially since refinancing that first lien debt is going to be very expensive and the company cannot afford ratio deterioration. While that dilution would be irritating for current shareholders, if management does not act promptly, there could be far more unfavorable solutions on the way.
The second challenge is to get as much of that first lien debt as possible off the credit line and into a more stable situation, such as bonds, in a very hostile environment. Then the credit line redeterminations are not nearly so threatening. It may not be possible to achieve this in an economic fashion in the current environment, so there may have to be some sort of compromise that leaves some money as a first lien while reducing the overall balance enough to make credit line redeterminations non-threatening. Based on hindsight, management should have been doing this a year ago, as the deals it thought were not in the best interest of the shareholders now look darn good compared to what will happen now. Hopefully management will learn from this experience.
To its credit, management did pay down some debt in the first quarter, however, in the future there will have to be far more progress than that. The real question is if management can pay down the first lien debt ahead of any further credit line cuts. Possibly, the company can cash in some of its hedging to reduce its loan balance. That would reduce future earnings protection to solve a current problem. This solution could work if operations finds enough significant improvements to make up for the lower income protection. Many companies in the industry are showing significant operational improvement, and this company has cited some high IRR rework projects. So this may be a viable, if scary avenue to try.
Typically, these limited partnerships were heavily leveraged to maximize the distribution paid to investors. The problem was that the leverage should be done in a hostile environment such as this so that the next time commodity prices dive, there is no question that the company could survive. Bankers who were so comfortable lending a lot of money when commodity prices were high are now a nervous wreck in the current environment despite their superior claim on the company's assets. The company is in a bind because non-core assets are not that liquid or are liquid at a significant discount. But the leverage may prevent selling properties at a discount. Obviously this is not working to the investor's advantage so the company will have to change how it does business in the future. That may involve ditching the limited partnership units and maybe going to a regular corporate model. Or the company could keep some of the income but make sure that enough money passes to the shareholders to pay the taxes. There are also limited partnerships out there that pay the taxes for shareholders and keep the cash while passing the earnings on to the shareholders. There are many possible models and solutions to choose from once the company survives the current downturn.
The big point of all this is that the distribution to shareholders is no longer a top priority. Reassuring the banks has to come first so that the credit line redetermination process does not become really painful in the future. Let's hope that shareholders do not get stuck with a big tax bill in the process. Commodity prices have rallied some lately, and a continued rally would certainly help the situation. On the other hand a continued drop in commodity pricing would probably doom the company.
In the meantime, the company has to figure out the best way to decrease its leverage in a way acceptable to the bankers, or receive some assurance that in the future the credit line redeterminations will not adjust the credit line downward (In the current hostile environment, don't count on that one.) In short, the company cleared a very important hurdle, but there are still many more to go and this company is not out of the woods yet. It has survived longer than many other partnerships in the industry so management should be commended, but its chances of making it to the next industry upswing are speculative at this point so management will need to keep working very hard. Investors need to wait this company out until the future clears up far more than it has.
Disclaimer: I am not an investment advisor and this is not a recommendation to buy or sell a security. Investors are recommended to read all of the company's filings and press releases as well as do their own research to determine if the company fits their own investment objectives and risk portfolios.
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