Pump Out Nearly 30% Yields With Memorial Production Partners LP Bonds Maturing May 2021

| About: Memorial Production (MEMP)

Summary

For Q1 2016, MEMP reported adjusted EBITDA of $81.3 million, largely because of its shrewd hedging strategy.

For 2016, the company has hedged 93% of its oil production at $85.48, 92% of its natural gas production at $4.14, and 98% of its natural gas liquids at $35.64.

Even at oil’s low point of $26/barrel, the company was still profitable, with interest coverage still at 2.5x.

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This week, we review an oil and natural gas producer that has employed an extremely successful hedging strategy to combat low oil prices. Memorial Production Partners LP (NASDAQ:MEMP) has done a fantastic job keeping its revenues/cash flow stable though the effective use of hedges on both its oil and natural gas production. In addition, the company has taken several steps to significantly reduce its expenses.

  • For 2016, the company has hedged 93% of its oil production at an average weighted price of $85.48, 92% of its natural gas production at an average weighted price of $4.14, and 98% of its natural gas liquid production at an average weighted price of $35.64.

  • Even at oil's low point of $26 / barrel, the company was still profitable, with interest coverage still at 2.5x.

  • Since last summer, MEMP has reduced headcount by 25%.

  • Lease operating expenses decreased 19% in Q4 over Q3 levels (2015) and decreased a further 5% in Q1.

  • In Q1, MEMP reduced its unitholder distribution from $0.10 to $0.03 / share in order to support its goal of debt reduction.

As lenders began shutting their doors to the oil sector, the markets likewise seem to have castigated most debt issuances in the sector and has remained wary of MEMP, as evidenced by the low price indication (around 45) for its May 2021 bonds. Couponed at 7.625%, this translates to a remarkable yield to maturity of nearly 30%, and presents what we see as a nice opportunity to increase the overall portfolio yield. In the space of two years, oil prices have been cut by nearly 75%. With the recently reported declines in oil rig count, in another two years it is possible to see oil prices climb significantly, especially after factoring in the production decay from existing wells. At this point, MEMP appears to have a virtually unlimited runway for oil prices to recover. Considering MEMP's hedging strategy and its commitment to decreasing its costs and debt levels, we do not expect its bonds to stay at these low prices for long. In light of these factors, we are looking to add these high yielding, 60-month bonds from Memorial Production Partners to both our FX1 and FX2 portfolios.

Commodity Prices - Looking Back, Looking Forward

The good news for oil exploration and production companies is that 2016 oil prices have begun to recover from the almost two-year rout. West Texas Intermediate (WTI) prices are up 21.5% from the beginning of this year (from $36.81 / barrel on January 4th to a trading price on May 2nd of $44.75) and more impressively, these prices are now almost 68% higher than their low point in January of $26.68 / barrel. While it may take some time to approach the $107 / barrel levels seen in June 2014, oil prices do appear to be steadily increasing, albeit slowly. Additionally, with the extended low price oil environment, many exploration and production companies have drastically cut their capital expenditures budgets which funds new wells / new production. Oil wells have a natural decay rate, with production decreasing during the life of the well. With very few new wells currently being drilled, supply will continue to decrease and will contribute to rising oil prices.

The market now also appears to be reactive to potential interruptions in supply. The recent wildfire in Alberta Canada's oil sands region, which has resulted in the full evacuation of the city of Fort McMurray, has caused several companies to suspend production as well as pipelines being shuttered as a precaution. And rising tensions in Libya could further delay the country's oil shipments, ultimately affecting production. Both of these events have driven up prices in the past week, with WTI rising 2.17% to $44.74 and Brent increasing 1.80% to $45.37 as of May 5th.

The impressive piece to note for Memorial Production Partners is that even with oil at $26 /barrel, the company was still profitable. For Q1 2016, the company registered adjusted EBITDA of $81.3 million. This is largely a result of its shrewd hedging strategy, which the company uses routinely to even out cash flow amidst oil and gas price volatility.

Hedging Effectively

Memorial Production Partners has effectively used its hedging strategy to reduce the impact to its cash flows from the inherent price volatility associated with commodities. Currently, the company is extremely well hedged. Between now and the end of 2018, MEMP has hedged over 90% of its expected oil production at prices ranging from $83.74 per barrel to $85.48 per barrel. The company has also effectively hedged its natural gas production. This year, it has hedges in place for 93% of expected natural gas production and 98% of its expected natural gas liquids (NGL) production. Here is a summary of MEMP's current hedging picture.

2016

2017

2018

2019

Oil Price Hedge

$85.48

$85.00

$83.74

$85.52

Percent Hedged

93%

92%

95%

49%

NG Hedge Price

$24.84

$24.36

$25.08

$25.86

Percent Hedged

92%

86%

79%

72%

NGL Hedge Price

$35.64

$37.55

$0.00

$0.00

Percent Hedged

98%

20%

0%

0%

Click to enlarge

MEMP's mark-to-market hedge book value stood at $605 million as of March 31, 2016. All of MEMP's current hedges are costless, fixed price swaps.

About the Issuer

Headquartered in Houston Texas, Memorial Production Partners is a publicly traded partnership focused on the acquisition, production and development of oil and natural gas properties in North America. Its assets consist primarily of producing oil and natural gas properties located in Texas, Louisiana, Colorado, Wyoming, and offshore Southern California. Most of its oil and natural gas properties are located in large, mature oil and natural gas reservoirs with well-known geologic characteristics and predictable production profiles, requiring modest capital requirements.

Expense and Debt Reductions

For 2016, MEMP management has established several goals for the company. These goals, emphasized in its last quarterly conference call, are to generate positive free cash flow, reduce debt, enhance liquidity and drive down costs. MEMP has already made excellent progress on its goal of cost reduction. For Q1 2016, the company decreased its lease operating expenses (LOE) by 5% over Q4 2015 levels. This comes on the heels of a 19% LOE reduction in Q4 over Q3 levels. In addition to decreasing its lease operating expenses, MEMP reduced company headcount in Q1 2016 by 15%. Since last summer, the company has reduced overall company headcount by 25%. This will directly impact and reduce its ongoing general and administrative (G & A) costs going forward. In order to free up cash to direct towards its other goals of reducing debt and improving liquidity, MEMP also recently reduced its quarterly distribution to its shareholders from the previous level of $0.10 / share to $0.03/ share. This move was in large part due to the recent credit facility re-determination (covered later in this article). Finally, MEMP significantly reduced its 2016 capital expenditures from the 2015 level of $214 million to $65 to $75 million for the year. This level of capital will allow the company to keep current with any maintenance on its wells, with an eye to overall debt reduction.

Moving Forward

As mentioned earlier, MEMP has done an outstanding job hedging the majority of its production for 2016, with a large amount of planned production for 2017 and 2018 hedged as well. These hedges will no doubt help the company secure a base level of cash flow while it makes progress toward reducing debt and increasing liquidity. MEMP has already made progress on paying down debt, decreasing its outstanding balance under its credit revolver by $44 million in Q1.

Interest Coverage

For 2015, MEMP had adjusted EBITDA of $340.4 million, with interest expense totaling $114.7 million. This gives an adjusted EBITDA to interest expense ratio of 2.96x. While this ratio decreased slightly for Q1, it still shows healthy coverage, with adjusted EBITDA of $81.3 million and interest expense of $32.5 million for an adjusted EBITDA / interest expense ratio of 2.5x.

Risks

The default risk is Memorial Production Partners ability to perform. While many oil production companies have been struggling through the continued low price oil environment, MEMP has smartly hedged the majority of both its oil and natural gas production for 2016, 2017 and 2018. This provides cash flow stability despite the price volatility of oil and natural gas. It has taken steps to reduce expenses, significantly reducing capital expenditures, headcount and unitholder distributions, and has begun to reduce levels outstanding on its credit revolver. Considering these factors, the outstanding 30% yields on these relatively short, 60-month notes appear to outweigh the risk factors identified.

Earlier this year, MEMP underwent a redetermination of its credit facility and borrowing base. This resulted in a revised borrowing base, decreasing to $925 million. While this move does impact the company's liquidity levels, it is no surprise given the current oil and gas price environment. In response, the company has been proactively addressing its debt levels, already paying down $44 million of its credit revolver in Q1

Since MEMP's revenues are derived from the sale of oil and natural gas, there is commodity price risk. However, due to the fact that the company has successfully hedged nearly all of its planned production for this year, along with a majority of its planned production for 2017 and 2018, commodity price volatility will not have as large of an effect on cash flow as it would absent these hedges.

These 60-month notes, with a current, excellent yield of nearly 30%, have similar yields or durations to other bonds reviewed on Bond-Yields.com, such as the 30% Natural Resource Partners and the 12.5% Transener bonds.

Summary and Conclusion

Memorial Production Partners has shrewdly and successfully used its hedging strategy to achieve consistent cash flow during the biggest oil downturn in recent history. With nearly all of its oil and natural gas production hedged for 2016 and a majority of production hedged for 2017-18, the company appears well-positioned to wait out the low price environment and be ready to forge ahead when prices begin their inevitable march upward. It is indeed impressive that MEMP was still profitable when oil bottomed at $26/ barrel, and it follows that the picture will continue to improve for them as oil prices rise. It has made the difficult decisions - headcount reductions, reduced capital expenditures and reduced distributions - to position the company for long-term viability and profitability. Continued oil price volatility and the company's recent borrowing base redetermination has plainly resulted in the market's wariness of MEMP, which we perceive as an outstanding opportunity to add these deeply discounted and remarkable, near 30% yielding bonds from MEMP to our global high yield income portfolios, Fixed-Income1.com and Fixed-Income2.com.

Issuer: Memorial Production Partners LP

Bond Coupon: 7.625%
Maturity: 5/01/2021
Rating: Caa3 / CCC
CUSIP: 586049AB4
Pays: Semi-annually
Price: 45.0
Yield to Maturity: ~29.37%

Disclosure: Durig Capital and certain clients may have positions in Memorial Production Partners 2021 bonds. To obtain higher yields and keep costs as low as possible, Durig Capital typically bundles smaller retail orders into larger institutional sized orders with many global trading firms and bond platforms. Our bond reviews are published on the Internet and distributed through our free email newsletter to thousands of prospective clients and competitive firms only after we have first served the needs of our clients. Bond selections may not be published if they have very limited availability or liquidity, or viewed as not being in the best interests of our clients.

Please note that all yield and price indications are shown from the time of our research. Our reports are never an offer to buy or sell any security. We are not a broker/dealer, and reports are intended for distribution to our clients. As a result of our institutional association, we frequently obtain better yield/price executions for our clients than is initially indicated in our reports. We welcome inquiries from other advisors that may also be interested in our work and the possibilities of achieving higher yields for retail clients.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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.