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Executives

Scott Smith – President and CEO

Richard Robert – EVP and CFO

Analysts

Stephen Beck – Jefferies & Company

Shawn Grant [ph] – ZLP [ph]

Vanguard Natural Resources, LLC (VNR) Q2 2008 Earnings Call Transcript August 12, 2008 10:00 AM ET

Operator

Good day, ladies and gentlemen. Welcome to the second quarter 2008 Vanguard Natural Resources earnings conference call. My name is Marcia and I will be your coordinator for today's call. At this time, all participants are in a listen-only mode. We will conduct a question-and-answer session toward the end of this conference. (Operator instructions) As a reminder, this conference is being recorded for replay purposes. I would now like to turn the call over to Mr. Scott Smith, President and CEO. Please proceed, sir.

Scott Smith

Thank you, Marcia, and welcome everyone and thanks for joining us today for our second quarter 2008 conference call. I'm joined today by Richard Robert, our Executive Vice President and Chief Financial Officer, and Britt Pence, our Vice President of Operations.

Before we get started, I will remind you that some of the information discussed today may be considered forward-looking statements. Please refer to the Forward-Looking Statements section in our press release this morning for a detailed description of what information constitutes forward-looking statements under the securities laws.

The results of the second quarter were very much in line with our expectations both operationally and financially. We saw an increase in our reported production volumes of approximately 19%, primarily as a result of including the Permian Basin assets for a full quarter but absent any contribution from new wells in the Permian because our development drilling there has been pushed back to the end of the third quarter due to rig availability.

In addition, our volumes in Appalachia were up slightly as well and we have maintained our drilling activity in that area having participated in the second quarter in 24 gross wells, 12 net. With respect to our Appalachian production, a point we feel investors should appreciate is the dramatic increase we have seen in our oil production on a year-over-year basis.

We are consistently seeing daily net production in the 110 to 120 barrel per day range, which is substantially higher than historical levels of 40 to 60 barrels per day. This increase is a result of a focused effort by the operational team at Vinland, the operator of the Appalachian wells, to identify and complete oil productive zones that in the past may have been bypassed to go focus on gas production or not pursue due to a lack of market or operational issues. Obviously, with the $100 plus oil, the economics of oil production are very robust. We would anticipate that the contribution from oil production in Appalachia will continue to be strong.

Another development in our operating area of Appalachia that we are excited about is the rapid increase in horizontal drilling to develop the devonian shale formation. DNX, Atlas and NGAS have all announced four to seven well programs that have been very successful in terms of well cost averaging 1.1 million to 1.5 million, sustained flow rates of 350 to 400 Mcf per day, and estimated reserves of 0.75 to a Bcf per well. All these companies have announced they plan to increase the pace of horizontal drilling going forward, with Atlas being the most active with a planned 50-well program over the next 18 months.

We and Vinland have drilled our first horizontal well to test the devonian on a 10,000-acre lease position in Harlan County, Kentucky. This was a 4,000-foot vertical well with a 3,500-foot lateral. Drilling of this well went very well and without any problems and we anticipate completing the well in the next several weeks once all the completion equipment can be arranged and mobilized.

In addition, we are participating with a 10% working interest in a two-well reentry project to test the shallower shale section at approximately 2,000 feet with a 2,000-foot lateral in Whitley County, Kentucky. The first of these wells is currently underway.

All of this horizontal shale activity is taking place on trend or in close proximity to our existing fields where we and our development partner, Vinland, have over 104,000 gross acres of HVP [ph] leasehold. It's still too early to say the use of horizontal drilling in Southeast Kentucky and Northeastern Tennessee to develop the devonian shale will be viable on a widespread basis. However, based on the reported results so far from our peers and our initial well experience, this application looks very promising and could have a profound impact on our drilling plans for 2009 and beyond.

In the Permian, our production has remained steady even though, as I mentioned before, our development -- drilling program has yet to begin. Our operations team in Houston and the guys in the field have done a great job with our properties and to maximizing our production and keeping our downtime to a minimum. We plan to move a rig next week to our Lovington field in New Mexico and look forward to drilling two to three wells in this area in the third quarter.

Hopefully most of you saw our announcement on July 30 concerning the closing of our South Texas acquisition from Lewis Energy. I think this is an excellent acquisition for the company, as we have added long life, high BTU natural gas reserves with an inventory of proved undeveloped locations to drill through 2013. The drilling of these locations is designed to keep our production from this property stable for the next five to six years.

In addition, with this acquisition, we acquired very favorable natural gas hedges covering 85% of the anticipated proved developed producing production through 2011. With this transaction, we now have a partner in the Lewis Energy Group, the largest producer in the Olmos trend of South Texas with over 1000 producing wells and net production in excess of 67 million per day.

With over 25 years in this trend, the Lewis team will operate the properties we acquired and we will jointly participate in the development drilling program. In this transaction, Rod Lewis, the owner of Lewis Energy, became one of our largest unitholders with almost 11% ownership position. And we are looking forward to a long and fruitful relationship with Rod and his company.

Before turning the call over to Richard for a review of the financial results, I'd like to comment on our approach to hedging and why we believe investors should appreciate this model, especially in times like these where we have seen such extreme volatility in the commodity markets. The bottom line is we hedge our production to ensure the economic returns of the investments we make in oil and gas properties and to ensure we have the cash flow available to pay our distributions, service our debt and conduct our development drilling activity to replace our reserves.

With our current hedge positions in place, our unitholders can feel confident in our ability to make our distributions even if prices continue to fall further than current levels. We hope investors will appreciate the stability of cash flow our hedging program provides and realize their distributions are not at risk from a falling commodity price scenario. With that, I will turn the call over to Richard for a review of the financial results.

Richard Robert

Thank you, Scott. Good morning. My name is Richard Robert. I’m the Chief Financial Officer of Vanguard. As Scott has mentioned, we are pleased with the results of the quarter as total production came in line with our expectations. We reported net daily production of 15,888 Mcfe for the second quarter, representing a 19% increase over the first quarter.

I would like to reiterate some of the financial highlights for the second quarter that you saw in our press release. As compared to the second quarter of 2007, our distributable cash flow increased 322% to $6 million and our net income was up 131% to $5.2 million. Adjusted EBITDA came in just under $12 million, which is 49% better than the $8 million generated in the second quarter of 2007 and 14% better than our first quarter this year. The principal driver of the improved results is the impact of the Permian Basin acquisition that was closed at the end of January this year as well as higher realized pricing for 2008 over 2007.

We are anticipating continuing improved results over the course of the year as we include the impact of the South Texas acquisition closed at the end of July. Although we only have five months of operations included in our results for 2008 and only two months in the third quarter, we felt the impact was significant enough to warrant our updating our guidance for the year.

Our methodology for updating the 2008 guidance included using commodity pricing of $9 for gas and $90 oil, as that is where most of our production is hedged, and then adjusting production expectations and other variables based on results for the first six months. And then of course, the impact of the South Texas acquisition was factored in. As it relates to the midpoint of our forecast range, the result increased our net income by approximately $3 million or 14%, increased adjusted EBITDA by $5.4 million or 11%, and increased distributable cash flow by $4.1 million or 17%.

As a result of these expectations, we reported yesterday that our Board of Directors elected to increase our third quarter distribution to $0.50, which is 12% higher than our second quarter distribution and 18% higher than our distribution when we went public nine months ago. In addition, it is important to note that while we have increased our distribution significantly, we have also improved our forecasted coverage ratio for 2008 to approximately 1.3 times.

With respect to coverage, I would caution investors to recognize that coverage will vacillate each quarter based on the timing of drilling expenditures. For example, if a significant amount of capital is spent at the end of a quarter, there would be a situation where little cash flow is generated in the quarter from the new drilling but all the capital is counted against the quarter. Clearly this can skew coverage on a quarter-over-quarter basis, and I suggest a longer-term outlook is warranted. This could be the situation we are faced with in the third quarter of this year, as a result of our horizontal drilling program in Appalachia and our Permian Basin drilling program that we expect to get underway shortly.

I would like to shift the discussion to our leverage and liquidity. Currently we have $132 million outstanding on our reserve-based credit facility. Our current borrowing base is $150 million, but we are in the process of a borrowing base redetermination. And early indications suggest that our new borrowing base will be set at $182 million, which leaves us with approximately $50 million of availability.

We have ample room to grow using debt financing from a debt covenant perspective and our availability provides us some dry powder for new acquisitions, which is especially important today based on the current capital market situation. This concludes my comments and I will turn it back over to Scott.

Scott Smith

Marcia, with that, I will -- let's open the call up for Q&A.

Question-and-Answer Session

Operator

(Operator instructions) And your first question comes from the line of Stephen Beck from Jefferies & Company. Please proceed.

Stephen Beck – Jefferies & Company

Good morning.

Scott Smith

Good morning, Stephen.

Richard Robert

Good morning.

Stephen Beck – Jefferies & Company

I guess first, can you provide a little bit more detail on the Appalachia, the wells that were drilled in the second quarter, where they were located, which fields and so forth?

Scott Smith

In any given quarter, Stephen, they are all over the place. I mean, we have interests in like 16 different fields. There really wasn't much concentration at all. I think probably the lion's share were -- if there was any concentration at all, it was in Brushy Branch area. We did drill -- of the 12 net wells, four of those were 100% wells that we drilled at 100%. But again, there is no concentration amongst any particular field. And that is done -- again, what you don't want to do is tax your gathering systems by bringing on too many new wells in any one particular area.

Stephen Beck – Jefferies & Company

Sure. Did you participate in any devonian wells or devonian horizontal type drilling?

Scott Smith

Not in the second quarter. We have in the third quarter. Again, as we’ve said there in the call, we've just finished -- just reached TD last week on the first devonian well that we drilled with Vinland on a 60/40 basis there in Harlan County. And again, we are taking a 10% working interest in a two-well reentry program, which is underway now there in (inaudible) the Whitley County, Kentucky. So we are just getting started in the devonian here in the third quarter.

Stephen Beck – Jefferies & Company

Okay. With respect to the Permian, I think you said you are going to move -- look at putting your first rig there in Q3. Given that the tightness in the rig market, do you have the rig already secured or are you still working on that?

Scott Smith

No, we already have the rig secured. And in fact, we plan on drilling several wells kind of basically back-to-back. Once we pay the mobilization costs, we really don't want to let it go.

Stephen Beck – Jefferies & Company

And then what’s your position with respect to the outlook for acquisitions -- bolt-ons and so forth?

Scott Smith

Obviously, just having finished one just a couple of weeks ago, we are looking forward to digesting that one and getting it done, although I will say there is quite a bit of product in the market. We are always evaluating things from $50 million to $75 million deals down to $5 million transactions. So, we are going to continue to look again with roughly $50 million of availability on our line. We have to be judicious in what we look at, but we will continue to look.

Stephen Beck – Jefferies & Company

Okay. I’ll let somebody else get in. Thanks.

Scott Smith

Thank you, Stephen.

Operator

And your next question comes from the line of Shawn Grant [ph] from ZLP [ph]. Please proceed.

Shawn Grant – ZLP

Hi, Richard. Good morning guys. Could you -- Richard, could you hit the availability under your credit facility again? I missed that right at the end.

Richard Robert

We anticipate it's going to be $50 million.

Shawn Grant – ZLP

After an increase?

Richard Robert

Yes, correct.

Shawn Grant – ZLP

Okay. Great, thanks.

Richard Robert

You bet.

Operator

(Operator instructions) And we have no further questions in the queue at this time.

Scott Smith

All right. With that, I appreciate everybody calling in, and we look forward to visiting with you again in November on our third quarter conference call. And again, if anybody has any questions, please don't hesitate to call either Richard or I. So, thanks again.

Operator

Thank you for your participation in today's conference. This concludes the presentation. And you may now disconnect. Good day.

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