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QR Energy LP (NYSE:QRE)

Definite Agreement to Acquire Oil Properties Call

November 1, 2012 3:00 PM ET

Executives

Taylor Miele – IR

Alan Smith – CEO

John Campbell – President and COO

Cedric Burgher – CFO

Analysts

John Ragozzino – RBC Capital Markets

Kevin Smith – Raymond James

Brett Reilly – Credit Suisse

Jeff Robertson – Barclays

Elliot Miller – Private Investor

Ethan Bellamy – Robert W. Baird

Will – RBC

Operator

Welcome to the QR Energy Acquisition Conference Call. We have Chief Executive Officer Alan Smith; President and Chief Operating Officer John Campbell; Chief Financial Officer Cedric Burgher; and Investor Relations Manager Taylor Miele.

I will now turn the call over to Ms. Taylor Miele. Ms. Miele, you may begin your conference.

Taylor Miele

Thank you and good afternoon everyone. Welcome to QR Energy’s call to discuss our acquisition of $250 million of oil properties which we announced today. We issued a press release this morning containing the details of the transaction and we also published presentation slides which are available on our website at qrenergylp.com on the Investor Relations tab.

I would like to remind all listeners that we will use forward-looking statements as defined by securities laws on today’s call. These statements reflect our current views with regard to future events and are subject to various risks, uncertainties and assumptions. Our results may differ materially from those conveyed in our forward-looking statements. For a more complete list of these risk factors, please read QR Energy’s filings with the Securities and Exchange Commission, which are available on our website or on the SEC website at sec.gov.

In addition, certain remarks on the call may be made in reference to estimated oil and natural gas reserves. The estimates of proved reserves referenced on this call have been prepared in accordance with our internal estimates as opposed to SEC reserve reporting requirement. Therefore, our internal proved reserve estimates may differ materially from the estimates of our proved reserve prepared by Miller and Lents.

Now I will turn the call over to our Chief Executive Officer Alan Smith.

Alan Smith

Well, thanks, Taylor, and thank you for joining us everyone. This morning we announced an acquisition of $250 million of conventional oil properties from a private seller. At this time, I wanted to direct your attention to the slide deck that Taylor referred to at the beginning and I plan to begin on page 3.

The assets are located in the heart of East Texas, in the East Texas field between Longview and Kilgore, Texas. This is a world-class oil field that was discovered back in 1930 and to put it in perspective, this field is the largest and most prolific oil field in the Continental U.S. The field has all the attributes we look for: large, original oil in place; mature, predictable production with lower declines; significant low-risk development inventory; and low maintenance capital requirements.

After I did something in specialty, this is where I began my career over 25 years ago as a production engineer in the East Texas field for ARCO Oil and Gas Company. I spent five years in the field and have significant familiarity with the areas we are acquiring and have very good understanding of the engineering and operations in this area. The field has certainly further matured since I worked there. The assets currently produce approximately 1400 barrels of oil per day equivalent with a base decline in the 6% to 7% range. The proved reserves are 10.7 million barrels of oil equivalent with a significant proved developed component of 99% of which 76% is proved developed producing. The proved reserve life is just under 21 years and the production and reserves are 90% oil. An important attribute to point out is that the expected maintenance capital is very attractive, that 10% of adjusted EBITDA to keep production flat for several years.

The low decline and minimal maintenance capital requirements make this field immediately accretive to our EBITDA and distributable cash flow per unit. We have executed commodity hedges on the large percentage of expected production through 2017 and our strong hedge position is expected to give our investors added comfort in our future distributions.

We will give you a full update on our hedges in our earnings call next Thursday.

We expect to finance the deal with cash on hand and borrowings under our bank credit facility and we will have a comfortable amount of liquidity after the acquisition closes in the mid-December timeframe.

Moving on to slide 4. This slide gives you a map of the assets we are acquiring and illustrates what I mean by the sure size of the East Texas field and why this is a world-class oil field. The original oil in place of the entire field is 7 billion barrels of oil and the field has currently produced 5.5 billion barrels of oil from the shallow Woodbine Sand located at 3500 feet. These numbers are staggering and this is why we like to own these kind of assets, a very small incremental recovery increase is very meaningful value creation for QRE.

We intend to increase the recovery in the years to come by performing reactivations of well bores, performing recompletions, installing electric submersible pumps or ESPs as we call them, and deepening wells to the lower Woodbine stringers.

There are over 100 well bores that we plan to reactive in return to production over the next several years. Most of the wells today are on rod pump and there are large number of opportunities to convert those rod pumps wells to ESPs. The lower Woodbine Stringer Sands are high quality and regionally contiguous, so there are also many opportunities to deepen wells in existing well bores.

One additional opportunity is in the areas of the field that do not have (Upshur support) where we may be able to waterflood the leases to achieve additional recovery. An offset operator is currently installing a large waterflood project near some of our leases and will be monitoring this closely as well as looking at other opportunities we have identified. As you can see, we are very excited about the multiple development opportunities that we gained by acquiring this set of assets.

Now let’s turn to slide 5. This was sort of the icing on the cake for us. We currently own natural gas assets in this area that produced from the Cotton Valley Sands. When we are looking at the deal, we realize that there was an overlap with our existing assets as you can see displayed on the map. This will allow us to have significant operational and field synergies in the area and more importantly to access lower Woodbine Stringers through inactive and future inactive Cotton Valley wellbores. These recompletions will give us access to additional low risk opportunities in the field.

Finally, slide 6. Hopefully, I’ve already laid out most of the investment rationale as to why we desire to own these assets but I will quickly summarize the key points of the transaction. The deal is very accretive transaction for us. In fact, the accretion expands in the outer years that have the characteristics of the assets that I described to you. We weren’t specifically looking for an oil transaction but this is a quality asset that has very good margins.

The East Texas field is a world-class oil field that clearly fits the investment criteria that you have heard us describe to you in the past and we always like transactions where we know a lot about the assets and the assets fit well with our existing assets in the area. This asset clearly has both and we expect to realize operational and field synergies due to the asset overlap.

So in summary, we are very excited about these assets and what they will do for us in 2013 and beyond. Over the past several weeks we have mentioned that we are also preparing for an accretive dropdown from our sponsor which will consist of approximately half of the remaining assets for about 2500 BOEs per day of oil production from our J field in Florida. We continue to advance that process and expect it to come to fruition early next year or possibly sooner. Should these accretive acquisitions close as expected, we believe the combination will significantly increase our distribution coverage ratio going forward. We are looking forward to giving you a more comprehensive update on our operations and outlook in next Thursday’s earnings call.

We appreciate you taking the time today to learn about our latest transaction. That concludes my remarks and I will now turn the call back over to the operator. John, Cedric and I will be glad to take any questions that you may have.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from the line of John with RBC Capital Markets.

John Ragozzino – RBC Capital Markets

Can you give me a little more detail just on the production stream breakdown? You know there is – 10% of it, is it dry gas or is it NGLs or –?

John Campbell

There is really no NGLs here, it’s going to be the oil and the balance is going to be natural gas.

John Ragozzino – RBC Capital Markets

13%, are they classified as PDNP, can you give us a little more color on (inaudible) additional compression, what classifies those reserves as such and what does it take to bring it back on line?

Alan Smith

For whatever reason, you are breaking up a little bit there. Could you repeat the question please?

John Ragozzino – RBC Capital Markets

I am storm-stranded in Connecticut, so bear with me, I apologize. The 13% of the reserves that are classified as PDNP, can you give us a little more color about what’s got them in that category and what it takes to remove them?

Alan Smith

Sure. Well, I think the reactivations are a large number of wells that – you remember, this field is owned by the majors predominantly and then it was bought by Independence about the time that we had water encroach all way across the field. So whenever that you first saw that happening we began to sell those assets as all these wells were shut in at the lower oil prices. I am talking about back in $30 to $45 dollar a barrel oil.

So a lot of those, just – quite frankly, I have not been worked over in term back on. The previous owner of the assets had very good success with reactivating the wellbores and returning wells to production and with the pricey world that we live in today, these are very economic wells with very low risk. We also see an opportunity to be able to – because of the synergy we have across our asset base that we already own today, we do see some recompletions in the lower Woodbine Stringer that is currently behind pipe today. So with those wellbores that are idle, we can go in and access those and again those are low risk because they are sitting there right behind pipe today just a recompletion.

And then we also see opportunities to come out here and be able to add or change out the rod pumps to electric submersible pumps and there is a couple of benefits to doing that. One is we can move more fluid which should give us more oil production but what they noticed in doing this in the past is that you are moving a lot of fluid out here and these pumping units run at relatively high strokes per minute and so you end up having quite a few tubing failures. So when they put the ESPs in and there are not lug in these pumps too much, you are seeing very long runtimes which is actually lowering your workover cost.

So those are some things – those are really the key behind pipe we call proved non-producing assets that make up those reserves.

Operator

Your next question comes from the line of Kevin with Raymond James.

Kevin Smith – Raymond James

Hi, this is Kevin Smith from Raymond James. Congratulations on the transaction. It’s very nice within your existing footprint. Have you guys requested a borrowing base increase along with this transaction or plan on it?

Cedric Burgher

That’s in process. Actually, we just got our borrowing base increased up $75 million to back to $730 million just about a week ago. That’s excluding this asset, we are in the process of going to the banks with this asset and we will be doing that shortly.

Kevin Smith – Raymond James

Can you speak to operating costs in this area? I am assuming you are somewhere in the neighborhood of $20 per barrel for lifting cost but just want to verify that?

Alan Smith

That’s a fair number, Kevin. We probably got into a range of somewhere between $21 and $24 a barrel, it’s somewhere in that range.

Kevin Smith – Raymond James

Does this provide Cotton Valley well, I mean could get it over the map but I mean you get the right stall (ph) at Cotton Valley wells as well?

Alan Smith

No, not through the assets we are acquiring, these are some debt severances in there that were taken by the majors back. So we still have some studying to do on all of that but we know that we don’t have all those.

Kevin Smith – Raymond James

Alan, I believe you mentioned this in your prepared remarks, I just wanted to verify. This is – you don’t expect this transaction to affect the timing of any potential asset dropdowns?

Alan Smith

Not at this time.

Operator

Your next question comes from the line of Brett with Credit Suisse.

Brett Reilly – Credit Suisse

Just one other follow-up. Is there any update on thoughts around SG&A costs moving into next year or do we pretty much have to wait for the quarter, maybe guidance of ‘13 for that?

Cedric Burgher

This is Cedric. We do plan to update you more fully on that at the earnings call, we’ve made good progress on that and so if you will dial in next week, we will give you a full account of that. We think this deal will add a million and a quarter of G&A in total to the overall company. But in terms of all the breakout methodology and all that, we really would prefer to do that next week.

Operator

We do have a question from the line of Jeff with Barclays

Jeff Robertson – Barclays

Can you talk a little bit more about the exploitation opportunities on these assets in terms of the kind of waterflood potential you see and what kind of production of reserves that might add? Also, what kind of capital you might have at the frontend on a project like that?

Alan Smith

So it sounds like you are asking more specifically about the waterflood potential.

Jeff Robertson – Barclays

Yes.

Alan Smith

Okay, it’s important to understand the way this field sets up, it’s about 30 miles long and we are up in the north end of the field. So most of that red that you see in the map on slide 4 is going to have pretty strong (Upshur support) and so there is not going to any waterflood opportunities up in the north end of the field. On the south end, right along that Rusk County line boundary, that is where the field does not have that same – any (Upshur support). Therefore you are going to be looking to – the good news is that we get sort of a free look from an operator that’s offsetting us that’s implementing a fairly large waterflood at this time. What we have not done because we did not value that today we thought we wanted to do a lot of work on that, it was completely in the probable category, it did not give any value, so therefore we didn’t spend our time trying to quantify the cost of it. But we think that we do know that the waterfloods out here in the southern part of the field have been very economic and have responded very well, just with the kind of rock you have here to water from a pressure maintenance point of view as well as the water displacement point of view.

So we think there is significant waterflood potential here. I think that when you think about the south Kilgore unit, which I think Zone Energy is currently installing their waterflood, they are going to spend somewhere in the neighborhood of probably $10 million of CapEx to go ahead and set up the patterns and injection wells and all that. As far as what the actual reserves will be from that, we don’t want to (credit) all that.

So we’ve got some work to do around the waterflood potential but we do think it’s real and we do intend to spend some time on that. John, do you think you want to add on that?

John Campbell

Yes, I think it’s probably going to be around $20 a barrel (inaudible). So that’s probably the reserve target that we are going after there.

Alan Smith

So happen to be in $20 per barrel range, something like that.

Jeff Robertson – Barclays

There reservoirs respond, do you all think they respond fairly quickly to pressure maintenance or water drawers?

Alan Smith

Pretty quickly, Jeff. The reason that Woodbine is so polite (ph) because it’s roughly 25% to 30% per (inaudible) in the darcy perm. It’s just incredible rocks up here in the Miles, Texas.

Jeff Robertson – Barclays

Is there any electrical issues you have to deal with, try to move to more ESP pumps?

Alan Smith

No, we actually did look into that, and it’s a very good question. The field has been electrified for sometime and there is a lot more wells online at one time. So there is not any issues there today.

John Campbell

We own about 75% of the infrastructure out there. So we don’t anticipate any problems there.

Alan Smith

The power infrastructure.

John Campbell

Power infrastructure.

Jeff Robertson – Barclays

John, that just dovetails into your other assets in that area then?

John Campbell

Yes, it does.

Jeff Robertson – Barclays

Okay. Just as you start to think about 2013 capital, would you anticipate that with these assets along with what you have in the Permian that almost all your capital next year will be on oil projects here or in the Permian?

John Campbell

I think that’s based on what we see today, I think that’s a fair comment that the major (inaudible) will be oil. We talked about – we do have some Cotton Valley drilling over here at current gas prices, it’s marginal. And so, I think what we will do there, we will (watch and see) what gas prices do the first of the year and depending on what they do, we may do some gas drilling late in 2013.

Operator

Your next question comes from the line of the Elliot, a private investor.

Elliot Miller – Private Investor

Three quick questions. What percentage of the 397 wells are operated, number one? Number two, who operates the balance? And number three, what percentage of your wells do not have access to pipes?

Alan Smith

90% plus are operated, the active wells today.

Alan Smith

Can you repeat the other two questions?

Elliot Miller – Private Investor

Yes, who operates the balance?

John Campbell

It’s going to be Basa and S&D, the other operators.

Alan Smith

There is a handful other operators here, some being local.

Elliot Miller – Private Investor

People you have worked with before?

Alan Smith

We know the basin guys pretty well. We are not too worried about those guys because we own pretty interest in everything we do and then the ones we don’t, they are not very meaningful to the overall value.

Elliot Miller – Private Investor

My last question was what percentage of the wells are without access to pipes?

Alan Smith

The infrastructure out there is very developed, very mature infrastructure. And so, we don’t know of any situation where we wouldn’t have access to either trucking or – about 50% of this field goes directly into a pipeline and about 50% of our assets in this particular deal are trucked.

Elliot Miller – Private Investor

Is there any program from any midstream operator to increase the number of pipes there?

Alan Smith

Not that we are aware of.

Elliot Miller – Private Investor

And you are satisfied with 50% trucking, eh?

Alan Smith

Absolutely. I mean there is a lot of places – most of the time you are not able to – you don’t have enough oil to be able to put it in a pipe right like we are doing here. And so, you are forced to do primarily trucking. The good thing about this area is that this oil is sort of looks like it’s coming out of the pencil bottle, which is really good quality crude oil. And therefore, we actually get premium to WTI in the neighborhood of anywhere from call it $3 to $5.

Elliot Miller – Private Investor

Really? What is the gravity of it?

Alan Smith

It’s about 39 degree.

Elliot Miller – Private Investor

It’s sweet?

Alan Smith

Very sweet.

Operator

Your next question comes from the line of Ethan with Baird.

Ethan Bellamy – Robert W. Baird

Was it an auction?

Alan Smith

It was an auction process, yes.

Ethan Bellamy – Robert W. Baird

Okay. What do you guys pay for gathering out there? Blending, trucking and (inaudible).

Alan Smith

It’s probably around – about $1.75 to $2.

Ethan Bellamy – Robert W. Baird

What’s your pro forma liquidity after this closes?

Cedric Burgher

As I mentioned, we are still working on getting the borrowing base addition that would come from this asset, it ought to be pretty good because it’s highly developed, long lived, it’s oil and we put our hedges on already. So the hedges are in place that adds to the borrowing base. I can’t give you a number but it’s probably 40% to 50% of the cost would be added in terms of borrowing base. And then like I said a minute ago, we have $730 million in the redetermination that just occurred a week or so ago. So all in, I would tell you, we would have comfortable liquidity with this deal and the dropdown and still have some excess liquidity.

Operator

We do have a follow-up question from the line of John with RBC Capital Markets.

John Ragozzino – RBC Capital Markets

(Inaudible) on the maintenance CapEx (inaudible) 12-month EBITDA (inaudible) indicative of lot of that types of multiples that you are seeing out there now, I think it seems like things are creeping up a little bit. Can you just comment on the (inaudible) market?

Taylor Miele

John, just to make sure we got it right, you said that the EBITDA multiple implied is around 7 times and you are asking a status what we see out in the market for others as well?

John Ragozzino – RBC Capital Markets

(Inaudible).

Taylor Miele

That’s what he asked.

Alan Smith

It’s a tough line, he is breaking up a lot. I would say that what we primarily – the only way we look at value in an asset is discounting cash flow analysis, that’s really gone away. We know how to do it, and so these metrics sort of pop out and you look at and you say what does that really tell you but understand that if you look at where QRE is trading today versus where (inaudible) trading, this was a little bit less than where we trade today. I think the longer the life of the asset and the lower the decline of the asset is going to bring these higher multiples. There is certainly some wells we look at that had a little higher decline that ultimately whenever you get – just kind of cash flow analysis maybe somewhat less than 7 – maybe down to 5 to 6 range. It just depends on the assets. This particular asset being 67% decline, having the 20-year reserve life ended up being just north of 7 times.

Cedric Burgher

The only thing I would add to that is that it is a higher multiple because of the low decline and the accretion in the outer years like Alan said. But this is very accretive in 2013 and it gets more accretive overtime because of that low decline.

John Ragozzino – RBC Capital Markets

Can you share what you came up with in terms of accretion in the back of the envelope?

Cedric Burgher

No, we don’t give that kind of guidance out.

Operator

Your next question comes from the line of Will with RBC, Royal Bank of Canada.

Will – RBC

Just a couple of quick questions. Most of have mine, others have been answered. What are the zones do you have access to in this purchase?

Alan Smith

I think most of the – what we are getting here is the – everything above the lower Woodbine stringer. There are – I mean we have some pockets in here where we actually have the deep rights but as you can see from the overlay we have here that we own the deep rights over a lot of the sacred. So primarily this is Woodbine rights.

Will – RBC

Back to the liquidity question, you are going to (inaudible) with your line now, but you are going to do a 50-50 equity debt, is that basically where you are going with this with the dropdowns coming in the first quarter?

Cedric Burgher

We have ample liquidity to do both deals and still have some excess but we certainly look to finance the company with – additional equity or even high yield, overtime will do that opportunistically but we don’t have to do it for either of these deals. We will look to do it as opportunities present themselves in the future.

Operator

We have no further questions in queue.

Alan Smith

We sure appreciate everyone joining us today and thanks for your time.

Operator

This concludes today’s conference call. You may now disconnect.

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