EV Energy Partners: The Price Is Finally Right

| About: EV Energy (EVEP-OLD)
This article is now exclusive for PRO subscribers.

EV Energy Partners (NASDAQ:EVEP-OLD), an oil and gas MLP, has had a rocky road over the last year. After capitulating into the mid-40s last summer, as concerns over natural gas producers peaked, the units rocked back into the mid 60s by October as the optimism over their Ohio-Utica acreage soared. EVEP management added to the froth last year with hopes of $15,000 per acre and a deal in hand by year end. They own ~170k acres, mostly in the volatile-oil fairway, so this would have been a nice year-end bonus. When reality struck that a deal was not to be had so soon, management (and bullish investors) had to eat some humble pie with the realization that the money was short and not on time. That said, with EVEP now priced at 52 and change (as of Wed. close), we believe the price is right for an exceptional rate of return over the next few years as the partnership expands into midstream processing and (finally) begins to monetize their Utica acreage. With more realistic expectations set, and priced in, long-term investors should view this as an excellent entry point.

Recently, the Ohio Department of Natural Resources (ODNR) released updated geological data for the Ohio-Utica play. Of particular interest are the source rock geochemistry maps, which give a sense of the value of different parts of the play. There are four commonly used parameters, to provide a picture of the Utica, denoted as TOC, S1, S2, and R0. Please refer to the definitions in the ODNR presentation here. In general, high TOC is good with a minimum of .5 generally regarded as needed for hydrocarbon sourcing with values above 2 considered "very good." S1 measures free hydrocarbons that can be extracted and usually a value better than 1 is desirable. S2 is a measure of hydrocarbons that can be extracted via cracking and, while a higher value of S2 is generally better, if an area has very high S2 (> 5) and low S1, it is a sign of immaturity. Finally R0, measures vitrinite or Type III kerogens and determines maturity and hydrocarbon type. An R0 < .5 indicates immature oil and R0 > 1.35 indicates mature dry gas. Shown below is the TOC map from the ODNR website where we overlaid an approximate depiction of EVEP's acreage with rectangles being in their JV and ovals being EVEP owned.

Chart 1: TOC Map of Ohio-Utica Shale with approximate EVEP acres

What is clear from looking at the map is that EVEP's acreage has very good to excellent TOC content. In particular, Stark county, where they have ~40k acres looks to be a hot-spot. This was highlighted in a recent article, which noted that the updated ODNR maps have moved the prospective producing windows to the west. Looking at the other maps (e.g., S1) presents a similar picture that EVEP is in a very prospective NE-SW fairway straddling the light-oil/wet gas window. One caveat is that the oil flow rates still appear lower than desired and artificial lifts may be required. Until takeaway infrastructure is in place, however, it will be hard to determine true IP rates let alone a type curve. Turning this into an estimate of acreage value is not an exact science although there have been recent transactions that can aide in the process (e.g., GPOR 10k/acre in Guernsey).

Chart 2: Geochemical Statistics by County and EVEP Acres

Shown above, in Chart 2, are the county-average statistics for the four geochemical parameters from data available on the ODNR website. In particular, we show the counties and acreage (~103 out of 170 acres) that EVEP is looking to monetize in their first pass. Some counties, like Carroll and Stark, have a lot of data (N is the number of samples), while others have not truly been de-risked. Averaging the data over a whole county is like hitting a finishing nail with a sledge hammer but it's really the best we can discretize to. We calibrated a regression analysis based on observed transactions to the data and optimized to obtain sensible regression coefficients and high R^2 (a regression with priors). The results are intuitive in that base acreage values are $1.2k with, for example, a $2k increase for every unit increase in TOC holding all else constant. The resulting acreage values are shown in the chart with, for example, Stark county expected to fetch about $12.2k/acre while Muskingum a much lower $3.1/acre. Note we give unclassified acres a base value of only $1.2k/acre. One should consider these results with a grain of salt as it is a first-cut guide to what different counties may obtain in terms of $/acre. We don't adjust for the fact that EVEP has large tracts of contiguous acres, held by older conventional production, which is important given the economics of drilling (e.g., a desirable one six-acre pad servicing two square miles).

Summing up the different counties leads to a per acre value of about $10k for EVEP's current package which is rather boring considering that is what most pundits are looking for. This would be about $24/unit (assuming 43mn outstanding) but one has to be careful with that as monetization entails time value (discounting). A more reasonable valuation would be $20/share assuming a year to monetize at 15% discount. The remaining 70k acres that EVEP wants to monetize is worth about $7.5k per acre according to the regression and, fairly discounted, is worth about $7/share. Adding it up, we see EVEP's Utica acreage conservatively valued at $27/unit in today's dollars. Coupled with reasonable assumptions on their existing (producing) asset base and their midstream and ORRI (royalty interest) assets, EVEP's units appear undervalued today.

To get a better handle on current valuations, we ran a discounted cash flow model on EVEP assuming the Utica monetization as above into producing assets (e.g., mid year 2013 for the first tranche) and the coming of age of their ORRI and midstream assets over the course of the next few years. For example, ORRI is expected to produce $50mn in annual EBITDA but not for a few years. Similarly, it will take time to ramp up midstream production, which the company recently gave guidance on. We incorporated IDR rights, which are currently out of the money, as well as likely share issuance, in the future, to fund further distribution growth and keep leverage constrained. Capital expenditures are based on company guidance and historical measures of maintenance capex as a percentage of production. All told, we feel we are conservative in our assessment and do not see any significant distribution growth until 2014. That said, we see significant distribution growth into 2015 with $5/unit being achievable. Running our model at a 15% required IRR, produces fair value at about $56/unit. Today's price calibrates to a 16.25% IRR so clearly the "fair value" is sensitive to one's own IRR requirement. That said, with little liquidity issues, production set to ramp up with monetization of existing assets, a new midstream and ORRI cash flow stream, and no equity issuance needs near term, this volatile MLP is set to return to the camp of steady and growing distributions over the next few years. Investors should take notice now.

Disclosure: I am long EVEP-OLD. 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.