Mid-Con Energy Partners: A Bargain At $1, But Current Valuation Is Less Attractive

| About: Mid-Con Energy (MCEP)
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Summary

Mid-Con has a high percentage of oil production and a relatively low differential, making its production relatively valuable and able to benefit significantly from a modest oil price rebound.

Its breakeven is in the $40-50 oil range due to the above factors plus low interest costs. It is one of the best US producers in this measure.

Mid-Con is likely to face a significant borrowing base deficiency on its credit facility despite strong cash flow in 2016 and a low breakeven point overall.

This may result in the company needing to raise capital to pay down its credit facility borrowings, potentially causing dilution or increased interest costs.

Mid-Con was a bargain earlier in 2016, but the recent run-up in its unit price has left me more ambivalent about its value compared to other opportunities in the sector.

Mid-Con Energy Partners (NASDAQ:MCEP) is a company that I've liked before due to its high percentage of oil production, relatively narrow differentials and low interest costs. Those combine to make its breakeven point in the $40-50 oil range, leaving it one of the best-positioned US producers.

I had listed it as a position in my Distressed Value Investing subscription service at $1.14 per unit and closed the position off at $2.29 per unit. Perhaps that was a little early, given the continued run-up in Mid-Con (which I think is partly due to MLP investors switching to Mid-Con as other MLPs such as Linn (LINN) and BreitBurn (BBEP) faltered), but I think the stock is starting to get potentially overvalued now for the current market conditions. It still offers considerable upside if oil prices become stronger, but relative to other opportunities, it is no longer the bargain it once was. There is also some uncertainty around its credit facility borrowings, as I will discuss below.

High Percentage Of Oil Production And Narrow Differentials

A couple of key items that work in Mid-Con's favor are that its production is mostly oil, and it also has fairly narrow oil differentials.

Around 94-95% of the production at Mid-Con Energy Partners is oil, which helps boost the average value of its production and also makes it more likely that the company will be able to deliver a significant amount of positive cash flow in the future. At $40 oil and $2.25 natural gas, a company with 95% oil production can realize around $34-35 per BOE without hedges. A company with 50% oil production would realize approximately $24 per BOE - a gap of around $10 per BOE.

This gap will increase as oil prices go up as well. At $70 oil and $3.25 natural gas, a company with 95% oil production would realize around $62-63 per BOE without hedges, compared to only $42-43 per BOE for a company with 50% oil production. Thus, with an improvement from $40 to $70 oil, the company with 95% oil production would increase its realized price per BOE by $10 more than the company with 50% oil production increased its realized price per BOE.

In addition to the high percentage of oil production, Mid-Con also manages to realize a relatively high price for its oil compared to WTI. There are many producers which have a typical oil differential in the upper-single digits, but Mid-Con's differential is around $3-4.

The company's differentials have been helped by low oil prices that have slowed overall production growth and allowed transportation capacity to catch up. In 2014, Permian oil (36% of Mid-Con's production in 2015 was from the Permian) sold for a large discount to WTI, as transportation bottlenecks forced producers to often ship crude by rail instead of pipeline (at a cost of $10 per barrel, compared to $3 per barrel for pipelines).

In August 2014, the Permian was producing 1.68 million barrels of oil per day, with expectations that production would rise to around 2.7 million barrels per day by 2018. In April 2016, the Permian was producing 2.036 million barrels of oil per day, essentially flat versus previous months. Production by 2018 may end up being at least 500,000 barrels per day less than previously expected, while substantial new pipeline capacity is still being added. Therefore, it seems quite likely that if oil prices remain low enough (sub-$50) to limit growth, the oil differentials will continue narrowing. If oil prices rocket up to a level such as $70 that encourages substantial production growth, the oil differential may widen again as production growth exceeds pipeline capacity growth.

Mid-Con's most recent presentation mentions an average differential of $5.78, but that is per BOE (not per barrel of oil) and includes the effect of the 5-6% portion of production that is natural gas bringing down the average price per BOE.

2016 Results

I have modeled Mid-Con's 2016 results using an average of $40 oil below. This assumes the company produces around 4,200 BOEPD (the midpoint of its guidance) with a 95% oil split. Including the $26.4 million in hedge value, it would generate $80.6 million in revenue.

Barrels/Mcf

$ Per Unit

$ Million

Oil

1,460,340

$36.50

$53.3

Natural Gas

461,160

$1.85

$0.9

Hedge Value

$26.4

Total

$80.6

Using the midpoint of Mid-Con's guidance for lease operating expenses and production taxes as well leads to an estimate of $52.7 million in cash expenditures in 2016. Thus, at $40 oil in 2016, the company would be able to pay down its credit facility borrowings by approximately $28 million, reducing the outstanding borrowings to approximately $152 million at the end of 2016.

$ Million

Lease Operating Expenses

$27.7

Production Taxes

$3.0

Cash G&A

$6.2

Interest Expense

$6.8

Capital Expenditures

$9.0

Total

$52.7

2017 Results

With $50 oil in 2017, Mid-Con would generate approximately $67.5 million in revenue. Its hedges would have negative value of $6.59 per barrel hedged, bringing down the company's revenues to approximately $64.1 million.

Barrels/Mcf

$ Per Unit

$ Million

Oil

1,456,350

$46.50

$67.7

Natural Gas

459,900

$2.10

$1.0

Hedge Value

-$4.6

Total

$64.1

Mid-Con's cash expenses are estimated at $56 million, including $12 million in capital expenditures. This is an estimate of what the company needs to keep production at 4,200 BOEPD. Capital expenditures for keeping production steady through waterflooding appears to be a bit challenging to estimate. However, it appears that $13.9 million in capital expenditures was enough to provide slight production growth in 2015 versus December 2014 levels, while $9 million is not enough to maintain 2015 production levels in 2016.

$ Million

Lease Operating Expenses

$27.6

Production Taxes

$3.8

Cash G&A

$6.2

Interest Expense

$6.4

Capital Expenditures

$12.0

Total

$56.0

If oil averages $50 in 2017, then Mid-Con could produce a $8 million cash surplus. The company also looks capable of reaching breakeven without hedges at just over $40 oil, although this is dependent on the level of capital expenditures it requires to maintain production. I am not sure if $12 million can maintain 4,200 BOEPD of production for an extended period of time, since that is significantly less than most US producers (albeit with different methods). I think Mid-Con's long-term breakeven level is in the $40-50 oil range though, making it one of the most well-positioned producers.

Credit Facility Challenges

While Mid-Con has a number of advantages, it does have some challenges surrounding its credit facility. The company took on a fair amount of debt to grow production before oil prices crashed. The credit facility debt has a relatively low interest cost, with the projected average interest rate being 4.25% for 2016, according to the company's latest presentation. Mid-Con's cash interest costs are therefore less than $5 per BOE of production, which is quite reasonable considering the high value nature of its production.

However, the credit facility is also currently the greatest area of concern for Mid-Con Energy. Its borrowing base was reduced to $190 million in November 2015, and consists of a conforming borrowing base of $165 million and a non-conforming borrowing base of $25 million. The conforming borrowing base is being reduced by $2.5 million per month and will reach $150 million by the May 2016 redetermination. The non-conforming borrowing base is to be reduced to zero in May 2016.

Mid-Con's latest presentation indicated that it had $169 million in credit facility borrowings at the end of March 2016. This is down from $180 million at the end of 2015. Its hedges are weaker in Q2 2016, so the rate of credit facility payback will probably slow to around $2 million per month at current oil prices, leaving it at around $165 million at the end of May 2016.

This leaves the outstanding borrowings $15 million above the $150 million mark by the May 2016 redetermination. As well, with the deterioration in oil prices since the November 2015 redetermination, I would not be surprised to see Mid-Con's borrowing base reduced further to potentially $125 million. For comparison, the PV-10 of its reserves is $191 million at SEC pricing (basically $50 oil).

I don't believe a borrowing base deficiency will be a significant threat to the company, since the credit facility represents its only debt, and it will still likely deliver positive cash flow once its hedges dwindle. Due to those items, credit facility lenders are unlikely to push Mid-Con into restructuring, as that would threaten their recovery. This is a contrast to companies such as Linn and BreitBurn, where the large amount of non-credit facility debt and high breakeven point without hedges make it advantageous for credit facility lenders to push for a near-term restructuring.

There is the possibility that Mid-Con may need to take additional actions to reduce its credit facility debt, though. This may result in the company taking on second-lien debt (if such financing is available) or doing an equity offering. This could serve to somewhat limit its upside (due to dilution) or increase its breakeven point (due to higher interest costs). The credit facility lenders appear to be willing to work with Mid-Con, according to management's comments, but that does not preclude the lenders from nudging the company to do an equity offering, for example, if prices are decent.

Valuing Mid-Con

Mid-Con's value is highly dependent on the price of oil. The company can generate approximately $38 million EBITDA at $55 oil and $52 million EBITDA at $65 oil, leading to a value of approximately $2.70 per share at $55 long-term oil and $5.70 per share at $65 oil, based on a 6x EV/EBITDA multiple. With my current pricing expectations at between $55 and $60 oil, this would make Mid-Con's value approximately $2.70-4.20 per share. With the uncertainty around what the company may need to do to address a borrowing base deficiency, though, I'd put its value at closer to $2.15-3.40 per share until that uncertainty gets resolved.

Conclusion

Mid-Con Energy Partners was a relative bargain at near $1 per unit. However, its price has increased rapidly recently, perhaps due to interest from MLP-focused investors looking at companies that can survive a prolonged oil slump. Mid-Con fits that criteria, with its high percentage of oil production and low interest costs contributing to a breakeven point that is one of the best for US producers. However, there are some concerns around its credit facility, which is likely to have a significant borrowing base deficiency in May 2016. The company may need to take some measures to reduce the borrowing base deficiency, including taking out higher interest debt or issuing additional units. Due to that uncertainty, I closed my Mid-Con position earlier, but may re-open it if the uncertainty gets resolved or if its unit price gets down to under $2 again (with similar oil market conditions to now). I like evaluating the price of companies relative to oil futures options to determine whether they appear to be relative bargains, and at under $2 per unit is where Mid-Con would be cheaply priced compared to the June 2018 oil futures options at this particular time.

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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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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