Legacy Reserves: Abandon Ship Or Full Steam Ahead?

Summary

• I've written several articles on Legacy Reserves over the years.
• While I have never recommended the common, at times I've considered the preferred and debt to have favorable risk versus reward.
• The debt and preferred trade at significant discounts to par but a long ways from zero.
• Q3 results came out Wednesday with several material updates. Let's analyze and see if this investment vehicle is hanging tough or in dire straits.
• This analysis will be a concise review of Q3 results and Legacy's current position. I'll take more time to go through covenants and credit line details after the conference call when I have more information.

Legacy Reserves LP (NASDAQ:LGCY) with preferred tickers LGCYO and LGCYP, is a Permian Basin-headquartered and focused firm with assets also located in the Midcontinent, East Texas, and the panhandle as well as the Rocky Mountain formation located in, you guessed it, the Rockies. This analysis will be a concise review of Q3 results and Legacy's current position. I'll take more time to go through covenants and credit line details after the conference call when I have more information.

Upstream MLP Graveyard

Legacy is one of few upstream master limited partnerships ("MLP") and one of exceptionally few highly levered MLPs still in existence after the new three-year downturn in crude oil prices and fairly stagnant natural gas market. The names Memorial Production Partners (MEMP), Atlas Resources (OTCPK:TTEN), Linn Energy (LNGG), Breitburn Energy Partners (OTCPK:BBEPQ), among others, give feelings of regret, remorse, and perhaps even physical pain. I consider graveyard fitting, and as a bonus, it is in the Halloween spirit.

Legacy Reserves LP, to its credit, has refused to go down easy. Despite shuffling its asset base, slashing costs, eliminating dividends to common and preferred shareholders, the market came to the somewhat justified conclusion that Legacy still had to do more or it would soon join the upstream MLP graveyard. Legacy unsecured bonds collapsed to levels suggesting a 95%+ chance default.

I got long the bonds and preferred near the bottom as shown above and have stayed long ever since. Almost exactly a year ago, Legacy Reserves LP did what many thought was impossible and secured a $300 million second lien term loan via prominent oil and gas credit investors GSO Capital Partners, a division of Blackstone Group (BX).

Their borrowing base was reaffirmed at $600 in March of this year. Then in August of this year, Legacy announced the acceleration of payments to their private equity joint venture partner, effectively buying out TSSP's upside in future drilling operations. To summarize, Legacy had to get partners on the credit and debt side to stay afloat, and without it, would have failed like the rest of its peers.

Source: Legacy

As we saw above, Legacy's debt is trading around 70, which is well into junk territory but not quite at the level of "guaranteed" default - investors buying at these levels realize the upside is somewhat limited, call it 30%, and the downside if there is zero recovery rate in the event of a default is very high.

Source: Google Finance & WER

Unsurprisingly. given its subordination in the capital structure, the preferred has faltered as well and experienced very high volatility. Both issues will trade in the low $20s if Legacy Reserves LP survives and $0.0 if it dies.

Critical Takeaways From Q3 Results

Legacy Reserves LP is getting closer and closer to the point it will either garner a sustainable business model with a cost and revenue structure that support its levered balance sheet or it won't.

Source: Legacy

• Completed $3.3 million of acreage acquisitions expanding its future development opportunities including:
  • 24 horizontal Spraberry and Wolfcamp drilling locations in the Midland Basin, and
  • 9 horizontal San Andres drilling locations on the Central Basin Platform that leverage Legacy's existing infrastructure and have attractive offset development economics.
• Reduced commodity price risk by adding 5,300 Bbls/d of 2018 WTI crude oil swaps at an average swap price of $52.97 per barrel.
• Increased oil production to a record 14,380 Bbls/d, a 25% increase relative to Q2 2017.
• Generated a net loss of $33.9 million. It is worth adding here that the firm took $33.7 million in non-cash losses of depreciation, amortization, and accretion over the period or net income would have been flat.
• Generated Adjusted EBITDA of $58.8 million representing a 33% increase compared to Q2 2017.
• Reduced lease operating expenses, excluding ad valorem taxes, to $39.5 million representing a 6.5% decrease compared to Q2 2017 and yielding a record low LOE/BOE of $9.36.
• Extended the availability of the remaining $95 million undrawn portion of the second lien term loan to October 25, 2018.

Balance Sheet Reality Check

I'll add a few things you will not find in Legacy's next investor presentation. The firm's total partners' deficit, which is where it normally says total partners' equity on a healthy firm's balance sheet, is $(247,221,000). Legacy's total liabilities exceed its total assets by this amount. Yes, the firm has accumulated depletion, depreciation, amortization and impairments of $2.159 billion rendering GAAP accounting misleading. It's still not ideal to see sustained negative partners' equity. Total liabilities are $1.74 billion primarily consisting of $1.33 billion in long-term debt made up of several components as shown below.

Source: SEC.gov Q3 2017 10-Q

Cash Flow

Source: Legacy

Adjusted EBITDA, which certainly has its flaws but it is much more informative than any GAAP measure, such as net income, rose substantially year over year no matter how you slice it. Note that non-cash expenses were actually higher in 2016 versus 2017. If it was the other way around, the increase in Adjusted EBITDA for 2017 would be less meaningful.

On the negative side, interest expense continues to climb as the firm takes on additional leverage through GSO. Q3 2017's adjusted EBITDA might have risen from $40.7 million in 2016 to $58.8 million in 2017 (44.5% increase), but on a percentage basis, interest expense rose nearly as much at 38.1%. Legacy is still trying to escape its debt load but cannot quite break the chains just yet.

Realized* Pricing

Those that follow oil and gas companies know, often painfully so, that spot prices do not equal realized prices. As reported by Legacy through Q3, average realized price, excluding net cash settlements from commodity derivatives to normalize the figure, increased 37% to $25.17 per barrel of oil equivalent ("Boe") in 2017 from $18.32 per Boe in 2016 driven primarily by the significant increase in commodity prices. Even though I personally don't like the figure, a lot of reporting is done on a Boe basis so it is important to monitor.

Average realized oil price increased 26% to $45.33 in 2017 from $35.94 in 2016 driven by an increase in the average WTI crude oil price of $7.95 per barrel. Average realized natural gas price increased 35% to $2.73 per Mcf in 2017 from $2.03 per Mcf in 2016. This increase is a result of the increase in the average Henry Hub natural gas index price of approximately $0.67 per Mcf partially offset by worsening realized regional differentials. Legacy's average realized NGL price increased the most at 70% to $0.61 per gallon in 2017 from $0.36 per gallon in 2016. Its impact on the bottom line is negligible but we'll take whatever we can get.

Production

In general, analysts overstate the importance of production growth or declines in my opinion. Economics are what matter, not volumes. That being said, Legacy Reserves LP is in a unique situation. After buying out its JV partner's interest in a meaningful amount of its acreage, coupled with drawing down its second lien facility by hundreds of millions to fund capital expenditures, Legacy needs to drill and get its production numbers up hard and fast.

These changes, however, were all relatively recent given it takes time to find, permit, design, and drill a well then get production figures. We'd only expect to see the initial signs of its increased activity but we need to see something.

Source: Legacy

This chart assumes NYMEX strip pricing at 10/1/2017 (2018 average oil $51.94 / $3.05 natural gas). Hopefully, a reader can explain how Full Year 2017 production figures can be below that of Q4 2017's. For reference, Q3 saw oil production of 13,323 Bbls/d. The LEOs, capital expenditures, as well as Adjusted EBITDA figures provided elsewhere in the above document, make sense, however. It's underwhelming to see 2018's production range only modestly higher than 2017's almost fully realized figure.

On a percentage basis, Legacy is targeting daily Boe growth of 7-19%. The entire gain is attributable to crude oil production, however, with natural gas actually expected to decline slightly, meaning that the more lucrative per unit crude oil causes Adjusted EBITDA expectations to jump from approximately $212.5 million for 2017 to $280 to $330 million in 2018.

Costs

General and Administrative costs (think sales staff, accountants, management, assistants, et cetera) were flat for Q1-Q3 of 2016 versus 2017. Production costs rose marginally by 2% to $131.0 million excluding ad valorem taxes. On a more useful Boe basis (I still don't like that metric), production costs actually rose 4% to 11.02 per Boe. That being said, the additional working interests that Legacy purchased also came with additional maintenance and workover costs. It is hard to determine exactly what the apples to apples comparison would be, but production costs would likely be flat or slightly down excluding this.

Hedging

There are not a ton of material updates here but this is the bottom line: Legacy's hedging policy is fairly conservative and sacrifices some upside (sold calls) above $60 WTI for protection if crude dips below $45 (bought puts). That being said, higher oil prices will directly contribute to the bottom line as they have in the past. Both Legacy's natural gas and crude oil hedges are a net positive to the firm through the end of 2018 meaning they locked in the derivative positions when people's expectation of spot prices were in fact more bearish than they came to be.

Constructing Legacy's Combined Outlook

We looked at the numbers behind Legacy's Adjusted EBITDA for 2017 and 2018. Its reasonable NYMEX strip pricing coupled with its fairly broad and conservative hedging policy means the estimates are more reliable than they otherwise could be. Taking into account annualized Q3 interest expense of $94 million, 2018's cash flow falls to $196-$244 million for 2018. Unfortunately, this is nearly the exact range of estimated capital expenditures for full year 2018.

As we reviewed, Legacy, due to luck or skill, has no near-term maturities but must come up with $432 million to pay off its 2020 and 2021 maturities or have a structurally sound enough business that lenders will refinance these sums at reasonable rates prior to that. On top of that, it will need to maintain its second lien position, which has grown to $485 million. Its liquidity of $95 million that was just announced on its 2L facility is certainly a positive.

To have a reasonable chance of pulling this off, Legacy Reserves LP must effectively put all its current and remaining capital to use nearly flawlessly. Current investors are putting tremendous faith into Legacy's drilling program, as there is not any financial data, be it at the Legacy or spot price futures curve level, to support the thesis that Legacy is in a favorable position. It remains a highly speculative play extremely dependent on oil and gas prices, with a greater tilt toward crude oil than in past periods.

It has, however, no near-term liquidity issues and any restructuring between now and October 2018 will be voluntary excluding tripping one of its many covenants. It takes a lot of time to go through covenants (I often have to calculate the ratios from the financial statements from scratch as the SEC does not require them to be clearly stated) but I'll update this article or write a new one and link it in the comments section once I have a chance to do so later this week. Because of the potential upside of my high-risk tolerance, I will remain long the preferred and unsecured debt in small positions relative to the rest of my portfolio through the conference call.

Editor's Note: This article covers one or more microcap stocks. Please be aware of the risks associated with these stocks.

Analyst’s Disclosure: I am/we are long BXMT, HMC, CF, POT, RY, MRCC, GST-B, F, GST-A, SBRA, QCP, HCP, OAS, LGCYO, KMI, NFX. 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.

The author owns senior unsecured bonds issued by Legacy Reserves LP. The author may enter into long or short positions in any part of the capital structure of any of the firms mentioned in this article. Readers should always conduct their own independent due diligence and not rely upon information or opinions provided by the author.