Legacy Reserves: Restructuring Continues To Appear Very Likely After Q1 2019 Report

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About: Legacy Reserves Inc. (LGCY)
by: Elephant Analytics
Summary

Legacy's Q1 2019 report points to a high chance of a near-term restructuring.

Projected 2019 EBITDA is falling due to low realised prices for NGLs and declining oil production.

Legacy does not appear able to maintain production without cash burn at current strip prices.

The company may also be restricted in terms of its capex due to a second-lien term loan covenant. Further production declines would exacerbate its leverage issues.

Leverage is projected to be over 4.5x by the end of 2019 based on current strip prices and its $135 million capex budget.

Legacy Reserves (LGCY) reported Q1 2019 earnings that weren't terrible, but doesn't provide hope that it can avoid restructuring given that the company has little margin for error.

Legacy's average daily oil production dropped from Q4 2018 to Q1 2019, indicating that the company may have trouble maintaining oil production with its reduced 2019 capital expenditure budget. In addition to the effect of decreased oil production, lower realised prices for NGLs are negatively affecting its projected EBITDA, leaving its projected leverage above 4.5x at the end of the year.

As well, Legacy may be restricted to an even lower level (than budgeted) of capital expenditures going forward due to one of its second-lien term loan covenants that it currently appears to be in violation of.

Production Levels

A significant negative for Legacy was that its Q1 2019 average daily oil production declined by -3.8% compared to Q4 2018. There was no commentary from the company on what caused its oil production to decline, but the most likely explanation is that it just isn't spending enough on capex to maintain its oil production (which is mostly generated from high-decline horizontal wells).

Close to 85% of Legacy's oil production is from the Permian, so winter freeze-offs would not have affected enough of its oil production to result in a significant decline. The company mentioned that its Permian horizontal wells had a 28% three-year PDP decline rate, but that means that its quarter-over-quarter PDP decline rate may be around 13-14% for its Permian horizontal wells.

Legacy had mentioned that it brought seven Permian horizontal wells on-line late in Q4 2018 (thus putting most of the production impact in Q1 2019), so there was an assumption that it could at least hold oil production constant quarter over quarter for Q1 2019 despite a lower capital expenditure budget in 2019. The company's inability to do so means that its average 2019 oil production is very likely going to be below Q4 2018 levels given its reduced capex budget.

Effect On EBITDA

I had thought that Legacy could generate at least $70 million EBITDA in Q1 2019, but it fell short and only generated $63.9 million in Q1 2019. The decrease in oil production was a major contributor to the lower EBITDA. As well, the company reported a significant decline in the realised price for its NGLs, which fell around -38% from $0.72 per gallon in Q4 2018 to $0.45 per gallon in Q1 2019. I had expected some quarter-over-quarter decline in realised prices for NGLs, but Legacy's decline was particularly large. Although NGLs only are 6% of its total production, such a decline in realised prices could knock up to $10 million per year off the company's EBITDA.

Legacy did make good progress on costs during Q1 2019, lowering production costs to $10.77 per BOE (my 2019 model had it at $11 per BOE), but that improvement doesn't come close to offsetting the negative impact of the items mentioned above.

The company's 2019 EBITDA now appears likely to come in at around $285 million (including hedges) at current strip prices, assuming that there are no further declines in its oil production.

Notes On Capital Expenditures

Another thing to note is that Legacy's second-lien term loan has a covenant that limits its capex to $60 million over the subsequent four quarters if its first-lien debt-to-EBITDA ratio is above a certain amount (1.5x for Q1 2019). Legacy's first-lien debt-to-EBITDA ratio was at 2.1x at the end of Q1 2019, so if it doesn't get that covenant relaxed, its capex will be restricted to well below maintenance levels.

The combination of declining production and high fixed costs (mainly from interest expense) is a very challenging situation for a company.

Conclusion

Legacy Reserves looks very likely to restructure soon. I'd put the odds of that happening at around 95% now.

The company saw its oil production drop, while low realised prices for NGLs is helping to drive its projected EBITDA lower and its leverage up. It does not appear to be able to maintain production levels without cash burn at current strip prices, and may also be limited in its capital expenditures going forward. That situation would be untenable, since declining production would need to support a high level of fixed costs (mostly interest). Thus, even if Legacy managed to get its credit facility extended further, $60-ish oil would still spell doom for the company due to its debt burden and associated interest costs.

As well, Legacy's leverage is projected to be over 4.5x by the end of the year at current strip prices, which is much too high for the current environment.

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.