Antero Midstream: Appalachia Rebounds

Summary

• Antero Midstream plunged on assumed insolvency at Antero Resources, pretty much the sole source of its earnings.
• In my view (and this was not always the case) Appalachian E&P bankruptcy fears are wildly overstated.
• Even in a bankruptcy/reorganization, Antero Midstream's rates are in line with peers' and the acreage would be worked at roughly the same level post reorganization.
• While always dependent on how parties negotiate, both Antero Resources and Antero Midstream need one another. I don't see materially lower rates in a second rate renegotiation.
• This idea was discussed in more depth with members of my private investing community, Energy Income Authority. Get started today »

Antero Midstream (NYSE:AM) is a captive partnership, sourcing substantially all of its revenue and earnings from its corporate sponsor, Antero Resources (AR). Its position in Appalachia is built around gathering and processing (“G&P”) assets, compression, and water handling, business where it earns 100% fixed fees based on volumes served. Historically, Antero Midstream has earned top tier returns on invested capital; in fact, one of the strongest rates of return in the space. This strength has come about despite natural gas spot pricing having done nothing but trend down since the initial public offering (“IPO”) back in 2014. Much of this comes down to the condensed nature of the business, something that is true of Appalachian acreage as a whole: Antero Midstream is operating less than one thousand miles of pipe. The Marcellus is an incredibly rich play, with thousands of potential drilling locations in close proximity. Coupled with the contiguous acreage footprint of Antero Resources – more than half of the past two years of drilling activity has taken place in Tyler County, an area with a less than 250 square mile footprint - return on investment has been quite healthy and it has taken lower relative investment than other midstream entities to build out the infrastructure (something we will return to later).

Why the sell-off then? Antero Resources is one of the largest national producers of both dry gas and natural gas liquids (“NGLs”), however it has come into its own set of problems. Given significant implied insolvency risk at its partner and its overreliance on it for earnings, the market has carried over its bearishness onto this partnership. Today, only Oasis Midstream (OMP) and Noble Midstream (NBLX) trade at a lower multiple based on near-term EV/EBITDA, non-coincidentally also captive partnerships that have sponsors in even deeper fiscal trouble. The market is sending a clear signal: rates earned on these pipelines are at risk of renegotiation or stranded once the core customers potentially file for bankruptcy. Within midstream, heavy emphasis is placed on cash flow visibility and safety. While the contract structure is there, customer risk has developed into a major concern.

However, there is a large difference in asset quality here in my view. Antero Resources continues to hold one of the strongest undrilled location inventories in Appalachia. While cash breakevens have been lackluster on a per mcfe basis, much of that comes down to corporate cost bloat, financing expense, and expensive firm transport agreements to move gas out of the Marcellus into core selling markets. As shown below, reduction in marketing expense, transport costs, and lower lease operating expense per well should lead to cash breakevens getting to where the firm is profitable alongside better dry gas pricing. Note that my numbers differ from management (targeting $2.10/mcfe by 2022) because of lower expectations and my inclusion of stock expense (this exercise also assumes normalization of NGLs to $0.40/gallon). Note that this is on a cash basis and does not incorporate reserve replacement, an issue that many E&Ps are facing with current spot pricing. This is an important aspect to the natural gas story in the United States. While crude oil players have to think about their position on a global scale (import competition), outside of some minor flows from Canada the United States has to be self-sustaining.

*Source: Author Calculations.

As management points out in its most recent Investor Presentation (Source: Antero Midstream, February 2020 Investor Update, Slide 41), 45% of domestic natural gas needs from 2020–2024 are uneconomic at current futures pricing. Much of this is dry gas production - Marcellus, Utica, Haynesville – that has struggled in the recent environment. The market cannot assume that upstream producers would drill for dry gas indefinitely while generating negative free cash flow. Eventually, capital markets access gets frozen and natural gas would have to move to a higher price where, at least at a minimum, creditors have a cushion on their interest payment coverage. This was an eventuality but has come about quicker than expected as the outlook for associated gas production growth has changed meaningfully. Whether or not Antero Resources, as least the entity as it exists today, makes it through the gyrations in the market is a point of contention. This raises a few questions: 1) Is Antero Resources production needed to meet demand needs 2) Are the rates between Antero Resources and Antero Midstream fair market rates 3) Would production stay elevated on the other side of a bankruptcy or reorganization.

Rate Renegotiation Terms

Late in December of 2019, Antero Resources and Antero Midstream announced a cut to paid midstream rates via what it called the new “Growth Incentive Program.” Under the terms of the deal, Antero Midstream would reduce its gathering, processing, and transportation fee rates to Antero Resources by a total $350mm over the next four years, aligning itself with the annual production growth plan at Antero Resources (8–10% annual). Overall, the market accepted the rate cut as a positive – mainly because expectations were for worse. Management had been alluding to a deal to cut fees for quite some time, often pointing out the wide disparity between earnings at Antero Midstream and its sponsor. The commitment to production is a bit flat. As shown below, Antero Resources has to grow production from current levels to meet its firm transport agreements on interstate pipelines. For several years now, it has been buying natural gas in the open market and shipping it in order to meet those commitments, booking losses. There was already plenty of external incentive in place for Antero Resources to grow its field production – hence why it has maintained a high single digit growth outlook even as the rest of Appalachia cuts back to maintenance.

I expect Antero Resources to bias towards the low end of its guidance. NGLs are under pressure which harms their profitability and free cash flow. Antero Resources is still going to track along the minimal level to trigger its quarterly fee reductions, beginning at 2,700 mmcf/d on the low pressure lines in early 2020, ramping to more than 2,900 mmcf/d by end of year, with higher levels in calendar years 2021–2023. As of Q4 2019, low pressure volumes stood at 2,639 mmcf/d, so the company is right there. The top rate reduction, reached when volumes increase 25%, implies an annual rate reduction of $76mm. Approached another way, that is about a $450mm-600mm in value transferred to Antero Resources (valuing the loss at 6-8x EBITDA). Some might take the view that a contract is a contract – and I get it – all parties in the energy value stream (upstream, midstream, downstream) do need to be able to earn their cost of capital for the market to be healthy.

Rate Norms In Appalachia, Bankruptcy Speculation

The above shows billed rates in Appalachia among the major publicly-traded players for 2019, making it a snapshot of the rates prior to recent renegotiations. There was a little massaging of this data that was required – not all firms provide gathering only revenue and compression and processing had to be both backed out and estimated. MPLX is particularly thorny in this regard, but I do feel like these numbers are a solid best effort. I would not necessarily treat the higher rates seen here as “bad” per se for MPLX; their gathering system ties in to their processing plants (where nameplate capacity far outstrips their pipeline flow) which does allow them to get away with marginally higher rates. I think EQM Midstream provides the cleanest comp, and both have since announced some fee waivers (see EQM Midstream announcement which ties lower rates to Mountain Valley Pipeline completion). Antero Midstream, given the glide path of Antero Resources to the Tier 3 reduction level, will be billing about $0.43/mmbtu in a couple of years. This level firmly puts it in the lower spectrum of rates charged in Appalachia in my view, including some privately-owned gathering systems I have spoken to.

While I hold a counter-consensus opinion on Antero Resources' survivability over the next several years, the market certainly has concerns. For instance, the June 2023 bonds (CUSIP 03674XAF3) trade at 45c or 37% yield to maturity, down significantly since the beginning of the year. While arguably a lot of operational positives have occurred since then (improved gas supply/demand as associated gas expectations roll off, materially better natural gas futures pricing), energy credit is tight. When even free cash flow positive energy names have implied refinance issues, something like Antero Resources which relies on a lot going right is going to have elevated concerns.

What happens to midstream rates in bankruptcy is rather organic. Sometimes rates remain unchanged, in others they are negotiated. It really does depend on who swings the bigger stick; both parties need one another at the end of the day. But, at least given the above statistics, if Antero Resources go bankrupt, it has little leverage to negotiate rates even lower based on comps. That’s a big positive. The other is that projected cash costs per mmbtu, especially if interest expense is materially lowered, positions Antero Resources' acreage above ~40-50 Bcf/d of current production. In other words, Antero Resources would not be a swing producer when it comes to the United States' demand needs. It is highly likely that, even in the event of a bankruptcy or reorganization, Antero Resources emerges from a reorganization producing substantially similar volumes to what it did prior. That would maintain volume on Antero Midstream pipes, a key aspect of profitability given the fixed cost nature of the midstream business.

Company Specific Worries

The Water Handling Business

For several quarters, Antero Resources has pushed Antero Midstream to emphasize its water handling business. Wetter completions have been en vogue, with many drillers seeing better well results when using both more water and proppant. At least last year, this was the case for Antero Resources as well. However, it had been trucking in much of its water needs, an expensive prospect. Antero Midstream had been tapped to handle more of the logistics via piped water, and it has been a growing business; freshwater delivery and produced water handling makes up a decent chunk of the project backlog. However, water is a completion-sensitive business: freshwater is used during initial fracking and produced water flows tend to be highest immediately after drilling. Contrasting some further water commitments lately, Antero Resources has begun to emphasize dryer completions (less water use per fracked well) which does offset the potential value of the fresh and produced water pipeline build-out. Much of the recent declines in sell-side consensus at Antero Midstream has stemmed more from lower water earnings forecasts, both from lower well completions and from less water use on a per well basis. This was clear in Q4 2019 results, where higher water operating expenditures and lower freshwater volumes drove most of the miss versus Wall Street expectations. This came despite the addition of a fourth completion crew on Antero Midstream acreage.

Free Cash Flow/Share Buybacks

The 2020 Antero Midstream capital budget is $400mm in free cash flow at the midpoint (pre-distributions). This guidance was given in January 2020, and I think there is some mild downside to the guidance (see my earnings models below). Also, this does not include a $125mm water earn-out payment to Antero Resources. This means that Antero Midstream will be a significant spender this year: $630mm in distributable cash flow (“DCF”) against $312mm in capital spending, $598mm in distributions, and the $125mm water earn-out. This is a deficit of more than $400mm. So, while there was $1,170mm in liquidity on the Revolver as of 2019 year end, a good chunk of this liquidity will be tapped in 2020, with smaller deficits being run in both 2021 and 2022. This does position the firm to have one of the highest utilization rates on its Credit Facility among midstreams and, as 2021 and 2022 EBITDA will be relatively flat as the company continues to spend and negotiated rate decreases impact earnings, leverage will continue to trend upward. By 2022, debt/EBITDA will be meaningfully above 4.0x, erasing much of the leverage advantage story the company enjoyed versus peers in prior years. While management could certainly aim to be aggressive in this environment, it seems like the more prudent path leads to limited share buybacks despite the share price.

Sponsor Stake Liquidation

Antero Resources has several paths forward to bridge its financing issues. Upcoming maturities are likely to be rolled onto the Revolver, but after that it is likely to take various unorthodox paths to raise cash such as asset sales, monetizing its hedge book, or potentially selling its Antero Midstream stake into the open market. While this last method is unlikely with units yielding 35% at current market prices, any significant upside (such as a return to levels seen last summer) could see Antero Resources incentivized to monetize its stake. At the end of the day, Antero Resources will prioritize its own health and going concern status. A potential alternative is pledging its Antero Midstream stake as collateral, but that could open its own can of worms if share prices unwind.

EBITDA/DCF Model 2020-2022

Takeaways

Are there some earnings or execution related risks? Sure. Antero Midstream is not perfect. But over the next three years, the partnership will generate the equivalent of its entire market cap back in distributable cash flow, the bulk of which will be returned to owners in the form of distributions. The precipitous position of Antero Resources means that the distribution is likely to remain elevated to help free cash flow at the sponsor, but Antero Resources is also in a solid enough position that it likely survives until its Credit Facility matures. A successful redetermination on its borrowing base should clear the way for at least a few years of survival.

Once one considers the fact that Antero Resources' acreage is likely to be worked in the event of a reorganization/bankruptcy exit and current rates are in line with market norms, I think even a second rate renegotiation would still result in available cash flow to the equity - if rates are even changed materially at all. That brings a lot of value to the table at current prices, and it makes sense as a speculative long buy in my opinion.

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.