Investors Not Appreciating Improvement In Eagle Rock Energy Partners LP's Underlying Business

| About: Eagle Rock (EROC)
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Unlike most energy-related MLPs, Eagle Rock Energy Partners LP (EROC) operates in both the upstream and midstream segments of the energy business. Roughly 60 percent of the partnership's total operating income comes from oil, gas and NGL production, while its gathering pipelines and processing facilities account for the remaining 40 percent.

Eagle Rock Energy Partners is a far stronger company than it was two years ago. The MLP went public in late 2006, and the bull market for energy commodities enabled the firm to boost its quarterly payout steadily throughout 2007. But two obstacles tripped up the MLP in 2008: significant exposure to oil and gas prices, and a heavy reliance on short-term lines of credit with banks.

By their very nature, upstream operations have some exposure to commodity prices. Some partnerships such as Linn Energy LLC (LINE) limit their exposure to fluctuations in oil, gas and NGL prices by hedging future production. Eagle Rock Energy Partners doesn't fully hedge its expect output, a strategic decision that decimated the firm's cash flow when oil and gas prices collapsed in later 2008 and early 2009.

Eagle Rock Energy Partners' midstream business also has some built-in exposure to commodity prices, as a slowdown in drilling activity reduces the number of wells hooked up to the MLP's gathering system and weighs on throughput. In 2008-09, the firm's processing margins also suffered because of the collapse in energy prices.

The MLP's debt structure compounded these problems. At the beginning of 2010, Eagle Rock Energy Partners' outstanding credit facility accounted for 60 percent of the firm's $1.2 billion enterprise value. This outsized debt amounted to more than 4.5 times the MLP's earnings before interest, taxation, depreciation and amortization (EBITDA).

Credit facilities are subject to periodic evaluations and potential redetermination. At the height of the financial crisis, Eagle Rock Energy Partners faced an unwelcome liquidity crisis, as the MLP's lenders slashed its credit facility.

To conserve cash, the firm in early 2009 cut its quarterly to $0.021136 per unit from almost $0.35 per unit. This news sent the stock plummeting to a low of $2.24 per unit from a high of about $23 per unit.

In 2010 Eagle Rock Energy Partners completed a series of transactions that drastically altered the MLP's risk profile. The firm sold off its volatile minerals business for $174.5 million, raised another $53.9 million by issuing common units and warrants, and eliminated its incentive distribution rights-fees an MLP pays to its general partner for managing daily operations.

Today, Eagle Rock Energy Partners' credit facility is only 24 percent of the firm's enterprise value. The partnership's leverage ratio has declined to less than 3.5 times EBITDA.

As market conditions improved, Eagle Rock Energy Partners has returned to growth mode, expanding its midstream and upstream businesses via acquisitions and organic projects. The MLP now disburses a quarterly payout of $0.22 per unit, and management aims to growth the distribution to $0.25 per unit by early 2012.

Although Eagle Rock Energy Partners has reduced its business and financial risks, the stock's valuation continues to suffer from the stigma of the MLP's troubles in 2008-09.


Eagle Rock Energy Partners' upstream segment comprises 591 operated oil and natural gas wells and the equivalent of 371 billion cubic feet of natural gas reserves. Gas accounts for about 63 percent of the MLP's total reserves, while oil accounts for 19 percent of this resource base and NGLs represent 18 percent. Daily production in 2011 averaged 85 million cubic feet of natural gas equivalent.

As explained in Jim Fink's article, Natural Gas Prices Will Rise in 2015 on LNG Exports, US natural gas prices will likely remain depressed for at least the next few years, thanks to reduced demand during the unseasonably warm 2011-12 winter and rising production from the nation's prolific shale plays. Based on my outlook for natural gas prices, Eagle Rock Energy Partners' significant exposure to this out-of-favor commodity is a red flag.

Fortunately, the MLP has hedged 81 percent of its estimated natural gas and ethane output at an average price of $5.82 per million British thermal units-more than double the current price of natural gas. The firm has hedged about 70 percent of the firm's estimated gas and ethane production in 2013, 43 percent in 2014 and 24 percent in 2015. Eagle Rock Energy Partners has also hedged about 87 percent of its expected oil and NGL production in 2012.

More important, Eagle Rock Energy Partners has a significant inventory of drilling prospects in the Cana Shale and the Golden Trend in Oklahoma, two liquids-rich plays that offer superior wellhead economics. Continental Resources (CLR), Devon Energy Corp (DVN) and other independent exploration and production firms are spearheading development in the Cana Shale, a subsection of the larger Woodford Shale. Forty-seven rigs are currently drilling horizontal wells in the region.

Eagle Rock Energy Partners has amassed a leasehold of 14,600 acres of in the region, with four operated wells and 59 non-operated wells that are in production. The majority of the MLP's acreage in the Cana Shale is located in the wet-gas window, the portion that produces significant volumes of NGLs and condensate. Because of this favorable production mix, Eagle Rock Energy Partners in 2011 earned about $4 per thousand cubic feet of output in the Cana Shale.

Eagle Rock Energy Partners and other upstream operators continue to drill test wells in the southeast of the play, a peripheral region where the productive formation is about 2,000 feet deeper than in the Cana Shale's fairway. The master limited partnership owns 1,636 net acres in the region and is participating in two wells: the Continental Resources-operated Olson 1-22H and the 100 percent-owned Beckham 1-27H, which is scheduled to be spudded in the second quarter of 2012.

Other wells in the vicinity have yielded initial production rates of 7 million cubic feet of natural gas per day, 300 barrels of oil per day and volumes of NGLs. Additional drilling results in the region could be an upside catalyst for the stock.

The Golden Trend already accounts for about one-quarter of Eagle Rock Energy Partners' production and contains multiple productive formations.

In the first quarter, the MLP's overall production declined slightly from the final three months of 2011. Management also cut its planned capital spending by $20 million and reduced its 2012 production guidance by 2 million cubic feet equivalent of natural gas per day, to 90 million cubic feet of natural gas equivalent per day. This revised target still represents production growth of roughly 12 percent.

Management's cuts to upstream spending and production guidance are part of a plan to focus drilling activity in liquids-rich plays. Eagle Rock Energy Partners' current forecast calls for oil output to grow by 8 percent in 2012, while NGL production is expected to surge by more than 50 percent. By year-end, liquid hydrocarbons will account for 46 percent of the MLP's output.

Eagle Rock Energy Partners will operate a total of three to four rigs this in the Cana Shale, the Golden Trend and the Permian Basin.

Management told analysts at the NAPTP conference that the pipeline of potential upstream acquisitions remains robust, as exploration and production companies divest mature assets to fund drilling activity in emerging shale plays. The firm is also eyeing opportunities to pick up gas-focused acreage at bargain prices that guarantee solid returns even in the current pricing environment. Closing an upstream acquisition that's immediately accretive to cash flow would be welcome news for the hard-hit stock.


Eagle Rock Energy Partners' midstream business comprises 5,500 miles of gathering pipelines in the Texas Panhandle, east Texas and Louisiana, south Texas, the Gulf of Mexico and west Texas. These small-diameter pipelines connect individual wells to processing facilities and, ultimately, the US interstate pipeline network. The firm also owns 19 gas-processing plants that separate NGLs such as propane and ethane from raw natural gas.

In the first quarter of 2012, Eagle Rock Energy Partners transported an average of 453 million cubic feet of natural gas equivalent per day through its gathering systems.

The partnership's gathering pipelines in the Texas Panhandle should benefit from rising liquids-rich production in the Granite Wash and Brown Dolomite play, a mature formation that yields more than 8 gallons of liquids for every 1,000 cubic feet of natural gas produced. Drilling activity in the Granite Wash has driven most of the system's throughput growth in recent quarters.

The Granite Wash yields 4 gallons to 6 gallons of liquid hydrocarbons for every 1,000 feet of natural gas. About 55 rigs currently operate in the play's Texas portion, with four rigs dedicated to acreage served by Eagle Rock Energy Partners' midstream assets. Management expects the number of rigs targeting acreage in the MLP's service area to at least hold steady, implying flat-to-increasing demand gathering and processing.

The MLP's processing plant in its East Panhandle system ran at more than 90 percent of headline capacity in the first quarter.

With producers drilling test wells in nearby plays such as the Tonkawa, Hogshooter and Cleveland, as well as the Atoka and Morrow zones located beneath the Granite Wash, demand for midstream capacity could increase. Operators have reported solid liquids production from all these pay zones, suggesting that drilling activity in these basins will only increase.

To accommodate demand, Eagle Rock Energy Partners plans a number of expansion projects in the Texas Panhandle, including the construction of the Woodall processing plant, a facility capable of handling 60 million cubic feet of natural gas per day. This $72 million facility should come onstream in early June. The Wheeler processing plant, which will also serve the eastern portion of the Texas Panhandle, will boast a nameplate capacity of 60 million cubic feet per day once it's completed in April 2013.

Although throughput on Eagle Rock Energy Partners' gathering and processing assets in east Texas has suffered from declining activity in the dry-gas Haynesville Shale, drilling activity in the Austin Chalk play could offset some of this weakness. The MLP's management team is contemplating the construction of another processing facility in Louisiana that will handle volumes from this basin.

Recent drilling results in the Tuscaloosa Marine Shale - sometimes called the Louisiana Eagle Ford Shale - should spur additional development. Goodrich Petroleum Corp (GDP) in late May announced a three-day initial production rate of 1,082 barrels of oil equivalent per day from a test well in this emerging play.

In the first quarter of 2012, gathered volumes on Eagle Rock Energy Partners' east Texas assets increased by 2 percent from year-ago levels, but NGL and condensate throughput tumbled by 12 percent. This decline, which stemmed primarily from downtime at a third-party processing plant on the Gulf Coast, should prove temporary. The MLP's processing facilities in east Texas operated at a utilization rate of 70 percent to 75 percent in the first three months of the year.

Cash flow from Eagle Rock Energy Partners' processing assets can fluctuate with commodity prices. About one-quarter of the MLP's contracts guarantee the MLP a fixed fee for processing services. However, percent-of-proceeds (POP) agreements account for more than half the firm's contract base and percent-of-index (POI) deals account for another 15 percent.

Under a POP arrangement, Eagle Rock Energy Partners receives a predetermined percentage of the total sales proceeds as compensation. Although the MLP hedges its exposure to NGL and gas volumes, declining commodity prices would weigh on the profitability of POP and POI processing contracts.

First-Quarter Results

Eagle Rock Energy Partners boosted its distribution by 5 percent sequentially and 47 percent from a year ago in the first quarter. The MLP's DCF covered this higher payout by almost 1.4 times-a healthy margin that should enable the firm's payout to withstand any further downside to energy prices.

Analysts continue to question whether Eagle Rock Energy Partners will be able to reach management's targeted fourth-quarter distribution of $0.25 per unit (payable in February 2013). The emerging consensus suggests that the MLP will hit this goal-albeit a quarter or two later because of weakening energy prices.

An explosion at Eagle Rock Energy Partners' Phoenix processing plant in the Texas Panhandle will keep the facility offline for up to 60 days. The MLP has rerouted about 80 percent to 85 percent of these volumes to the newly opened Woodall Plant, and insurance eventually will offset some of the direct financial impact from the explosion.

With a yield of 11.5 percent, units of Eagle Rock Energy Partners offer ample compensation for the risks to the firm's distribution growth. Investors simply aren't giving the MLP enough credit for its lower-risk financial structure, rising liquids production and its midstream segment's organic growth potential.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in LINE over the next 72 hours.