This week, we delve into the oil and gas sector to discover a producer who excelled in 2014, even as global oil prices were cut in half. Vanguard Natural Resources (VNR) is an MLP (master limited partnership) whose focus in on the production and development of domestic oil and natural gas properties. Last year, as oil prices plummeted, this producer had a 41% increase in sales and 35% growth in adjusted EBITDA over the previous year. In 2012, Vanguard made the brilliant decision to begin the shift towards acquiring natural gas properties, and the decision has brought diversity and growth, while Vanguard’s competitors are still suffering amidst the current low oil price environment. As natural gas demand continues to grow, Vanguard is superbly positioned to benefit, as its revenues are presently about half from oil sales and half from natural gas sales. The company has strategically hedged a majority of its oil and gas production for the next two years, providing cash flow stability in the uncertain environment of commodity pricing. Vanguard’s well-planned and well-executed decision to diversify with natural gas has not only insulated them from the full effect of oil’s decline, but it has allowed the company to continue with its strategy of growth through acquisition, buying assets on the cheap from other producers in distress. Therefore, we have marked these 4 year US dollar bonds from VNR, discounted to about 95 and indicating a 9.15% yield, for addition to our Fixed-Income 1 and Fixed-Income 2 high yield global income portfolios.
Natural Resources – Oil AND Natural Gas
Vanguard’s beginnings were concentrated in domestic oil properties. In 2012, with the Arkoma acquisition, it began the strategic shift towards natural gas weighted properties. Since that time, it has completed seven primarily natural gas acquisitions for a total investment of more than US $2.2 billion dollars. Today, in terms of revenue, Vanguard is a half oil, half natural gas company. Vanguard management has made this shift at what appears to be an extremely fortuitous time. According the BP’s annual Energy Outlook published in February 2015, “Globally, natural gas is the fastest growing fossil fuel, with demand rising at the rate of 1.9%/year over the next two decades, while oil falls to just 0.8%/year.” Domestic demand also continues to increase with increasing exports to Mexico, retiring coal plants being replaced with natural gas plants, and additional industrial growth as the US economy continues to improve.
About the Issuer
Vanguard Natural Resources, LLC, an upstream MLP (Master Limited Partnership), was founded in 2006. Headquartered in Houston, Texas, it is focused on the acquisition, production and development of mature, long-lived oil and natural gas properties in the United States. Through the Company’s operating subsidiaries, it owns properties and oil and natural gas reserves located in nine operating areas: the Arkoma Basin in Arkansas and Oklahoma; the Permian Basin in West Texas and New Mexico; the Big Horn Basin in Wyoming and Montana; the Piceance Basin in Colorado; South Texas; the Williston Basin in North Dakota and Montana; the Wind River Basin in Wyoming; the Powder River Basin in Wyoming; and Mississippi.
The company has grown through well-planned and well-executed annual acquisitions beginning in 2007. Since that time, Vanguard has made 23 acquisitions, representing US $4.2 billion in investment. These investments have paid off richly, with reserves growing from 2007 – 2014 at a CAGR of 63% and EBITDA growth during the same time period of CAGR 46%.
Solid Performance in the Midst of Declining Oil Prices
Between June and December 2014, oil prices dropped by over 50%. Yet, during this time, Vanguard continued moving forward while many of its competitors lost ground. For Q4 2014, the company reported adjusted EBITDA of $126 million, a 69% increase over Q4 2013, and a 16% increase over Q3 2014. Furthermore, for all of 2014, Vanguard reported adjusted EBITDA of $421 million, a 36% increase over 2013. Average production also increased in 2014, up 54% as compared to 2013. These solid performance numbers directly relate to the company’s strategic and well-executed decision in 2012 to shift towards acquiring natural gas properties.
A further encouragement for bondholders is that the management expectations for 2015-16 EBITDA and capital expenditures indicate more than adequate debt service coverage.
Positioning for Growth
In response to recent oil price declines, Vanguard is positioning itself for continued growth. As a master limited partnership (MLP), Vanguard was created with the intention to pay income distributions to its unitholders (unitholders are comparable to stockholders in a publicly traded company). In February 2015, Vanguard’s management made the decision to reduce the company’s distribution by 44%. CEO Scott Smith said the reduction is “to address the economic headwinds we face as a result of the dramatic collapse in commodity prices over the past several months”. By reducing the distribution rate, Vanguard is securing a stronger long-term future for the company. MLP’s, like Vanguard, achieve most of their growth by acquiring oil and gas assets. Currently, there is a large inventory of mature oil and gas basins which provide significant future growth opportunities. By reducing the distribution, the company can accomplish one of the goals it set for 2015 – to improve its financial outlook through accretive acquisitions.
Hedging for the Future
Vanguard has incorporated hedging strategies to help stabilize the prices they receive for their oil and natural gas. Their primary hedging strategy involves the use of swaps. Swaps are popular amongst oil and gas producers to hedge their exposure to volatile oil and gas prices as it allows them to lock in the price they receive for their oil and gas production. Vanguard recently made changes to its hedging portfolio to limit its downside risk on oil and natural gas prices in 2015 and 2016. Natural gas is hedged 82% in 2015 and 67% in 2016 at an average price of $4.31. Oil is hedged at 77% in 2015 and 45% in 2016, at an average weighted price of $78.68 / barrel. Through hedging, Vanguard is able to mitigate price risk and cash flow volatility.
In addition to the solid EBITDA growth for Q4 and 2014 discussed earlier in this review, Vanguard also had remarkable revenue increases for Q4 2014 and calendar year 2014. For the three months ended December 31, 2014, Vanguard recorded sales of oil, natural gas and natural gas liquids of $156 million, as compared to $108 million for the same time period 2013. For the calendar year 2014, sales grew to $624 million, up from $443 million in 2013, a 41% increase.
For 2014, Vanguard had operating income of $172.4 million and interest expense of $73.8 million for a solid interest coverage ratio of 2.3x.
The default risk is Vanguard Natural Resources’ ability to perform. Vanguard’s management has done a masterful job in making the strategic decision a few years ago to move the company towards being more heavily weighted in the natural gas sector. This decision has been executed flawlessly within a stressful low-priced oil environment, and is evidenced in its sales and EBITDA results for 2014, one of the stormiest seasons for oil producers in the past decade. While oil and natural gas both took a beating in 2014, the decrease in natural gas prices was not nearly as pronounced as oil. Consequently, Vanguard fared much better than many of its competitors.
Commodity price volatility is also a risk for Vanguard. As indicated earlier in this review, the company’s revenues are approximately 50% each from oil and natural gas. It is, difficult, if not impossible, to predict where oil and natural gas prices will go from their current levels. However, anyone who has followed oil and natural gas understands the cyclical nature of these commodities. Also, Vanguard has a hedging portfolio in place to help mitigate its cash flow volatility from the price fluctuations in oil and natural gas.
This Vanguard Natural Resources bond, in US dollars, appears to have similar risks and maturities to other US dollar coporate bonds, such as the 10.6% Fortescue Metals Bonds, the 11.25% IAMGOLD Bonds, or the 9.66% Dana Gas Bonds that we have previously reviewed on our Bond-Yields.com blog site.
Summary and Conclusion
Vanguard made the shrewd decision three years ago to make natural gas a significant part of its production portfolio. That decision has created a company that is thriving and excelling in the current low price oil environment. The company prospered in 2014, while many oil companies struggled. It has smartly hedged a majority of its oil and gas production for 2015 and 2016. Vanguard is meeting all of its commitments, still paying a dividend, and still searching for tactical acquisitions that meet its growth criteria. Consequently we see these 4 year, 7.875% couponed bonds from Vanguard Natural Resources, discounted to about 95 93 and indicating a yield of 9.75%, as a savvy opportunity offering excellent cash flow and high yields, and are therefore adding them to our FX1 and FX2 high yield global income portfolios.
Issuer: Vanguard Natural Resources, LLC
Yield to Maturity: ~9.15%
Disclosure: Durig Capital and certain clients may have positions in Vanguard Natural Resource 2020 bonds.
Please note that all yield and price indications are shown from the time of our research. Our reports are never an offer to buy or sell any security. We are not a broker/dealer, and reports are intended for distribution to our clients. As a result of our institutional association, we frequently obtain better yield/price executions for our clients than is initially indicated in our reports. We welcome inquiries from other advisors that may also be interested in our work and the possibilities of achieving higher yields for retail client.
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