This week, Durig Capital is reviewing an oil and gas exploration and production (E&P) company with operations in the Permian Basin, the Eagle Ford Shale formation as the Uinta Basin in Utah. EP Energy (EPE) spent 2017 keeping production costs low, signed two joint venture agreements and was also able to push out the maturity of a significant amount of its debt. EP Energy also installed new management “in order to transition from an asset-based organization to a function-based organization” last November.
- Joint venture agreements have been working. In its latest quarter, the company saw increases of 35% and 8% in the production areas where it has active joint venture agreements.
- New management successfully instituted and oversaw the successful exchange of bonds ranging in maturity from 2020 to 2023 for new notes due 2024, a total of approximately $1.1 billion.
The new year has seen recent highs in the price of West Texas Intermediate (WTI), due to increased demand as well as continued OPEC restrictions. Both of these factors bode well for E&P companies like EP Energy. The company’s remaining outstanding 2022 bonds are currently trading at a 27 point discount, giving them a yield to maturity of over 16.5%. With increasing demand for oil along with WTI prices rising, it appears to be an ideal opportunity to add these 55-month bonds to both Durig Capital’s Fixed Income 2 (FX2) managed income portfolio and Distressed Debt 1 Hedge Fund, the benchmarked aggregate year-end performance of FX2 is shown below.
EP Energy has released quarterly results for the three months ending September 30, 2017. Some of the highlights from these results include:
- An impressive increase in total year-to-date operating revenues (as of September 30, 2017) – $842 million, versus $579 million for the same period in 2016, a 45% increase.
- An equally impressive turnaround for operating income – for the first nine months 2017, operating income was $132 million, as compared to a loss of $39 million for the same period in 2016.
- Net cash provided by operating activities of $117 million for Q3, and $298 million for the nine months ending September 30, 2017.
- In July, EPE successfully repurchased $101 million at a discount to face value. As a result of these debt repurchases, the company anticipates reduced annualized interest expense.
In addition to these items, EPE successfully reaffirmed its borrowing base in October at $1.4 billion. This will continue to provide the necessary liquidity for the company’s ongoing operational and capital expenditures as it seeks to improve its balance sheet through debt reductions.
About the Issuer
EP Energy was formed in 2012 when the former El Paso Corporation sold its exploration and production assets to an investment group for $7.2 billion. Today, EP Energy is an oil and gas exploration and production (E&P) company with assets located in the Wolfcamp / Permian Basin in Texas, the Uinta Basin in Utah and Eagle Ford Shale formation in South Texas. EP Energy is active in key phases of the E&P value chain—acquiring, developing and producing oil and natural gas. Based in Houston Texas, 44% of EPE’s stock is owned by Apollo Global Management, a private equity firm based in New York. Everest Acquisition L.L.C., which is a co-issuer of the company’s senior secured notes and unsecured notes, was the acquisition vehicle formed by Apollo Global Management LLC, Riverstone Holdings LLC, Access Industries Inc., Korea National Oil Company, and other investors to acquire all of El Paso Corporation’s oil and gas exploration & production assets. Upon closing, Everest was renamed EP Energy, LLC (EP Energy).
Recent Debt Exchange
EPE recently completed an exchange offer with many of the holders of its 2020, 2022, and 2023 bonds. The results of this exchange were as follows:
- Approximately 79.5% of the 2020 notes were exchanged.
- Approximately 21.5% of the 2022 notes were exchanged.
- Approximately 26.9% of the 2023 notes were exchanged.
In all, approximately $1.1 billion in aggregate principal of new 2024 notes were issued to replace the old notes. This vastly extends a significant portion of EPE’s debt maturities.
The Joint Venture Advantage
In the low price environment that has dominated the oil and gas industry in the past 3 years, many oil and gas exploration and production (E&P) companies have signed joint venture agreements with other oil and gas players as well as with companies looking to invest in the oil and gas industry. According to a study done by Founders Investment Banking, there are several reasons why this is advantageous for the oil E&P company:
- Capital constraints: Many oil and gas producers have reduced capital spending as a result of low commodity prices. Having outside capital infused into their development programs helps combat the natural decay of oil production from existing wells.
- Geographic Positioning: This is where the E&P company and the joint venture partner can pool assets and / or complementary services and products to build a leading position within a geographical area.
- Reduce Acquisition Risk: A joint venture allows the partners to be involved in a “test run” by working with another company’s capabilities without the capital risk of acquisition.
EP Energy signed two joint venture agreements in 2017. In January 2017, EPE teamed up with Wolfcamp Drillco Operating to fund oil and natural gas development in its Wolfcamp Shale – Permian Basin acreage. Under the terms of the agreement, Wolfcamp Drillco will fund 60% of the drilling, completion and equipping costs in exchange for a 50% working interest in the joint venture wells. This encompasses up to 150 wells in two 75 well tranches. Once Wolfcamp Drillco achieves a 12% internal rate of return, working interest then reduces to 15%.
The second joint venture signed by EPE involves Tesoro Corporation, and EPE’s Altamont program located in the Uinta Basin of Utah. This joint venture is a 60-well program, with Tesoro providing a capital carry in exchange for 50% of EPE’s working interest in the joint venture wells. In addition to the drilling / production joint venture agreement, the two partners also signed a separate agreement whereby Tesoro agrees to purchase all of oil produced through the joint venture wells. This oil will supply local crude for Tesoro’s refinery in Salt Lake City.
The joint ventures appear to working well for EPE. In its latest results (Q3), EPE cited its highest quarterly production from its Wolfcamp assets since the program’s inception at 29.9 thousand barrels of oil equivalent per day. This represents a 35% increase compared with the third quarter of 2016. In addition, EPE expects continued production increases in Q4 from the Wolfcamp area. The company’s Altamont program also showed a healthy increase in production in Q3. Total production for Q3 2017 was 18.2 thousand barrels of oil equivalent per day, an increase of 8% over third quarter 2016.
As shown in the following graphic, the price of West Texas Intermediate crude oil (WTI) has had an overall upward trend since last summer. There are several factors that are likely influencing this trend.
(WTI Prices – Past 12 months as of January 16, 2018. Source – Macrotrends.net)
Most notably, prices have likely been driven up by the continuing production cuts from the OPEC nations. Currently, these production cuts are set to continue throughout 2018. In addition to these production cuts, there has been a robust demand for oil which has resulted in a 15% price increase since the first of December. The exploration and production oil and gas companies which have weathered this historically low oil price environment of the past 3 years are now more lean and efficient. This increased efficiency along with Increasing oil prices should provide much welcomed relief, adding profits and production through increased capital spending.
Interest Coverage and Liquidity
For the three months ended September 30, 2017, EPE had net cash from operating activities of $117 million, along with interest expense of $80 million for the same period. Using these figures, interest coverage is just below 1.5x. Q3 operating income was $100 million (without the non-cash charge of depreciation, depletion and amortization), so interest coverage is 1.25x when using this figure. With the slated increases in production as well as the the steady climb in WTI prices seen recently in the markets, EPE’s interest coverage should increase as well.
As mentioned previously, EPE reaffirmed its borrowing base in October. As of September 30, 2017, the company had total liquidity of $934 million.
The risk for bondholders is whether EPE can continue to increase profits while holding down costs and continuing to improve its debt picture. The company has smartly invested in two joint venture agreements in 2017 which will add production at a significantly reduced cost as opposed to EPE solely funding all of its production activities. These joint ventures have already begun to yield favorable results. Demand for oil has recently increased. Together with commodity price increases (oil prices), this should spell great news for EPE.
As EPE’s revenues are tied directly to the prices of oil and gas, there is commodity price risk present for bondholders. If prices were to decrease significantly, this could affect EPE’s ability to fund its operational needs, including interest expense for bondholders. The company does have an active hedging program that it uses to negate some of the ongoing volatility of commodity prices.
In general, bond prices rise when interest rates fall and vice versa. This effect tends to be more pronounced for lower couponed, longer-term debt instruments. Any fixed income security sold or redeemed prior to maturity may be subject to a gain or loss. Higher yielding bonds typically have lower credit ratings, if any, and therefore involve higher degrees of risk and may not be suitable for all investors.
Summary and Conclusion
Like all exploration and production companies in the oil and gas industry, EP Energy has experienced a few lean years since oil prices began their steep decline in mid-2014. In 2017, the company has added production through two smart joint venture agreements, one with Tesoro and one with Wolfcamp Drillco. Since being added, both agreements have already shown promise with increased production, as high as 35% year-over-year increase. Company management (a new executive team) also made a shrewd decision to lengthen debt maturities through a bond exchange which was just recently completed. The company’s remaining, outstanding 2022 bonds, couponed at 7.750%, currently have a yield to maturity over 16% and will make an ideal addition to both our Distressed Debt 1 Hedge Fund and FX2 managed income portfolios, the most recent tear sheet of Distressed Debt 1 is shown above.
Issuer: Everest Acquisition Finance, LLC
Ratings: Caa3 / CCC+
Yield to Maturity: ~16.71%
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