This week, we examine another oil and natural gas producer that is systematically decreasing debt, reducing costs and increasing production. Legacy Reserves (LGCY) has taken effective steps to position itself to reap prominent benefits as commodity prices continue to improve.
Legacy Reserves has reduced outstanding debt by $217 million since the end of 2015.
In Q1 2016, the company impressively reduced production costs by 35% year-over-year, with costs now at $11.26 per Boe (barrel oil equivalent).
In Q1 2016, Legacy increased its total production by 35% over Q1 2015.
The company recently signed a joint development agreement that is adding daily production with minimal capital spending.
This 8% couponed bond from Legacy matures in just 4½ years, and priced around 46 offers over 16% annual cash flow and a lip smacking 31% yield to maturity. As oil and gas prices have continued to rise, we think the high quality, low-decline production assets of this oil and gas producer make holding its debt significantly less risky, and therefore see a fantastic opportunity here to increase both cash flow and overall portfolio returns with its deeply discounted bonds. Given the recent volatility and rise in price of these Legacy bonds, we are looking to move quickly and take advantage of these low prices, and will be adding them to both our FX1 and FX2 high yield fixed income portfolios.
About the Issuer
Legacy Reserves LP is a master limited partnership headquartered in Midland, Texas, focused on the acquisition and development of oil and natural gas properties primarily located in the Permian Basin, Mid-Continent and Rocky Mountain regions of the United States. Its primary business objective is to generate stable cash flows from the acquisition and development of long-lived oil and natural gas properties, allowing the company to support and increase quarterly cash distributions over time.
Since 2006, Legacy has made 137 acquisitions of producing properties for approximately $2.6 billion. In its efforts to generate stable cash flows and reduce our commodity price risk, the company has an active oil and natural gas hedging program.
In Q1 2016, Legacy Reserves generated 50% of its revenues from the sale of natural gas, 46% of its revenues from the sale of oil, and 4% from the sale of natural gas liquids (NGL). In comparison, for 2015, the company revenues were broken down as follows: 59% oil, 36% natural gas and 5% NGL.
For 2016, the company is projecting its production as follows: 69% from natural gas, 26% from oil, and 6% from NGL’s. Looking at Legacy’s projected production this year, it is heavily weighted in natural gas. The good news for Legacy is the recent increase in the price of natural gas. Natural gas for July delivery settled up 2.4 cents, or 1%, at $2.405 a million British thermal units on the New York Mercantile Exchange, the highest settlement since Jan. 8.
Debt Reductions Through Asset Sales
Legacy is currently focusing on deleveraging through the sale of select asset properties. Its goal in Q1 was to complete $50 million in asset sales. They achieved this level and more. By the end of March 2016, the company had realized $69 million in asset sales comprised of seven separate sales, including both acreage and high operating cost properties. For the acreage sold, the company netted a very respectable $12,000 per acre, 36x the past twelve months’ cash flow for these properties.
The company then seized an opportunity to buy back some of its bonds in the open market at a significant discount, using $21.5 million from the asset sales proceeds to repurchase $169 million of its senior notes. This action will translate to an annual net cash interest savings of approximately $11.9 million. This repurchase, along with the company’s cost efficiency measures, and its recent suspension of distributions to its unitholders, has translated to Legacy reducing its debt by $217 million since the end of 2015. Legacy’s goal is to generate $100 million from asset sales in the first half of 2016. It is well on its way, judging from the $69 million in Q1. Legacy also completed an additional $5.4 million in asset sales in the month of April.
Driving Down Costs while Increasing Production
Legacy Reserves has worked diligently to bring down its costs as the prices of oil and natural gas have decreased over the past few years. In Q4 2015, the company lowered its operating expenses significantly, decreasing by 23% year-over-year. Also in Q4 2015, the company drove down single-well costs by an average of 16%. Equally impressive, in Q1 2016, Legacy’s average cost per Boe (barrel oil equivalent) production expenses decreased 25% to $11.26 per Boe in 2016 from $15.11 Boe in 2015 (excluding ad valorem taxes).
While Legacy was very intentional on bringing down its costs, it also increased production at the same time. In Q1, the company increased its total production year-over-year by 35%, from 33,778 Boe/day in Q1 2015 to 45,527 Boe/day. And, they accomplished this while also reducing lease operating expenses a further 4% from Q4 2015 levels.
Joint Development Agreement
In July 2015, Legacy Reserves signed a definitive agreement with TPG Special Situations Partners (TSSP) to fund the development of certain areas of its Permian Basin properties. Under this agreement, initially, TSSP will fund 95% of Legacy’s development costs in the specified areas, with Legacy covering the remaining 5%. As certain return parameters are met, TSSP’s interest in the production from these wells goes from 87.5% down to 15%. This agreement maximizes the potential of Legacy’s high-quality, underdeveloped Permian acreage, reduces its capital expenditures in capital intensive, high-cost horizontal drilling and maintains a long-lived, low-decline production profile. Since the inception of this agreement, 12 wells have been drilled and completed, and in Q1, generated 567 Boe per day of production for Legacy.
For Q1, Legacy had operating income (removing non-cash impairment and depreciation & amortization) of $35.53 million, with interest expense of $25.18 million for an interest coverage of 1.4x. While this coverage is lower than what we normally like to see, Legacy is taking the necessary steps to remain viable (suspending distributions in January, selling assets to decrease debt, reducing expenses). With the price of oil recently hitting $50 per barrel (almost double its low of $26 per barrel in Q1), Legacy’s revenues should also steadily increase.
The default risk is Legacy Reserves’ failure to perform. Legacy has attacked its outstanding debt, reducing it by $217 million since December 31, 2015. It has effectively reduced its costs, reducing per Boe costs down to $11.26, 35% lower than in Q1 2015. It also increased production while bringing costs down, which is a fantastic combination. Its recent joint development agreement with TSSP is adding daily production with minimal capital expenditures. Interest coverage should improve as oil prices continue their steady climb. Therefore, the over 30% current yields on these 5 ½ year bonds appear to outweigh the risks we can identified.
Legacy generates revenues from its sales of oil and natural gas. Both oil and natural gas prices have declined significantly over the past few years. However, oil appears to be making a steady recovery, with current prices around $48 per barrel, up from their lows of $26 per barrel early this year. Natural gas, although also still experiencing low prices, has started to rebound and is forecast to also increase in price later this year, due to supply constraints late in 2016. There are of course, no guarantees that oil and natural gas prices will recover, and continued low prices could have adverse effects on Legacy Reserves’ revenues.
Legacy Reserves recently had its spring redetermination for its revolving credit line. At that time, the banks reduced the credit line from $725 million to $630 million. Currently, Legacy still has $69 million undrawn on this credit line. Any proceeds gained from asset sales are likely to go toward paying this down further. If oil and natural gas prices were to decrease again, Legacy may need to draw additional amounts and / or the banks could reduce the credit limit further.
Summary and Conclusion
The management team at Legacy Reserves has taken positive steps in order to position the company for the long-term. This includes cost reductions, paying down debt through asset sales, and suspending unitholder distributions. The company has also smartly signed a joint development agreement which will add daily production to their bottom line without spending a great deal of capital. While 2015 presented challenges, so far in 2016, Legacy has positioned itself as a much stronger company that is able not only to survive, but that will greatly benefit from the pending commodity price upturn. Therefore we are opportunistically adding these 54 month bonds from Legacy Reserves to our Fixed-Income1.com and Fixed-Income2.com global high yield fixed income portfolios at prices around a 31% yield to maturity.
Issuer: Legacy Reserves LP
Ratings: Ca / CCC+
Yield to Maturity: ~31.09%
About Durig Capital
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Disclosure: Durig Capital and certain clients may have a position in Legacy Reserves LP Corporate bonds.
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