Legacy Reserves: 19.75% Yield-to-Maturity, Maturing December 2020
Durig’s Fixed Income 2 (FX2) looks again at an oil and gas producer whose focus is primarily in the Permian Basin in Texas. We have looked at Legacy Reserves three times, once in July of 2016, once in December of 2016 and most recently in June of 2017. The company’s Q3 results have just been released and the company looks to be building momentum:
Legacy has increased Adjusted EBITDA in each consecutive quarter this year, in Q3 registering a 33% increase over Q2.
Oil production increased 25% in Q3 over Q2.
Average realized oil price for Q3 increased 11% year-over-year.
Legacy had excellent Q3 interest coverage of 2.2x.
Although natural gas revenues have declined as a percentage of total revenues, Legacy still retains nearly half of its revenues from natural gas and natural gas liquids, offsetting revenues from more traditional oil production and providing a level of revenue diversification for this producer. Legacy’s 2020 bonds, couponed at 8.0% are currently trading at a discount giving them a yield-to-maturity of about 19.75%. These high-yielding bonds are ideal for additional weighting in our high-yielding managed income portfolio, Fixed Income 2 (FX2) as well as our Distressed Debt 1 hedge fund. The aggregated and benchmarked third quarter end 2017 performance of FX2 is displayed below.
Third Quarter Highlights
Legacy continued to show improvements in key metrics for its latest reported quarterly results:
Increased oil production to a record 14,380 barrels per day, a 25% increase over Q2 2017 levels.
Continued reducing expenses, with lease operating expenses (LOE) decreasing by 6.5% over Q2 2017 LOE.
Average realized price for oil increased 11% year-over-year, from $40.28 in Q3 2016 to $44.64 in Q3 2017.
Revenues increased for both Q3 and for the nine months ended September 30, 2017, by 52.4% and 39.8% respectively.
For the nine months ending June 30, 2017, Legacy increased its adjusted EBITDA year over year by 30.9%, from $109.4 million to $143.3 million.
In reference to adjusted EBITDA, the company has consistently grown its adjusted EBITDA in each consecutive quarter this year. If Legacy stays true to its current trajectory, it could continue to further increase their position to significant enhancements to their balance sheet.
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 its commodity price risk, the company has implemented an active oil and natural gas hedging program.
Update on Joint Development Agreements
Legacy’s ongoing partnership with TPG Special Situation Partners (TSSP) has helped to contribute to the company’s production increases. On August 1, 2017, Legacy agreed to make an acceleration payment to TSSP. This payment increased Legacy’s interest in the joint wells from 20% to 85% of the combined working interest, effective August 1, 2017. This payment applied to the first tranche of wells (48 wells in total). The company’s increased interest should translate to increased production. And with the recent appreciation seen in WTI prices, production increases should also increase revenues and profits.
Legacy: Still an Oil AND Natural Gas Company
As we’ve pointed out in previous reviews, Legacy is probably most recognized as an oil company. The company does, however, generate nearly half of its revenues from the sale of natural gas and natural gas liquids (NGL’s). The following table illustrates the increasing role of natural gas / NGLs on Legacy’s revenues. Although the percentage of revenues from natural gas has decreased a bit for the first nine months of 2017, natural gas still represents a sizable proportion of Legacy’s total revenues.
On the natural gas front, prices have varied between $2.63 and $3.71 per thousand cubic feet since January, 2017. Gas use typically hits a seasonal low with Spring’s mild temperatures, before warmer weather increases demand for gas-fired electricity generation to power air conditioning. The U.S. Energy Information Administration regularly tracks and makes projections for commodity prices and the outlook for the Henry Hub spot price looks fairly stable.
Most often, consumers will hear oil prices quoted for Brent crude and West Texas Intermediate (WTI), of which, WTI is typically lower. The prevailing price for WTI is the benchmark for oil consumed in the United States, hence the benchmark most applicable to Legacy’s production. WTI prices have climbed in recent weeks (see graph below) and the U.S. Energy Information Administration has recently raised its price projections for the rest of 2017 as well as 2018. Both of these developments are definitely positives for producers such as Legacy. Legacy’s challenge and goal will be to keep costs low to maximize its realized price per barrel.
(Source: Macrotrends, November 13, 2017)
Interest Coverage and Liquidity
Interest coverage is of primary important for bondholders as it indicates the company’s ability to cover the interest on its outstanding debt. For its latest quarterly results, Legacy had operating income of $51.3 million (without the non-cash charges of depreciation and impairment). Interest expense for Q3 was $23.6 million, which gives an interest coverage of nearly 2.2x. This is a healthy interest coverage ratio, especially considering the current discounted price of these bonds and an outstanding yield-to-maturity of nearly 20%. Also, Legacy reported in its latest results that it has extended the availability of the remaining $95 million on its second lien term loan to October 25, 2018. This will buy time for Legacy as they continue increasing production while keeping costs under control.
The default risk for bondholders is whether Legacy can continue the momentum it has built up over the past three quarters. Challenges do remain for this commodity producer, especially the ever-changing prices of oil and natural gas. In addition, the company’s high leverage is a continued concern. It is encouraging that the U.S. Energy Information Administration (EIA) has raised its projections for WTI spot prices for the balance of this year and for 2018 as well. Although this is not a guarantee that these prices will attain hold these expected levels, it does provide a benchmark and a level of confidence for investors. In addition, the company does not have any debt deadlines until late next year. This gives Legacy time to continue with increases to its production while keeping costs manageable in order to maximize profits. In light of these factors, the 19.75% yield-to-maturity indicated with these 2020 bonds appears to outweigh the risks identified.
Legacy generates its revenues from the sale of oil and natural gas. While both oil and natural gas have experienced significant price volatility in the last few years, both appear to be making a significant recovery, especially the recent price of WTI. However, if prices of oil and natural gas were to return to the low levels seen in the past three years, this would definitely have an adverse affect on Legacy’s ability to meet its ongoing operating expenses as well as debt obligations.
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
Legacy Reserves appears to be on an upswing, investing capital to increase production, while still keeping costs manageable. Increases in revenues, production and adjusted EBITDA in its latest quarter have been encouraging. It will be critical for Legacy to perform well over the next nine months in order to be in a position to address the due date of its second lien term loan in late October of 2018. With WTI pricing in the $50+ / barrel range in the past few months, it appears that oil pricing could finally be stabilizing for the long-term. The company’s 2020 bonds, couponed at 8% and with a yield-to-maturity of nearly 20% are ideal for additional weighting in both our managed high-yield fixed income portfolio, FX2, as well as our Distressed Debt 1 hedge fund, the most recent tearsheet of which is shown above.
Issuer: Legacy Reserves LP
Ticker: (NASDAQ: LGCY)
Ratings: Caa3 / CC
Yield to Maturity: ~19.78%
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