This week, we revisit a domestic oil and gas producer that posted a solid 3.6x interest coverage in Q1 of 2016. In this look at Vanguard Natural Resources (VNR), we target its shorter maturity and higher 8.375% couponed bonds issued by Eagle Rock Energy Partners, a company which VNR acquired entirely through a stock issuance (valued at the time at $614 Million) shortly after our initial review in April of 2015. VNR’s more recent Q1 2016 results were particularly encouraging, especially given the state of commodity prices during that time frame.
Q1 2016 adjusted EBITDA was up 9% year-over-year.
Q1 2016 production was up 21% year-over-year.
In Q1 2016, VNR executed a bond swap, resulting in annual interest savings of almost $8.0M.
The adjusted EBITDA / interest ratio in Q1 2016 is 3.6x
Vanguard, which continues to primarily be a natural gas producer, also continues to use an effective hedging program to help keep revenues consistent despite commodity volatility. The less liquid Eagle Rock 2019 bonds, couponed at 8.375% are currently trading at a steep discount (in the lower 40’s), indicating a mind boggling yield to maturity that’s near 50%. This is a noticeably better yield and price that the parent company’s more common 7.875% 2020 bonds are trading for, making the EROC bonds what we see as the better target between the two. With the recent notable improvement in natural gas prices, we think either of these Vanguard Resource bonds can help add significant cash flow and healthy capital gains to our clients portfolios, and are therefore marking this issue for addition and overweighting in our FX1 and FX2 global high yield income portfolios.
Solid Q1 Results
Vanguard posted a sold Q1 2016 despite the continuing challenges in commodity pricing. Oil prices bottomed in Q1 around $26 per barrel and natural gas prices also bottomed around $1.49 / MMBtu. In spite of these lows, Vanguard registered an increase in Q1 for its adjusted EBITDA and posted healthy interest coverage. Vanguard’s adjusted EBITDA for Q1 was $92.8 M, a 9% increase from Q1 2015’s level of $85.3 M. With interest expense for the quarter at $25.7 M, this results in an adjusted EBITDA/ interest ratio of 3.6x, which is excellent coverage, especially considering the outstanding yield.
Vanguard recently completed its spring redetermination for its borrowing base. At its conclusion, the company’s borrowing base was reduced from $1.8 B to $1.325 B, with VNR’s balance at $1.43 B. As a result, the company must pay $17.3 M per month over the next six months (with the first payment made June 27th), to bring them into compliance. Management continues to actively work with the banks in addressing this issue and has stated that they feel comfortable they can meet these payments with current cash flow.
In a recent press release on its updated 2016 guidance, management is forecasting cash flow of $150M this year. This forecast assumes natural gas prices at $2.01 for Q2, $2.22 for Q3 and $2.48 for Q4, and oil prices between $44.45 and $48.51 per barrel. This redetermination was made in May, prior to the run up in natural gas prices. During the month of June, natural gas prices were up over 30% from May levels, with an average Henry Hub spot price of $2.52 MMBtu. And recent oil prices have been hovering between $45-$47 / barrel. If prices remain at their current levels, VNR would actually exceed their estimated cash flow for the balance of 2016 and would still have spare cash flow after paying down its borrowing base.
We last covered Vanguard Natural Resources in early 2015. Since that time, the company has increased its production capabilities via two mergers and has taken actions to shore up its balance sheet. In October 2015, Vanguard completed two mergers, one with Eagle Rock Energy Partners and the other with LRR Energy. Both of these mergers added acreage as well as producing wells to VNR’s established presence in the Gulf Coast, Permian and Arkoma Basins, as well as established a new platform in the Anadarko Basin. These mergers no doubt contributed to VNR’s increased production in Q1, which increased year-over-year by 21%.
In February, Vanguard executed a bond swap for eligible holders of these 2020 notes, issuing $75.6 M principal 7% notes due 2023 in exchange for $168.2 M aggregate principal of the 2020 notes. The bond swap resulted in a gain on extinguishment of debt of $89.7 M as well as reduced Vanguard’s annual interest expense by $7.9M.
Finally, in March, VNR completed the sale of some of its oil / natural gas / natural gas liquids assets in the SCOOP / STACK areas of Oklahoma to Titanium Partners for $280.0 Million cash. The proceeds from this sale were used to shore up VNR’s balance sheet, reducing VNR’s borrowings under it Reserve-Based Credit Facility.
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 ten operating areas: the Green River Basin, the Permian Basin, the Gulf Coast Basin, the Andarko Basin, the Piceance Basin, the Big Horn Basin, the Arkoma Basin, the Williston Basin, the Wind River Basin, and the Powder River Basin. Since its initial public offering in October of 2007, VNR has completed 25 strategic acquisitions increasing its reserves by over 3,316%.
For 2015, Vanguard’s total production was heavily weighted in natural gas with 70% of production in natural gas, 16% oil and 14% natural gas liquids. In its latest reported quarter (Q1), the company was close to these same numbers, coming in at 66% natural gas, 19% oil and 15% natural gas liquids.
Vanguard continues to use hedging strategies to help stabilize revenues received for its sales of oil and natural gas. The company continues to primarily use swaps, 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. For the period of April 1 to December 31, 2016, the company has hedged 84% of its natural gas production at a weighted average price of $4.17/MMBtu. VNR has also hedged 89% of its expected oil production at a weighted average price of $66.43 per barrel, as well as hedged 26% of its natural gas liquids production at an average weighted price of $30.31 per barrel.
For 2017, it has more than half of its natural gas production and a portion of its oil production. For natural gas in 2017, 69% is hedged at an average price of $3.70 / MMBtu and oil production is currently 23% hedged at $84.68 per barrel.
The default risk is Vanguard’s ability to perform. Vanguard showed excellent interest coverage in Q1, during the lowest oil and natural gas price of this commodity downturn. And the company also increased adjusted EBITDA year-over-year during this same time. In light of the company’s reduced capital expenditures for 2016, it has smartly merged with other producers to secure consistent (and even increasing) production. Given these factors, we feel the outstanding yields on these short-term bonds outweigh the risks identified.
Commodity price volatility is also present. Both oil and natural gas have experienced steep price declines, both commodities bottoming out in Q1. Vanguard has smartly hedged a vast majority of both its oil and natural gas production for 2016 (discussed earlier) and nearly three-quarters of its natural gas production for 2017, which should help to even out revenue. However, at the current time, only 23% of 2017 oil production has been hedged.
Vanguard will have another redetermination this fall. If the company’s borrowing base is adjusted down at that time, this would further impact cash flows. In addition, the company may consider additional asset sales to meet the reduced borrowing base, which would impact current and future production.
Summary and Conclusion
Vanguard admirably increased its adjusted EBITDA year-over-year in Q1 2016 in spite of the worst oil and natural gas prices in recent history. In Q4 2015, it was part of two mergers that helped to boost its production in Q1, 21% over Q1 2015. It swapped a portion of its current debt, which has reduced its annual interest expense by almost $8.0M. Its hedging program for most of its 2016 production and a good majority of its 2017 natural gas production will help keep cash flows consistent while management continues making progress on strengthening the company’s balance sheet. Oil and natural gas prices appear to be making a recovery. With Vanguard’s increased production, these price increases should also increase revenues and profits. Investors looking to increase portfolio return should consider Vanguard’s deeply discounted Eagle Rock 2019 bonds, currently indicating a whopping 47.75% yield to maturity. Therefore, we think these 35 month bonds, couponed at 8.375%, make a superb addition to our Fixed-Income1.com and Fixed-Income2.com global high yield income portfolios.
Issuer: Eagle Rock Energy Partners (now a part of Vanguard Natural Resources, LLC)
Yield to Maturity: ~47.75%
About Durig Capital
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Disclosure: Durig Capital and certain clients may have a position in these Eagle Rock Energy 2019 bonds.
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