Breitburn Energy Partners LP (NASDAQ:BBEP) reported [Source] financial and operating results for the fourth quarter 2014 (4Q14) and full year 2014. It was a good quarter and full year especially in light of the sharp decline in crude oil and natural gas prices since mid-year 2014. The company’s management team is experienced and has navigated successfully through turbulent cyclical downturns before. They are on track to do it again; operationally it was a good report and with respect to our investment thesis, very encouraging.
As a brief recap, our investment in BBEP was initiated when the company’s unit price dropped almost 75% from the $20/unit range to around $5/unit at the time of purchase. BBEP’s income oriented investors feared the Breitburn distribution would be cut or suspended with the sharp drop in crude oil prices as it was during the financial crises. That’s what the company did, announcing [Source] the monthly paid distribution would be reduced from $2.08 per year to $1.00 per year and 2015 capital expenditures would be reduced to $200 million. These measures were needed for financial flexibility during the crude oil price downturn and for the debt service associated with the recent QRE acquisition.
The basic premise of investing in BBEP is Mr. Market, prone to make mistakes assessing probabilities often leads to misperceptions and mispricing. We believe it has done so with BBEP. These misjudgment create opportunities for value investors because the market will eventually correct the misperception. The misperceptions with BBEP include: (1) crude oil prices will remain low (for a long period of time), (2) the distribution may be further cut, suspended, or even eliminated, (3) the line of credit used for the QRE acquisition will force their creditors to take measures detrimental to the company and equity holders, and (4) financially strapped, BBEP will not be able to offset the steep crude oil decline rates experienced by tight oil producers and widely covered in the media. We’ll address each of these misperceptions later below.
As equity holders we stand first in line to suffer the downside, but if Mr. Market is wrong, we are also first in line as equity holders to benefit from upside. That is the essence of value investing; and we’re often going against the herd. Sure, BBEP’s equity is distressed but we believe the current price is well below the likely fair value offering us a margin of safety. While our thesis plays out, good operations and prudent management is needed during these turbulent times so let’s cover the results first.
Halbert S. Washburn, Breitburn’s Chief Executive Officer, was encouraging as he summarized the 4Q14 and 2014 results this way (underline is ours added for emphasis):“Our recent acquisitions changed the nature of our portfolio, solidifying and expanding our presence in the Permian, the Mid-Continent and Ark-La-Tex, some of the most prolific oil and gas regions of the country. We announced a substantially reduced capital program of $200 million for 2015, and we remain focused on operating within our cash flow this year. With more than half of our production coming from the Permian, the Mid-Continent and Ark-La-Tex, we plan to allocate a large portion of our capital this year to these areas. Based on our operating results sofar this year, we feel comfortable with our 2015 guidance issued on January 2nd. At the midpoint of that guidance, we expect to generate approximately $80 million of excess cash after distributions and capital spending and have a DCF coverage ratio ofapproximately 1.35x. We are focused on reducing all costs wherever we can, and we will continue to look for every opportunity to maximize operational and financial flexibility.”
- Closed on the acquisitions of QR Energy and strategic bolt-on acreage in the Permian Basin for approximately $2.7 billion, including debt assumed.
- Increased fourth quarter 2014 production to 4.2 million Boe, a 35% increase from fourth quarter 2013, and increased full year production to 14.1 million Boe, a 29% increase from 2013. Excluding production from QR Energy assets, Breitburn’s production increased 6% in the fourth quarter 2014 compared to fourth quarter 2013 and 20% for 2014 compared to Annual production was in line with the forecast in Breitburn’s third quarter Form 10Q.
- Increased Adjusted EBITDA, a non-GAAP financial measure, to $127.4 million (including acquisition and integration costs of $11.7 million), a 7% increase from third quarter 2014. Increased full year Adjusted EBITDA to $473.8 million (including acquisition and integration costs of $14.5 million), a 28% increase from 2013.
- Total estimated proved reserves as of December 31, 2014, were 315.3 million Boe compared to 214.3 million Boe as of December 31, 2013, a 47% increase.
- Total oil and gas capital expenditures for 2014 were $389 million, a 32% increase from 2013. Excluding capital spending of $25 million attributable to QR Energy assets, 2014 capital spending was within the range that was forecast in Breitburn’s third quarter Form 10Q.
BBEP 4Q14 Press Release [Source]
Total Production and Sales in Thousand Barrel Oil Equivalents (MBoe):
Adjusted EBITDA or Earnings Before Interest Taxes Depreciation and Amortization is a commonly used metric in the oil industry to measure cash flow. It provides a measure of the performance of the company’s assets, without regard to financing methods or capital structure and is a measure of the company’s ability to service debt. It is a measure used by the company and will be used in our assessments of BBEP going forward.
Distributable Cash Flow:
Distributable Cash Flow (DCF) is a measure of the cash distributions that couldpotentially be paid to unitholders. This metric shows if the company is generating sufficient cash flow to support the distribution rate to unitholders and is another measures used by the BBEP. We will be use it in our assessment of the company going forward as well. The distribution coverage level in the table below reflects the coverage before the distribution cut was made. It illustrates why the cut was needed. Management estimated the current coverage based on the lowered $1.00/unit distribution is 1.35x.
2015 Outlook [Source 10K]:
“We expect our full year 2015 oil and gas capital spending program (which now encompasses the assets we acquired in the QRE Merger) to be approximately $200 million , including capitalized engineering costs and excluding potential acquisitions, compared with approximately $389 million in 2014 . The reduction in capital expenditures reflects our outlook for 2015 performance measured against the ongoing weakness in commodity prices. In 2015, we anticipate spending approximately 87% principally on oil projects in Mid-Continent, Ark-La-Tex, Florida and the Permian Basin and approximately 13% principally on oil projects in California, the Rockies and MI/IN/KY. We anticipate 87% of our total capital spending will be focused on drilling and rate-generating projects and CO2 purchases that are designed to increase or add to production or reserves. We plan to drill 61 wells in Mid-Continent, Ark-La-Tex, Florida and the Permian Basin. We expect our 2015 production to be between 19.5 MMBoe and 20.7 MMBoe.”
The Misperceptions: Our investment thesis is Mr. Market has misjudged the company and created an opportunity for value investors. Eventually a capable management team and the market will correct these misperception:
Misperception 1: Crude oil prices will remain low.
Energy industry fundamentals have not changed. What has changed is the OPEC cartel (led by Saudi Arabia) has decided not to intervene to bring an over supply back into balance by cutting production. It is a change for the better and will allow market fundamentals, not politics in the cartel, to prevail. North America tight oil (shale oil) producers are now by default the marginal crude oil suppliers. They added six million b/d of crude oil and condensate over the past few years contributing to the oversupply in the world market. All other crude oil supply increases combined were just about sufficient to help offset demand growth and the natural 4-5% per year decline in conventional crude oil sources.
As marginal cost producers, and by default, swing producers the tight oil producer must adjust to supply and demand imbalances first. At today’s crude oil price levels their breakeven price for new oil is not met. Tight oil producers are being forced to respond quickly to these crude oil price signals, if not willingly, forcibly as their lenders and investors will demand. Drilling will decline and the fast decline rates characteristic of tight oil wells will reduce production until prices return to more sustainable levels.
Tight oil producers have relatively quick response times (months vs. years) because new drilling programs can be initiated within months to add supply; and the 60-90% first three year decline rates will subtract relatively fast from supply once drilling stops. This enables supply and demand adjustment to occur much faster than in the larger conventional reserves with multiyear projects typically needed to bring new sources of crude oil online.
The graph below shows the number of active oil rigs in the U.S. has declined from about 1600 in mid-September 2014 to 986 at the end of February 2015 for a 38% decline in about 24 weeks. The U.S. Energy Information Administration (EIA) current report [Source] shows overall crude oil production growth declined from an increase of about 108,000 barrels per day from January to February to about 67,000 barrels per day from February to March or about a 38% decline in the growth rate. We expect this growth to change to a decline shortly as the high rate of depletion characteristic of tight oil supplies surpasses new oil added due to the slower rate of drilling.
U.S. Onshore Oil Rig Count:
Information [Source] Baker Hughes
Implications for our investment in BBEP:
The time required to “adjust” crude oil supplies and the subsequent change in the price of crude oil has shorten considerably. It is likely a recovery to the probable range of $70-90/bbl., will be sooner than many anticipate because the shorter reaction time, perhaps as soon as 6 to 18 months.
A Notional Pricing Model with Tight Oil as the Marginal Cost Crude Oil Supply:
Misperception 2: the dividend may be further cut, suspended, or eliminated. BBEP’s hedging program and quick response with conservation measures during the cycle downturn will likely preserve the existing distribution level through 2015. Management’s outlook remains essentially unchanged from when the new distribution level was determined. Things can change however and if the distribution is cut or suspended, it would certainly be a temporary measure, as it was during the financial crises.
During the conference call management indicate their top priority is to maximize the distribution at a prudent level. It is encouraging to hear they are working to balance the resources of the company through this difficult period while keeping unit holder’s income a priority. In response to an analyst question, CEO Hal Washburn responded;“…we expect to generate approximately 80 million of excess cash after distributions [and] capital spending. Based on our operating results so far we feel comfortable with our 2015 guidance as we navigate through this down cycle we’re also very focused on maximizing Breitburn’s operational and financial flexibility.”
Misperception 3: The line of credit used for the QRE acquisition will force their creditors to take measures detrimental to the company and equity holders. In the company’s 2014 10K SEC Filing [Source] and during the conference call management addressed this issue. From the filing: “Based upon current commodity prices and other factors at the time of future redeterminations, we expect our borrowing base to bedecreased. Without a waiver from our lenders, our credit facility currently provides that if the borrowing base is reduced below our current outstanding borrowings, we are required to repay the deficiency in five equal monthly installments. We continue to evaluate the public and private markets for capital raising opportunities to reduce borrowings under our credit facility in advance of the April 2015 redetermination.Although our lenders have the discretion to redetermine the borrowing base below our outstanding borrowings, we do not expect that to occur.”
The line of credit is based on SEC classified Proved Developed Producing (PDP) and Proved Developed Non-Producing (PDNP) reserves. It was renewed in November with the QRE acquisition for a total of $5.0 billion of which $2.5 billion is currently authorized and $2.2 billion used (primarily for the QRE acquisition). Wells Fargo (WF) is BBEP’s banker and there are about 30 lenders in the credit syndicate so no one lender is determinate. WF has been BBEP’s banker for 20+ years including the financial crises when BBEP was a much smaller company. They reduced the line of credit (only) 15% in a more sever environment.
The outcome of the line of credit re-determination will likely be negotiated not dictated as BBEP has and continues to be proactive with WF. The lenders have the sole discretion in this matter but it is in the interest of both parties, the lenders and borrowers to work cooperatively through this cycle downturn as they have many times in the past. These relationships between lenders and borrowers are more often business partnerships than adversarial in nature.
Importantly, this is an industry wide issue not a company specific issue, helping to assure a cooperative approach by the lenders. The lenders who use their own crude oil price deck for forecasting are unlikely to downgrade their entire O&G loan portfolio with a harsh over reaction to what may well be a transient issue. Further, BBEP line of credit has an EBITDA coverage ratio of 2.5x which it well exceeds at about 4-4.5x based on management’s 2015 outlook volume and the company’s reserves remain economical at current crude oil price levels for the most part.
Misperception 4: BBEP will not be able to offset the steep crude oil decline rates by tight oil producers widely covered in the media. The news stories of smaller “tight oil” companies potentially going bankrupt are likely true for oil producers requiring continued drilling to offset the steep decline curves of 65-90% in the first three years to maintain cash flow and pay loans. BBEP is not a tight oil company but a conventional production company with an estimated 15+ years of production and the slower decline rates typical of conventional fields. Ironically the tight oil producers dilemma, these steep decline curves, will help make this crude oil over supply (and price downturn) shorter lived than those of the past and make BBEP’s hedge position over the next two years more reassuring.
BBEP’s management team is experienced with industry cycle downturns, they’ve been here before, and remain focused on the key priorities of operations and capital management. It is encouraging to see open and honest communications from management and their view of key stakeholders including lenders and unit holders. Management’s openness is always beneficial in assessing our thesis progress, the investment thesis remains on track, and at today’s prices still offers an attractive entry point.
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