BreitBurn Energy Partners L.P. Risk & Reward Turns Unfavorable: Time to Exit

Management characterized EIG’s investment as strategic and anchoring a comprehensive plan to materially enhance liquidity, visibility, and strategic capability consisting of the following points:

• BBEP will sell $350 million of convertible preferred units to EIG at a price of $7.50/unit with an 8% annual distribution convertible to common units at the option of the holder after three years.
• BBEP will also sell $650 million senior secured notes to EIG with an annual interest rate of 9.25%, secured on a second priority basis and subordinated to the credit facility collateral.
• The credit facility up for redetermination in April 2015 will be amended to reset the borrowing base from $2.5 billion to $1.8 billion through April 2016.
• BBEP will repay the credit facility, resulting in net borrowings, at closing of approximately $1.24 billion providing about $560 million liquidity.
• The common unit distribution will be reduced to $0.50/unit on an annualized basis, down from $1.00/unit.
• Kurt Talbot, Vice Chairman of EIG will be added to the Breitburn’s Board of Directors.

Our investment thesis is based on total return over a two to five year horizon. This solves the near term liquidity challenge of the April 2015 credit facility redetermination, although not what we had in mind.

We also assumed crude oil prices will recover sooner than many expect and to a level that offers promising returns to BBEP’s common unit holders. Fortunately BBEP’s hedge book continues to provide some margin of safety over the 2015-2016 period while we wait for crude oil prices to recover. However let’s look at where things are and the potential impact of EIG’s cash infusion on our investment thesis.

April Redetermination:

You will recall BBEP acquired QR Energy LP (NYSE:QRE) in a transaction valued at about $3.0 billion raising BBEP’s credit facility borrowings to $2.1 billion and approaching the approved credit limit of $2.5 billion. The transaction occurred in late 2014 when crude oil prices were dropping. This raised concerns on how BBEP’s lenders would react in the new crude oil price environment. Would it be detrimental to common unit holders?

The EIG proceeds of approximately $938 million will be used to repay borrowings under the credit facility, resulting in net borrowings of approximately $1.24 billion. The credit facility is revised to a borrowing base of $1.8 billion through April 2016 providing about $560 million of additional liquidity. The details of the EIG investment are released in the April 2 SEC Form 8 filing [Source].

Strategic Partner:

Hal Washburn, Chief Executive Officer of Breitburn commenting on the EIG investment said in part;

“The steps that we have outlined today, along with…reductions to our operating expenses and G&A, will substantially increase our distribution coverage and better position us for long-term value creation, as we believe we can reinvest this additional liquidity at higher rates of return in the current environment.”

BBEP appears to also gain a strategic partner willing to invest $1 billion when few others were interested. “We are excited to partner with a management team for whom we have great respect,” said R. Blair Thomas, Chief Executive Officer of EIG. “We will work with Breitburn with the goal of creating significant value and distribution growth for unitholders given the substantial liquidity our investment will provide and the growth opportunities available in the current market environment.”

Timing of Crude Oil Price Recovery Remains Uncertain:

Energy industry fundamentals have not changed but what did was the OPEC cartel decision not to bring the oversupply of crude oil back into balance by reducing their production and market share to the benefit of others. That change makes the North America tight oil (shale oil) producers, by default, the marginal crude oil suppliers.

Over the past few years the tight oil producers increased crude oil production by about six million barrels per day contributing to the oversupply in the world market. All other crude oil supply increases combined, were just about sufficient to help offset tepid demand growth and the natural 4-5% per year decline in conventional crude oil sources.

The tight oil producers have relatively quick response times because new drilling programs can be initiated within months and wells completed in weeks adding to supply. The high 60-90% first three year decline rates will reduce supply faster than conventional fields once drilling stops.

Today’s price levels do not meet tight oil producer’s breakeven price for “new oil.” The North American drilling rig count is falling rapidly. At some point the high decline rates of tight oil will surpass the additions of new oil to show net production declines. There is no precedent with tight oil response times so this adds to the usual uncertain timing of crude oil price recovery.

Crude oil prices

We believe it likely that crude oil prices will recover to a range of $70-90/bbl., sooner than many anticipate because the shorter reaction time, perhaps as soon as 6 to 18 months. We are in unchartered waters with tight oil producers as the marginal suppliers and the geo-political events around the world, many that could impact crude oil prices for better or worse.

Our initial investment in BBEP (1/21/2015) was at a time when management announced [Source] a distribution and capital program reduction along with guidance for the full year 2015. The distribution reduction was from $2.08/unit to $1.00/unit annually, a necessary but unpopular move with income investors and the price got crushed. We felt the market reaction was overdone with the reduced $1.00/unit annual distribution to be in place through 2015. Our two year valuation was based on the distribution continuing at that level through 2016 by which time crude oil prices would likely recover.

We were further encouraged when BBEP’s 4Q14 financial and operating results were announced on 3/3/15 [Source] and management’s comments on the previously announced full year 2015 guidance in part were:

“…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 of approximately 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.”

Cumulative Impact of the EIG Investment

While we believe the EIG investment to be an important step toward resolving BBEP’s near term liquidity issue, we also think the EIG investment has significantly changed the nature of the investment for common unit holders.

Size of Capital Infusion:

It appears management may have been too optimistic on the magnitude of capital required for the April redetermination of the credit facility. During the 4Q14 conference they commented in part; “…Although our lenders have the discretion to redetermine the borrowing base below our outstanding borrowings, we do not expect that to occur.” However, the then existing borrowing base of $2.1 billion was reduced to $1.3 billion or about $800 million lower.

Distribution Cut

The magnitude and cost of the capital raise was our first surprise and led to the next surprise; a second distribution reduction from $1.00 to $0.50/unit within months. During the 4Q14 conference call, management indicated their top priority was to maximize the distribution at a prudent level so it seemed the new distribution level was safe. Hal Washburn, Breitburn’s Chief Executive Officer, seemed to reinforce this in the 4Q14 conference call discussing the 2015 guidance (that included a $1.00 distribution through 2015): “so far this year 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.”

From Equity Holders to EIG

Equity holders are always in line behind debt and preferred unit holders. The second distribution cut of about $105 million per year more than offset the annual cost of the capital infusion from EIG and contributed to liquidity as well.

Distributions on the newly issued convertible preferred shares are $28 million per year and interest on the newly issued senior notes about $60 million per year.  This is partially offset by the credit facility interest reduction of $23 million per year for a net increase of about $66 million per year.

Potential Dilution

The third surprise is the potential issuance of equity at these prices through EIG’s preferred unit conversion. EIG’s preferred units will pay monthly distributions at 8% per annum in cash or additional preferred units at BBEP’s option for the first three years and in cash thereafter. After three years, the preferred units will be convertible at the option of the holder and by BBEP under certain circumstances. The newly issued preferred units will vote on an as-converted basis with BBEP’s common units with a combined voting interest of approximately 18%.

If converted, the common units outstanding will increase about 18% from 210 million units to 256.6 million units. If BBEP elects the option to pay the preferred distribution with shares, it would add another 11.2 million units convertible to common units for a total of 57.8 million units raising EIG’s equity position to 21.6%.

EIG’s potential conversion to common units on the one hand align their interests with common unit holders over time. They also paid $7.50/preferred unit or a premium of about 27% over the BBEP common unit’s $5.90 pre-announcement closing price. But at EIG’s cost of $7.50/preferred unit and today’s estimated book value of about $16.90/unit EIG stands to gain about $346 million over their cost of $350 million for almost a 100% return over three years excluding the distributions they received. Although the book value will surely change it is clearly a very expensive capital infusion.

The Impact

The table below summarizes the impact of the distribution change and EIG’s capital infusion on our investment thesis. The intent here is to quantify on an order of magnitude basis the sensitivity of the investment thesis to these changes.

Keep in mind during 2015 approximately 75% of BBEP’s liquids production is hedged at an average price of $93.51/bbl. and 71% of BBEP’s natural gas production is hedged at an average price ofo $4.98/mscf. For 2016 approximately 64% of liquids production is hedged at an average price of $89.01/bbl. and 56% of BBEP’s natural gas production is hedged at an average price of $4.25/mscf providing a time buffer.

The “Guidance” columns below show the company’s full year 2015 guidance. The “1/2/2015” column is the provided guidance and basically our investment thesis. The “Dist. Adjusted” column, is the impact that the distribution reduction only would have had on the guidance. Both Guidance columns represent 2015 guidance hedged and unhedged prices and volumes over a full 12 month period.

The “Post EIG” columns looks forward three years and assumes the midpoint of our probable crude oil and natural gas price range. It estimates the impact of the EIG capital infusion with Brent crude oil at $80.00/bbl., natural gas at $4.25/mscf, and relative price differentials. In effect it assumes new hedges by BBEP are at these prices.

The “w/o conversion” column assumes EIG’s preferred distributions are paid in cash for the first three years. The “with conversion” column assumes EIG’s preferred distributions are paid in cash the first three years and then EIG converts the preferred units to common units.

The following table shows the impact of the above on BBEP’s valuation and potential returns at today’s price of about $5.60/unit.

Key Observations:

1. Under these energy price assumptions it appears difficult for BBEP to maintain the recently reduced distribution at $0.50/unit.
2. A key step toward BBEP’s recovery is reducing debt. BBEP’s debt is about $3.7 billion, debt to equity is about 0.9 compared to the 0.6 industry average.
3. At our probable price range a distribution suspension is required for modest debt reduction.
4. Upstream MLPs rely on external financing to fund acquisitions and grow distributions. Unfortunately, BBEP acquired QR Energy at the top of the market, exhausted its credit lines, and the resultant low equity price makes it very expensive capital.
5. The cost and terms of EIG’s capital infusion implies BBEP’s guidance has been overly optimistic in the assessment of the company’s prospects. Is this continuing?
6. EIG is in a strong position and could take more control from equity holders before deleveraging can occur. The preferred conversion rights is a signs it may already be underway at bargain prices.
7. Upstream MLP’s require good distribution coverage and access to capital for growth, BBEP has neither good coverage nor access to reasonable capital.
8. BBEP equity is risky and it appears most of the upside potential and the margin of safety we require has shifted to the debt holders.

Summary

As a value investor the energy industry is a good place to be looking because most companies are likely selling at a discount to their intrinsic value, but not all. We recognized the uncertainty with BBEP but was comforted with the offsetting upside potential and significant margin of safety. Investments with high yields and potential outsized capital gains always have a downside that requires constant attention.

This uncertainty is what creates the potential for outsized gains but also requires us to constantly monitor the investment. As new information becomes available as with BBEP, especially if it’s contrary to our thinking, further analysis is required along with a large dose of humility.

Exiting the Position

We can never be certain of our decisions, because they are based on incomplete information and assumptions. In this case with the margin of safety evaporated, the risk seem to be increasing, the rewards decreasing and equity dilution a real prospect. We are selling all BBEP common units for a total return of about 11% (consisting of 7.9% in gains and 3.2% in distributions) and looking for better risk adjusted returns.

Disclosures: Long BBEP and BBEPP