Investing

Eagle Rock Energy (EROC) is an oil and gas Master Limited Partnership (MLP). The partnership is ultimately run, managed and partially owned by Natural Gas Partners out of Texas. They operate an

• Upstream - acquiring, developing and producing interests in oil and natural gas properties
  
• Midstream - gathering, compressing, treating, processing and transporting and selling natural gas and natural gas liquids
  
• Minerals - acquiring and managing fee mineral and royalty interests either directly or in partnership with others.

EROC is worth between 5 and 8 dollars and is currently trading for about 3.

Limited Partnerships
Owning a limited partnership is different to owning shares in a company. For example, as a limited partner you are responsible for paying taxes on the partnership earnings, regardless of whether or not you actually receive distributions (equivalent of dividends). MLPs are generally created to distribute most or all of their earnings to the limited partners. Therefore buyers of MLP units are generally seeking the high yields available.

Distributions
In April 2009 EROC announced that instead of a distribution of 41c (around 11% average yield in 2008) per unit received in 4Q 2008 that distributions would be cut to 2.5c. This was done to conserve cash to pay down debt over the next couple of years in recognition of the changed environment for debt. Eagle Rock has a nearly $1Bn credit line which had $837M drawn as of Q1 09.

Covenants
Covenants are the rules which the company must stay in compliance with, to keep their loan (i.e. you violate a covenant then the bank can demand their money back).

There is a unique arrangement when it comes to covenants for the EROC lines. They effectively have two buckets that their total loan can be distributed against. One bucket is attached to the value of their upstream business. The size of the bucket is re-evaluated twice yearly and is based on the current value of the upstream business in turn based on commodity prices. As commodity prices rise the borrowing base rises and more of the loan can be allocated to this bucket. Conversely as commodity prices fall, the borrowing base falls and less of the loan is allocated to this bucket. This bucket has a very easy covenant that the company is well within so they want this bucket to be as big as possible.

The second bucket is for the rest of their loan. It is notionally attached to their midstream and minerals business. The size of this bucket is not recalculated. It simply contains all of their debt that isn't captured by the upstream bucket. The second bucket (the midstream & minerals bucket) has much tougher covenants. Therefore the company would like this to be as small as possible.

In March 2009 the upstream bucket borrowing base was $206M. In April it was resized to $135M. Effectively growing the size of the other bucket.

The upstream covenant is defined in EROC's credit agreement (available on EDGAR) as Consolidated EBITDA divided by Consolidated Interest Expense. This was 6.0 as compared to a minimum covenant of 2.0. This is the easy one.

The other covenant, on the midstream & minerals business, is defined as Total Funded Indebtedness divided by Adjusted Consolidated EBITDA. This was 4 in Q1 09 versus a maximum of 5. As the companies' EBITDA falls as a result of lower commodity prices then the denominator falls and the ratio rises. By late April it had risen to 4.4. There are only two ways to stay within this covenant. Decrease debt or increase EBITDA.

The company recognized that they were going to have an upcoming problem, if they didn't reduce debt, based on futures prices for natural gas and oil. In fact with their current hedges it was likely that they would violate this covenant by the end of 2009. They are safe earlier in 2009 because EBITDA is calculated on a rolling 12 month basis so they still received the benefit from 2008.

EROC determined that they would like the ratio to be closer to 3 to 3.5 which with Q1 2009 EBITDA is a reduction of around $260M - $340M. Q1 2009 EBITDA was helped by high hedges but hindered by lower volumes and very poor commodity prices. For the rest of 2009 they expect to make around 40-45M in adjusted EBITDA (their cash flow measure) which will allow them to pay off 75-100M in debt in 2009. Based on a simple model of their EBITDA versus debt it is unlikely that they will violate this covenant in 2009. The problem, at face value, is in 2010.

With current hedges assuming a drop in 2010 earnings commensurate with the drop in their hedge prices (2010 will be 77% of 2009) EROC will earn Adjusted EBITDA of 32-35M per quarter in 2010. This could cause a covenant violation depending on exactly where they end up in the range. The violation would likely occur in Q3 2010.

2011 futures prices are similar to EROC's 2010 hedges so there will not be a further drop off in 2011.



Covenant violations end up being a moot point because the bank covenants are based on EBITDA. Earnings before Interest, Tax, Depreciation and Amortization.

The money paid for EROC's hedges is amortized. Therefore in the EBITDA calculation it isn't counted. This allows EROC to purchase in the money hedges, realize the increased price received from the in the money hedges while ignoring the cost of purchase.

EROC entered just such a transaction in January 2009. They reset their 2009 hedges higher. The actually paid cash to buy higher hedges. In turn they will receive higher payments for their product. In the calculation of EBITDA, only the higher payments will be recorded. They said this was the purpose of the transaction on their conference call.

WHILE EROC HAS CASH OR CREDIT AVAILABLE TO PURCHASE IN THE MONEY HEDGES, THEY CAN PERMANENTLY AVOID VIOLATING BANK COVENANTS.

This may sound unbelievable but it is true. EROC need only reset some mid to late 2010 hedges higher and they will avoid violating their covenants. As this isn't a particularly good use of cash (at least not in the absence of bank covenants) they will wait until they see how 2009/ early 2010 is looking before they commit cash to resetting their hedges. It looks like $5m worth of in the money hedges would push them over the line.

In the worst case of a covenant violation, it's possible that EROC would end up having to pay higher interest expenses on an amended credit line rather than being forced into bankruptcy.

Valuation
There are some more unique features to EROC. Firstly the units are entitled to a minimum quarterly distribution (MQD). For every quarter that you don't receive the MQD the unit acquires an arrearage for that amount.

EROC has about 50M LP units and the manager of EROC, Natural Gas Partners, owns 20.7M subordinated units. These can convert into 20.7M LP units after all arrearages are cleared. Therefore the manager is highly incented to convert their subordinated units into a nearly 30% ownership of EROC worth around $90M. However, before they can realize that $90M+ they need to pay out all arrearages. This is achievable over a number of years.

Valuing EROC is based on discounting future dividends at EROC's cost of capital. Using 17.5% for 2009 & 2010 and then 12.2% as the discount rate. Along with distributions of 8c in '09 & '10 followed by $1.45 (the MQD) increased at 3% per year until year 20. Then from 20 to 25 decreasing at 10% per year. This leaves you with a value of $7.66.

A key assumption is the amount that EROC can pay in 2011 onwards. This model assumes that the 2010 cashflow (33M per quarter EBITDA/ 131 per year) is their sustainable level. That is $67 oil and $6.9 gas. As energy prices exceed these levels then EROC's value increases.

Expectations for 2009 EBITDA are about 170M based on $90 oil and $7.40 gas. If these are the 2011 reality then 2011 distribution could be around $1.75 leading to a value closer to $8.90.

EROC is currently trading at $3 and has been as low as $2.65. It's likely that you're offered 155% upside because the original holders of EROC have been selling. These holders wanted a high, consistent, yield. Those buying EROC now are value investors. Once certainty develops over the 2010 covenants, EROC is likely to trade higher.