Legacy Reserves (NASDAQ:LGCY) announced earlier this week that it was forming a strategic alliance with WPX Energy (NYSE:WPX). It's a unique deal for a number of reasons. Let's take a closer look at the deal, and how it might have a game-changing impact on other oil and gas MLPs like Vanguard Natural Resources (NASDAQ:VNR).
Drilling down on the deal
Legacy Reserves is picking up a working interest in 2,730 of WPX Energy's natural gas wells in the Piceance Basin for $355 million in cash, and 10% of Legacy Reserves' newly created Incentive Distribution Units, or IDRs. The deal gives Legacy Reserves an initial working interest of 29% in those wells. However, its working interest will increase to 37% the first of next year, and to 41% on the first day of 2016. As the following slide shows, these are natural gas rich assets, which have a fairly stable production profile, making them solid assets for an MLP.
As mentioned, the Piceance Basin assets have a very low decline in production, with an average decline rate of 10% per year. However, as the graphic in the lower right-hand corner noted, the working interest escalations will keep the production decline to a minimum. That makes this an exceptional asset to add to Legacy Reserves' portfolio, and will go well with the company's earlier acquisition of low-decline oil properties.
The other important aspect of the deal is the inclusion of the IDRs, which WPX Energy is receiving in addition to cash. IDRs are pretty common among midstream MLPs, but oil and gas producing MLPs have typically avoided these payouts, as well as the general partners who typically own the IDRs. One of the reasons for this is the fact that these payment streams can have a big impact on an MLP's ability to grow its distribution. That being said, Legacy Reserves is taking the IDRs in a different direction, as it's keeping 70% of its newly created IDRs because it has an interesting new idea on how to use the payment streams to fuel future growth.
What the alliance means for oil and gas MLPs
Instead of lining the pockets of its general partner or its management team, the company plans to use its IDRs as an acquisition currency. WPX Energy, for example, can eventually earn up to 30% of the IDRs by completing additional drop-own transactions with Legacy Reserves. As the following slide notes, WPX Energy can vest 10,000 IDRs for every $35.5 million in deals it completes with Legacy Reserves.
This will enable WPX Energy to sell down some of its MLP-type assets without needing to create its own MLP. It makes its capital structure less complex, as it can cash in from the value uplift of selling to an MLP without having to be bothered with managing one. Yet, at the same time, the IDRs enable it to benefit as Legacy Reserves continues growing.
Further, Legacy Reserves will hold on to the 70% of IDRs it's not issuing to WPX Energy. It can then use these as a currency to buy assets in the future. Given the exchange rate with WPX Energy, this represents nearly $2.5 billion in capital that it can use to buy third-party assets, in addition to the more than $700 million in assets it should acquire from WPX Energy through future drop-down transactions. For a company with a $1.5 million market cap, that's a lot of growth capital.
This alliance really could be a game changer for the oil and gas MLP sector, which continues to have a voracious appetite for oil and gas deals. The problem is that appetite is capital constrained, which has these companies looking at every possible option to raise new capital. Vanguard Natural Resources, for example, has been using Preferred Units to raise cash to help pay for its acquisitions. Last year the company raised more than $200 million selling these Preferred Units to help pay fund acquisitions, while it raised more than $175 million again this year through a second public offering of Preferred Units. That said, it's always on the lookout for creative new ways to raise money to fund its next deal.
If Legacy Reserves finds success using its IDRs as a viable acquisition currency, we can almost guarantee that peers like Vanguard Natural Resources will follow suite and issue IDRs to fund growth. The non-dilutive nature of the IDRs, which is what drew Vanguard Natural Resources to Preferred Units, could enable these companies to acquire additional assets to boost distributable cash flow, without impacting the number of ordinary units outstanding.
The IRS is allowing MLPs to line your pockets with cash
Companies like Legacy Reserves and Vanguard Natural Resources are using a small IRS "loophole" to help line the pockets of investors like you with cash. It's a tax strategy you need to know, which is why we're offering you more details about it in our special report, "The IRS Is Daring You To Make This Energy Investment." Don't miss out on this timely opportunity; click here to access your report -- it's absolutely free.
Matt DiLallo has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.