Vanguard Natural Resources (NASDAQOTH:VNRSQ) isn't your typical oil and gas producer. Instead of being the typical wildcatter looking for undiscovered oil, Vanguard is happy to take another company's already producing mature assets off of its hands to allow it to pursue new growth opportunities. For Vanguard, that translates to stable, predictable production numbers for investors in the space who are more concerned with stable cash flow. For Vanguard to be successful with this type of strategy, it needs to be able to continually secure mature assets at good valuations and consistently find access to the capital markets.
To better understand how Vanguard is able to achieve this goal, I sat down with Vanguard's chief financial officer, Richard Robert. He took the reins as CFO in 2007, originally as part of Encore Energy Partners, which merged with Vanguard in 2011. In the following video, Robert and I discuss some of the critical aspects of Vanguard's business, including how it approaches mergers and acquisitions, access to the capital markets, and a broader conversation on the oil and gas environment today.
A full transcript follows the video.
Tyler Crowe: Hi, Fools, Tyler Crowe here with Richard Robert, chief financial officer of Vanguard Natural Resources. Mr. Robert, thank you very much for being with us today.
Richard Robert: My pleasure.
Crowe: We just wanted to get started a little bit. A lot of people, our investing community, a lot of our readers will understand Vanguard Natural Resources as an upstream oil and gas producer.
But obviously you guys are much more unique than that as a master limited partnership as well as in the upstream space. So if you could just kind of walk us through how you guys have carved out the position in that space and what is the strategic advantage of being a master limited partnership as an upstream producer.
Robert: Sure, yeah. That's true we have carved out a little niche for ourselves. We do serve a very particular purpose, and that is we serve as a financing source, essentially, for the C-corps. They tend to outspend their cash flow year in year out, and as they do that, they need to find financing sources, whether it be selling assets or raising common equity, or debt, and oftentimes what they choose to do is to sell their mature assets, their lower growth assets to companies such as ours.
Their investor base has a certain desire for growth, production growth, historically, and our investor base has a different desire, and that is stability in cash flows. And so to the extent that they want to raise capital to fund their development, they sell those more mature assets to us, and it's essentially an energy cycle. They develop the assets; once they've reached a certain maturity point, they sell them to us at a good valuation, and they then take those funds and redeploy those in high-growth assets and the cycle continues.
Crowe: Sure, so just from your guys' standpoint, what do you feel are the benefits of the growth through acquisition like you just explained, versus kind of the growth through the drillbit that we see a lot of other producers do?
Robert: Well, I mean, ours is, I guess, a less risky approach to growing. We buy assets that are typically already producing, so we know what we're buying; we understand what the cash flows are expected to be. And so we can create a cash flow profile that is relatively stable, as compared to a C-corp who has to go out and actually drill wells. And it's still a science. It's not guaranteed results, and so when you're buying already producing wells that are very mature and there's lots of data, you typically know what you're getting. And so we're creating, I guess, a less risky profile than your typical C-corp.
Crowe: OK, so when you're looking at mature properties, like you said, something that's already producing, what are some of the big characteristics that you are looking for in those properties?
Robert: Well, I mean, largely maturity production, high PDP wedge; if there is some undeveloped acreage typically we're not paying anything or much for it, because in this type of environment typically it's hard to make a decent return on most areas. And so you're getting a free option when you're getting the undeveloped acreage with the already producing assets.
So we're looking for high PDP wedge, stability, we're also looking for the infrastructure being built out. That's a problem in a lot of high-growth areas, is the infrastructure hasn't been built out yet. The nice thing about these mature assets is there's more than enough infrastructure to move the production that's being handled.
So we may be paying a lot for transportation initially because of the legacy transportation contracts that were in place that we acquired. But the good news is once those contracts terminate or go through the expiration date, we're going to have a lot of optionality as to where to take our gas without paying a large transportation fee. Like we did today, unfortunately.
Crowe: Yeah, and certainly having that optionality has been shown as a way to be very valuable with so many different venues going on.
Robert: It is.
Crowe: Especially down in, like, where we are in the Houston area, with all the growth that's going on in manufacturing and exports, and things like that.
Robert: Sure. Yeah, no, you need different outlets, and that is really one of the nice things about the mature production is you typically have three, four, five, six different pipelines that you interconnect with through a processing plant of some kind. And that allows us to send our gas to various parts of the country, wherever the basis is the best at that time.
Crowe: And kind of on that mature asset, something that's already producing, and as a master limited partnership, one of the things that you guys do very consistently is hedge. A lot of investors aren't necessarily familiar with the concept of hedging and the concept of the futures contracts. So if you could just maybe walk us through what that exactly i,s and what your guys' thought processes are on basically developing your hedging portfolio.
Robert: OK, there's two sides to hedging. Well, just the basic concept of hedging is you put a financial derivative in place that allows you to lock in a price, whether it be gas or oil or NGLs. There's a counterparty, and typically it's with our banks. They will quote you a price for whatever period of time you're looking for, whether it be a one-year hedge, or a two-year hedge, three years, four years, some people can do five and six years. The market's not as liquid out there, but I guess it's possible.
But it allows you to fix a price for your product. And so what that allows us to do is when we're looking at an acquisition, and we're looking at the cash at a particular cash flow profile, we want to make sure that cash profile actually exists. Because that's what we base our purchase price on.
So the way to create certainty in that cash flow profile is go out one, two, three. Typically we've been anywhere between three and five years on an acquisition that we will go in and lock a certain percentage of that production at a particular price. And that way we feel comfortable about the return we're going to generate for that period of time. Now again, you have exposure once those hedges start rolling off; if you've only done a three-year hedge and they're all expiring, it's up to you, and that's the second piece. On acquisitions it's pretty easy. You put in three- to five-year hedges; it's done.
What takes a little bit more time and effort and knowledge, I guess, or discipline, is putting in new hedges as the older ones are rolling off. We've always tried to be opportunistic about when we enter into new hedges, but there probably isn't a week that goes by that our CEO and myself and our treasurer aren't looking at our hedging profile, what's rolling off, is there a good opportunity, prices just spiked at the back end of the market, let's layer in another 5%.
We did that in the second quarter, actually, this year. We saw a nice movement in oil and NGLs, and we saw an opportunity to add 5% of our new production in 2016 at $65. So we added 5% more hedges on the oil side at a price we thought was pretty reasonable at that time, which was, as I said, $65, and then we also added 20% of our 2016 NGL production, because those purchases had improved. And in hindsight it was a good thing to do. I'm hoping that, you know, by the time 2016 rolls around, it looks like a bad trade.
But you just have to try and get emotion out of it and just systematically add hedges to create again, a stable cash flow profile.
Crowe: Yeah, I can imagine watching oil prices over the last year, natural gas, NGL, that it must be very hard to kind of take the emotion out of it, because it has been a pretty wild ride over the past year or so.
Robert: Absolutely, absolutely. And did we make all the right decisions? No, obviously not. We'd be 100% hedged on everything if we had known what was going to happen. But you know, the oil price decline was obviously quite substantial, and we're happy to say that we feel like we're in a fairly good position for 2016 in particular. And we're certainly hopeful that things will improve over the course of 2016 and we'll have other opportunities to add in '17 and beyond over the course of the next year.
Crowe: That's great. So just kind of, you were talking just before that about when you make a new acquisition about that three to five years. You guys actually just closed two brand-new acquisitions, with LRR Energy and Eagle Rock Energy Partners. If you kind of look at the, I guess you could say, the asset portfolio of the two companies, there's a lot of overlap, I would say, relatively similar in those.
So if you could maybe walk us through the strategic decisions that you made, or how you guys viewed these going forward and what made you decide to, let's say, pull the trigger on these acquisitions.
Robert: Well, you know, we're always looking for opportunities, and certainly in this kind of environment, adding assets at what we hope is the bottom of the energy cycle, we think, will pay off big dividends or distributions in the future. So we looked at potential parties that may be interested in merging with us, and we reached out. And LRR had run a small process, had invited a few people to come take a look at their operations, and fortunately for us they liked our offer. Fortunately for us their management team, when they were looking at what currency they wanted to take, fortunately for us they liked the Vanguard currency.
From our perspective we looked at it from a cash flow accretion standpoint. We looked at it from the perspective of a credit profile; kind of overall between the two we improved our cash flow on a per-unit basis, we increased our scale in diversity geographic as well as commodity-wise. They're a little bit more oily than we were. Not too much, but similar profiles. We improved our hedging profile a little bit, and probably one of the more important things for us was we improved our credit profile, too.
So it's not often when you can have cash flow accretion on a per-unit basis as well as de-lever at the same time. And those two transactions on an overall basis are doing just that for us.
Crowe: That's great. When you're actually making those screenings for new acquisitions and you guys obviously look at a lot of different things before you actually come down to maybe the small handful of deals that you do decide to make, what are some of the big characteristics, in turn, that you're looking for? Is it something within, like, geography and production? Or is it more along the lines of you look at it from a much more financial background, say, the cash flow and the credit rating and stuff like that?
Robert: It's certainly financially oriented.
Crowe: I'm sure, being the CFO, you're going to say financial oriented much more.
Robert: For me it's financially oriented.
Robert: For others in our organization, I'm sure they look at different metrics than I do. But certainly that's what I'm focused on is, you know, what does our leverage look after the transaction? How are we going to finance it? What's our cost of financing?
When we first look at transactions and we evaluate lots of transactions, initially it's just done on where's it geographically? Is it a good fit with our existing operations? Can we create some operational synergies and reduce costs? We consider all those things and we evaluate it on a standalone basis. And if it meets that test, then my group takes it and we put it into our company model and then we put a financing structure around it and see if it still has the cash flow accretion and the same benefits to our credit profile as we had expected it to do. And if it does, we proceed.
Crowe: OK. Obviously, one of the things that we've seen over the past year or so and something that a lot of investors may be scared about right now is, kind of, the financing environment for oil and gas.
How much does the financing environment for you guys play into that actual decision-making process?
Robert: It's critical. I mean, when people ask me, my answer to what keeps you up at night is typically my kids. But without jesting, it's capital availability. I mean, our structure, our business profile, is predicated on acquisitions and growing. We realize that we are on an acquisition treadmill. There's no ifs, ands, or buts about it. We have to replace our reserves; we typically replace our reserves by acquiring new ones. And that requires capital.
So in today's environment, when the capital markets are essentially closed to companies like ourselves, we have to look at different, more creative ways to continue to grow. And these two mergers are a good example of a way to grow without actually accessing the capital markets, and yet at having very good benefits to our unit holders. Yeah, we've talked about partnering with those that do have money. Private equity firms have raised a lot of money and are looking for ways to put it to work, and there are those that think we do pretty good job offering assets. And so it's very possible that we could partner with a private equity firm to buy some assets. And they would help finance our portion of the purchase price.
And unit, other unit-for-unit transactions, I think there's potentially other mergers to be done, whether it be with C-corps or other peers of upstream MLPs. And then there's also private companies that may decide to sell their assets for units, and thereby it's a tax-efficient way for them to dispose, not dispose, but to sell their assets. And they're also outselling at the low, because by taking our units they get to ride the wave as prices improve. They get to see the upside in our unit price, and so it's not selling out for cash.
So again, tax efficient, and they're able to ride the wave of the rebound when that occurs.
Crowe: That's great. One of the major challenges for companies in the merger-and-acquisition kind of aspect is after the actual purchase the integration of it, and you guys have made a ton of acquisitions over the past seven to eight years.
What do you feel is Vanguard's strength in terms of structure or culture that has allowed you to bring these companies into the fold rather successfully?
Robert: Well, with practice comes experience, and certainly I think we have 25 deals under our belt now. We have the benefit of a really good workforce, frankly. A workforce that cares, a workforce that has been with us for many of those years. And so we've learned, we've actually, our process includes putting an integration team together that's made up of managers from the different disciplines within our organization.
So they, it's communication. And I think that really is what helps us integrate these well is we communicate, not just with the seller, but within our own organization, making sure that the right hand knows what the left hand is doing. And that we don't let too many balls slip through the cracks.
We do a pretty good job of having a checklist of things that need to get done, and we get them done.
Crowe: That's great. As somebody who is actively looking at the merger-and-acquisition environment all the time, we have seen a lot of companies, I guess you could say, not directly in the oil production space, making mergers and acquisitions to oil services, some of the transport companies. But I think a lot of people expected mergers and acquisitions in oil and gas production to be a little bit more active than it has as of late.
And I was curious on your thoughts as to maybe if there's anything you have seen that has kind of impeded mergers and acquisitions in the oil and gas space over the past year.
Robert: Well, I mean, if you listen to most people, and I would agree, there has been a bid-ask spread. A pretty wide bid-ask spread. You know, the seller believes their assets are worth X and the buyer says, no, they're worth Y. I think when prices are coming down as quickly as they have come down, buyers get a little skittish, and they're not quite sure what price deck to use, because one week can represent a big change in pricing.
So I think there were a lot of processes that started and then stopped because there was so much volatility in prices that they thought they were going to get X and they got a bit of Y. And they just said, 'We'll wait for a better time." So I think capitulation hasn't occurred with a lot of sellers. I think that's changing. I think you're seeing a lot more assets that are coming to the market now, and I would expect that those sellers have to respect that the curve is what it is.
For us, we can't use anything other than what the curve is, because that's what you can hedge at. So, but a private equity firm, if they think the curve isn't right and they want to use $4 for next year as an average price, even though you can hedge it for $2.86, that's their prerogative. We can't do that. So I think it's changing. I think there are more assets coming to market, I think people wanted to understand what the fall determination, what impact that might have on their capital plans. And so I think as that has played out, people have decided to start putting assets in the market. We're certainly seeing an uptick in the number of deals that are out there.
Crowe: That's great. So just kind of maybe broadening out from not just mergers and acquisitions but kind of the larger oil and gas environment. I think a lot of investors in the space kind of affix all their attention to the price of oil and gas. And as we've seen over the past year, it's gone down a lot. But one thing that we've also noticed is with a lot of companies such as yourselves, there's been a lot of gains in efficiency in reducing the costs that have happened.
And I was just wondering if you could maybe walk through some of the things that you guys have done over maybe the past year or so that has enabled you guys to kind of, I wouldn't say disjoint, but kind of make a lower price that much more profitable for you.
Robert: Well, I mean, for different companies there are different ways that they're gaining efficiencies. I mean, for the C-corps, drilling efficiencies are much more important to them, because they spend a lot more capital in drilling. So for them to be, to save 30% or 40% on the cost of a well, substantially changes their economics. And, you know, when you have a 50% change in price, you need at least that to create the economics to actually get a well down. And that's still yet to be seen. I mean, how profitable a lot of the drilling that's being done today, you know, it's questionable, and time will tell whether or not it was a good decision or not.
But, you know, the efficiencies that we focus on is, because we have a lot of already producing properties, is how do we drive down costs in the field itself? And it's basically a lot of basics. We're looking at capital efficiency on every project that we do, large and small. If someone wants to do a $100,000 well workover, they do analysis on it and compute an IRR and determine whether or not it makes sense to do that well workover. And in many cases we've deferred a lot of our capital spending because it didn't make sense.
So I think we're being efficient with these uses of our capital. We're asking our partners, contractors, etc., to take a reduction in their pay, and they have. I just came out of a meeting where it showed on our operated properties the ones that we control, anyway, we've driven down costs by about 19%. And just blocking and tackling. And unfortunately we haven't seen similar cost reductions from our operating partners, but we hope in time we'll start seeing some of those cost savings as well.
Crowe: Actually, just to kind of follow-up on what you were saying where you guys are seeing those sort of levels of efficiency but some of your partners are not. What kind of communication would you guys have with one of your operating partners who says, "Hey, this is something we're seeing" in the kind of sharing or exchanging that you might have with them, in order to help them improve, because obviously it would help you as well?
Robert: Yeah, well, we need confirmation that our analysis is correct. As you might expect, you get joint interest billings several months after the fact. You see charters coming in from April and May still. So we keep accruals on our books for an extended period of time just to ensure that we don't under-accrue those costs. So it may be simply our accounting hasn't quite accounted for the reductions yet because we still are keeping those accruals on the books. So we're going to give it another quarter, see if those accruals are still needed on the books, and if they're not, we'll take them down.
And so maybe they are saving more money than we're expecting them to. But we've got, with the Eagle Rock transaction, actually, we've now separated our business units a little bit differently, and we have a dedicated manager who is going to only focus on properties operated by others. And so we expect by having more tension on those properties, they'll be able to focus on the economics and get to know those relationships perhaps better than we have in the past, and be able to make the calls and ask the questions that need to be asked.
Crowe: Awesome. Aside from the most recent acquisitions like Eagle Rock and LRR Energy, if we look at the things that you guys have bought in the past, it appears that you guys have had a very large focus on natural gas versus some other companies in the space -- 2012, 2013, started to make that shift more toward oil.
What was the strategic decision for you guys to say we want to be more involved in the gas end of it, versus be more in the oil?
Robert: Well, I mean, we have taken a view on commodities from time to time. I mean, it just seemed logical to us when oil dates back to 2000 and, when we started, or back in 2007, we were all gas. All Appalachia. And we decided we wanted to diversify, and the first transaction that came out of the chute was a Permian transaction with Apache (NYSE:APA). And so we got oil. And then we did two more gas transactions. So we reverted back to gas. And that took us to about the beginning to middle of '09, and that's when oil had come from $140 down to about $40.
And gas had gone from about $13 to $8. And so our CEO and I looked at each other, and we, would you rather buy oil at $40, $50? Or gas at $8? And we said, I think we'd rather buy oil. And so 10 of the next 11 transactions were oily. And so again we went back to an oily reserve mix. Well, and fortunately, that turned out to be the right decision, because by the end of 2011 oil was back up to $100 and gas had come down to $2 and change.
So we again looked at each other and said, and we had a reverse epiphany at that point, and said, "Would you rather buy oil at $100 or gas at $2 and change and get all this optionality on undeveloped acres that isn't economic at $2 and change but, perhaps it is at $3.50 or $4?" So we decided to focus our attention in 2012; up until recently, we focused our attention on gas transactions, and our thought process is simply that we paid a price, we hedged in a price. We didn't expect gas prices to go up dramatically anytime soon. So we actually put in pretty elongated hedges into 17 on most of those gas transactions.
So, we felt comfortable that by 17, 18, 19 there were enough catalysts, demand catalysts that were going to occur on the natural gas side to give gas a chance to improve from where it was. We still feel fairly confident that that will occur. There's a lot of LNG, there's five different LNG projects that are ongoing. That's a big gas demand driver. You've got industrial demand that's improving here in the United States, you've got exports in Mexico that are occurring, you've got coal to gas electrical generation that's been switching. So there's been a lot of drivers to expect gas to improve, and we still think that's a good theory.
Today, though, I have to say we're relatively agnostic. We think both products have good upsides. So we're happy to have done the transactions we've done with Eagle Rock and LRE. We increased our oil exposure a little bit. So even though on a reserve basis we're still quite natural gas-focused, but on a revenue basis for 2016 we're still anticipating almost half of our revenue, even at these depressed prices, will come from oil.
Crowe: That's actually quite surprising, so ...
Robert: It's also a function of gas being as low as it is too, unfortunately.
Crowe: Of course, yeah, yeah, yeah. So just kind of wrapping up here. So, say, speaking to an investor, somebody who is either invested in Vanguard or somebody who may be looking at Vanguard as a potential investment down the road. If you were to say to them, what would be three things that you think if they were invested in you, they should focus on as, like, for you guys to keep hitting your marks or hitting your targets -- like what should they be focusing on?
Robert: What metrics in particular?
Crowe: Yeah, metrics, or some things that are going on at the business.
Robert: Well, I think staying active, I think, is very important. I truly believe doing nothing in this environment is really the wrong thing to do. Because, you know, in this environment with adversity, opportunity is created, and again it really feels like adding assets in this environment is going to pay big dividends in the future. So to the extent that we continue to be creative and add value, I think that's a distinguishing factor. I think our scale in diversity can give people some comfort that we're not beholden to any one particular area, like if we were entirely a Marcellus player or entirely a Permian player.
We have a fairly low-risk profile, so I think that's a benefit. You know, clearly the typical metrics, leverage, liquidity, although, you know, liquidity for us is different than liquidity for a typical C-corp. And I think that's something that a lot of people miss. Because we do anticipate operating on a free cash flow-positive basis. So liquidity is just a nice thing to have, not a necessity. And liquidity is very expensive today. So my goal is to avoid, as much as I can, expensive financings to create something I don't necessarily need to run my business -- i.e., liquidity.
So, but I think coverage, all the typical metrics that have been used historically, are still important. So maintaining our hedge profile, showing that we have good hedges over the next couple of years, I think, is still very important. I think continuing to add to our hedge portfolio, I think people will want to see that even though it's depressed, we have to try and maintain some security in that cash flow profile. We'd like to think that we're at the bottom, but protecting the downside, I think, is still going to be important.
Crowe: OK, awesome. And actually, last question. This is kind of one of the ones we like to do, is, like, a very traditional Peter Lynch investing style of things, I guess, to ask management, who do you, other management teams or CEOs that you would look at inside energy, or maybe not even in energy, at all that you look to as either very innovative people, or someone that you look to as we feel like we could learn a little something from them?
Robert: I'm sure we could learn a lot from a lot of, I mean, there's a lot of good management teams out there, bottom line. I've been very fortunate to meet a lot of good teams and learn from many of them. I don't know about singling anyone out. I can tell you I've worked part of my career in the midstream space. The last eight years here with Vanguard in the upstream space, by and large, there's a reason that people become managers, management, because they're pretty bright.
So I have to say that I've met a number of very bright people, and I have a hard time singling any one company out. I prefer not to do that, if that's all right.
Crowe: That's fair enough, that's fine. Well, Mr. Robert, thank you very much for your time today.
Crowe: It was great to talk to you.