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March 24, 2010

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Lingering ENP Questions

Ordinarily an article about a company I own is taboo, but this posting is not about “talking my book”, it’s about opening a dialogue about a company with many questions, and about which not many people are talking.  Encore Energy Partners (ENP) is the often overlooked E&P MLP subsidiary of Encore Acquisition Company (EAC), which was recently acquired by Denbury Resources, Inc. (DNR).

ENP acquires and operates oil and gas producing properties with long-lived reserves. The company is unique among E&P MLPs in that it has a stated variable distribution policy, which means that the company is more likely than its peers to lower its distribution in any given quarter, but it’s also an indication that ENP management was more conservative than most E&P MLP management teams about the sustainability of flat or growing distributions supported by assets with declining production.  Whatever the rationale, the result of the variable distribution policy has produced mixed results for investors.



ENP went public in September 2007 at $21.00 per unit, or a 6.67% yield, and with an enterprise value of approximately $575 million.  Since its IPO, ENP has announced 5 acquisitions, 4 of which were from its parent company, Encore Acquisition Company.  Total purchase prices for its acquisitions: $540 million.

  • September 2007: IPO at $21.00
  • Drop Down Acquisitions from EAC:
    • December 2007: $250 mm acquisition of Permian and Williston Basins properties
    • December 2008: $46 mm acquisition of properties in Arkoma Basin
    • May 2009: $26 mm acquisition of properties in Williston Basin
    • June 2009: $190 mm acquisition of properties in the Rockies and the Permian Basin
  • Third Party Acquisitions
    • May 2009: $28 mm acquisition of properties in Texas
  • November 2009: EAC announces sale to DNR
  • March 2010: EAC sale completed and management of EAC/ENP replaced

ENP is currently trading around $20.00 per share, and a 10.75% yield based on latest quarterly distribution paid in January of $0.5375.  Enterprise value for the company is approximately $1.2 billion, including only $255 million of debt (21.9% of enterprise value).  If you invested in the IPO in 2007, your total return would be 18.1% as a result of the steady stream of quarterly distributions paid to date.  This return compares to 21.4% for the AMZ MLP index.  ENP was a laggard among MLPs in the 2009 rally as well, often forgotten among the other E&P MLPs that get more press and research coverage like LINE.


What MLP Investors Know About ENP’s new Parent, DNR

DNR has a history as a parent company of an MLP through its ownership of the GP of Genesis Energy, L.P. (GEL).  DNR recently divested its general partner in a deal with private equity firm Quintana in December 2009, then sold its remaining limited partner stake in a registered offering in March 2010. GEL was in a different, but complementary business than DNR, so the company was largely independent of DNR.  DNR did not provide much in the way of financial support, or drop down acquisition opportunities to GEL, but DNR did provide financial incentive for its independent management team.

DNR needs cash to fund drilling operations.  DNR has confirmed several times that the company is seeking to divest non-core assets to fund growth projects. ENP could be a potential cash source for them, but DNR thus far has not offered any plans that would indicate that ENP would get any favored treatment relative to any third party buyer of properties


What we don’t Know

How strategic is ENP to DNR, and will the new management team be incentivized to grow ENP?
The benefits to DNR of ENP: subsidiary has a separate currency and can purchase assets from DNR without DNR giving up operating control of those assets.  The difference here vs. a traditional MLP is that ENP’s general partner has no incentive distribution rights (IDRs) that really create extra juice when assets get dropped down.
For example, when El Paso sells assets to its subsidiary MLP El Paso Pipeline Partners (EPB), EP is going to see the proceeds from the sale, but then if EPB is able to raise its distribution as a result of the purchase, EP will see an increasing amount of quarterly cash flow from the IDRs it retains.  DNR does have LP units that it owns in ENP, but doesn’t have that extra juice.

It also isn’t clear that the long term benefits of ENP remaining a public company are there if DNR doesn’t use it as a cash source.  The administrative hassle of another public company to look after could outweigh some of the positives, and ENP could be spun off or bought out.

Will DNR change the distribution policy in place at DNR?

New management has provided no indication of a change from its current variable distribution policy, which states: “We plan to distribute to unitholders 50% of the excess distributable cash flow above: (1) maintenance capital requirements; (2) an implied minimum quarterly distribution of $0.4325 per unit, or $1.73 per unit annually; and (3) a minimum coverage ratio of 1.10.”  This is just a general guideline, and can be changed at any time, but the prior management team stuck to this policy since IPO.


Will ENP management lower its distribution this quarter?
Some of ENP’s hedges rolled off at the end of 2009 that included oil prices as high as $110 per barrel.  That provided an extra $30 per barrel sold for some of ENP’s production volume.  The lack of these hedges is the main reason analysts are predicting a distribution cut.  Most analysts expect distribution to go from $0.5375 last quarter to something like $0.48.

ENP current has approximately 60% of its production hedged in 2010 at prices in the low 80s per barrel for oil and around $7.00 per Mcf for gas.  Based on its current hedge book and its production guidance for the first quarter of 2010, distributable cash flow after maintenance capital should be approximately $30 million.  ENP’s minimum distribution of $0.4325 is $19.8 mm, leaving approximately $10.2 mm of excess distributable cash flow.  If ENP follows its policy above, 50% of the excess ($5.6 mm) will be distributed, for a total distribution of $24.9 mm, divided by units outstanding would be approximately $0.54 with a 1.22x coverage ratio.

So, ENP could hold its distribution constant based on their production guidance and distribution policy.  In addition, the new owners may keep the distribution steady this quarter just out of fear that ENP’s price would drop and push down their acquisition currency, and reduce the number of options for DNR to divest assets.


Is ENP priced for a distribution cut?
If we assume that the market generally thinks ENP will cut its distribution to $0.48 per unit this quarter, then its current price would equate to a 9.6% yield, which is roughly in line with its peer group yields (approximately 9.5%).  So, it appears that the market is pricing in a distribution cut.  The last time ENP announced a distribution cut was in early 2009, and ENP units actually traded up that day and that week following the announcement (I think people were just excited they were paying something, given the fears at the time throughout the markets).


Would ENP trade on par with its peers if ENP changed from variable distribution policy to a stable one?
This is a tough question to answer, I believe ENP would trade on par on a yield basis with its peers (approximately 9.5% currently) if management announced that the variable distribution policy was no longer in effect, but management would likely only say that in conjunction with a distribution cut to a more sustainable level.

Stay tuned for the next few weeks to see if the new ENP management or the market can answer some of these questions for us.

Disclosure: Curbstone is currently long ENP and EPB.  Curbstone does not mean this post as personalized investment advice and readers should consult their financial advisor before making any investments.

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