TEXT-S&P upgrades Vanguard Natural Resources to 'B+'
Overview -- U.S. oil and gas exploration and production company Vanguard Natural Resources has successfully completed several acquisitions this year, benefiting its business profile by nearly tripling its proved reserve base. -- We are raising our corporate credit rating to 'B+' and raising the rating on the company's senior unsecured debt to 'B'. -- The outlook is stable, reflecting our expectation that future acquisitions will be funded prudently such that credit protection measures remain appropriate for the current rating. Rating Action On Nov. 20, 2012, Standard & Poor's Ratings Services raised its corporate credit rating on Houston-based Vanguard Natural Resources LLC (Vanguard) to 'B+' from 'B'. The outlook is stable. We also raised the issue-level rating on the company's senior unsecured debt to 'B' (one notch lower than the corporate credit rating) from 'B-'. The recovery rating on this debt remains '5', indicating our expectation for modest (10% to 30%) recovery in the event of a payment default. Rationale The upgrade reflects our assessment that Vanguard's business risk profile has improved. The company's reserves have increased to approximately 1.1 to 1.2 trillion cubic feet equivalent (Tcfe), pro forma for recent acquisitions, from 476 Bcfe at the end of 2011. We expect that this growth will benefit production levels, which we think will average more than 200 MMcfe/d in 2013, compared with an average of slightly more than 80 MMcfe/d in the first quarter of 2012. While we expect a majority of this production to come from natural gas, pricing of which is relatively weak, Vanguard is very well hedged, meaning that internally generated cash flows should be relatively stable. We project that Vanguard will continue to be acquisitive, but we expect that the company will fund these acquisitions prudently, such that debt generally represents no more than 50% of the acquisition cost. The ratings on Vanguard Natural Resources LLC reflect our view of the company's "weak" business risk and "aggressive" financial risk. Its reserve replacement strategy relies heavily on acquisitions and Vanguard distributes almost all of its excess cash flow to unitholders. Partially buffering these weaknesses, the company has a decent hedge book over the next several years that should mitigate hydrocarbon volatility, a high percentage of lower-risk proved developed reserves, and modest capital spending requirements. We consider the company's liquidity to be "adequate." Vanguard is a limited liability company. However, it resembles a master limited partnership (MLP) in several ways. Vanguard pays out nearly all available cash flows to unitholders on a quarterly basis, and we believe that its equity investors typically value the company on a yield basis-meaning that management could be particularly reluctant to curtail the distribution. Unlike the typical MLP structure, there is neither a general partnership interest nor incentive distribution rights. To sustain its dividend, Vanguard operates with a mostly proven reserve base, taking on little exploration risk. Also, it acquires reserves in very mature basins where the geology is well-known and where wells have been operated for many years. Vanguard typically hedges a majority of its future production to provide additional stability to cash flows. Nevertheless, we expect that Vanguard will continue to rely heavily on acquisitions to grow production due to the limited organic growth prospects of its mature reserve base. This acquisition-focused growth strategy exposes Vanguard to the risk that it could overpay for assets or could have difficulty replenishing production during periods of capital market duress. Furthermore, Vanguard typically funds acquisitions through its corporate credit facility and then subsequently issues equity to repay a portion of the outstanding borrowings. This strategy exposes creditors to the risk that Vanguard might not be able to access equity capital to repay a portion of its credit facility if its shares weaken. Vanguard's reserve base, pro forma for its definitive agreement to purchase Colorado and Wyoming assets from Bill Barrett (300 Bcfe) and nonoperated assets in the Montana Bakken (undisclosed reserves), is in-line with similarly rated peers, with total pro forma reserves at approximately 1.1 to 1.2 trillion cubic feet equivalent (Tcfe); roughly 40% of reserves are exposed to oil and natural gas liquids (NGLs), which are enjoying robust prices compared with natural gas. Its proved reserve life, pro forma for its acquisitions, is long at approximately 15 years. Vanguard has a high percentage (roughly 75%) of proved developed producing (PDP) reserves, and therefore a low-risk production profile. Vanguard's cash operating costs average slightly more than $4/Mcfe, which is in line to E&P peers with a similar mix of gas and oil reserves. However, we could foresee its costs declining in 2013 due to the company's increasing proportion of lower cost gas. The company's reserves are scattered throughout the U.S., but a sizable portion of its reserves and future production comes from the Permian Basin in Texas, the Arkoma in portions of Arkansas and Oklahoma, and the Big Horn Basin in Wyoming. We consider Vanguard's financial risk profile to be "aggressive," based on its debt balance on Sept. 30, 2012, pro forma for its recent acquisitions, of approximately $1.4 billion. We forecast that debt-to-EBITDA will be in the low to mid 3x area over the next couple years. We currently project that the company will generate funds from operations (FFO) in 2013 and 2014 of $250 million and slightly more than $225 million, respectively. Following distributions and capital spending, we project that excess cash flow will be minimal over this period. Our projection incorporates the following expectations and assumptions: -- Standard & Poor's price assumption for natural gas is $3 per thousand cubic feet (Mcf) in 2013 and $3.50/Mcf thereafter. For crude oil, it is $80 per barrel (bbl) next year and $75/bbl thereafter. -- We project that production will total 207 MMcfe/d in 2013 and slightly less than 200 MMcfe/d in 2014, with natural gas representing approximately 60% of production in both years. We have not modeled any future acquisitions. -- Vanguard will distribute most of its internally generated cash flow to unitholders. We forecast that distributions will total nearly $170 million in 2013 and $180 million in 2014, representing a distribution coverage of more than 1.2x -- We forecast that Vanguard's capital spending program will be approximately $60 million in 2013 and $30 million 2014. The capital spending program is relatively low due to the highly developed nature of the reserves. -- We expect that equity will represent at least 50% of future acquisitions. However, we have not reflected an equity issuance for the acquisition from Bill Barrett or the Bakken acquisition due to uncertainty around timing and proceeds. -- We expect that the company will hedge a majority of future production. Our forecast assumes that the company will hedge roughly 90% of gas at nearly $4.60/Mcf and 90% of crude at more than $90/bbl in 2013. We assume that Vanguard will hedge 80% of natural gas at more than $4.60/Mcf and 65% of crude at $92/bbl in 2014. Liquidity We consider Vanguard's liquidity as adequate, reflecting the following assumptions and expectations: -- We project that sources of liquidity will exceed uses by more than 1.2x over the next year, excluding acquisitions. This includes our assumption that capital spending in 2013 will total about $60 million. -- Pro forma for its pending acquisitions, total liquidity on Sept. 30, 2012, was approximately $150 million. This includes pro forma availability of more than $125 million on its $960 million borrowing base that matures on Oct. 31, 2016, and cash on hand of $24 million. However, we expect at its next redetermination in April 2013, the borrowing base will increase due to the reserve adds from its acquisitions. -- We view Vanguard's relationship with its banks as well-established and solid. -- The company has a maximum leverage covenant of 4x and a minimum current ratio of 1x. We expect the company to remain in compliance with all covenants. Recovery analysis For the complete recovery analysis, please see our recovery report on Vanguard published on RatingsDirect on Oct. 4, 2012. Outlook The stable outlook reflects our expectation that Vanguard will fund its acquisitions prudently, such that debt generally represents no more than 50% of the acquisition cost. We also expect the company to continue to hedge nearly all future production, enabling it to maintain adequate liquidity. If this occurs, we foresee Vanguard's run rate leverage in the 3.5x area, which we consider appropriate for the current rating. We could lower the rating if leverage is likely to breach 4.25x on a run rate basis, which could occur if the company funds acquisitions such that debt represents more than 50% of the acquisition cost or if the company's production fails to meet our expectations. We consider an upgrade unlikely over the next 12 months given our assessment of Vanguard's modest internal growth prospects. Related Criteria And Research -- Key Credit Factors: Global Criteria For Rating The Oil And Gas Exploration And Production Industry, Jan. 20, 2012. -- Revised Assumptions For Assigning Recovery Ratings To The Debt Of U.S. Oil And Gas Exploration And Production Industry, Sept. 30, 2010. Temporary telephone contact numbers: Marc Bromberg (347-573-0897); Stephen Scovotti (347-839-0615) Ratings List Upgraded To From Vanguard Natural Resources LLC Corporate Credit Rating B+/Stable/-- B/Stable/-- Vanguard Natural Resources LLC Senior Unsecured B B- Recovery Rating 5 5 Complete ratings information is available to subscribers of RatingsDirect on the Global Credit Portal at www.globalcreditportal.com. All ratings affected by this rating action can be found on Standard & Poor's public Web site at www.standardandpoors.com. Use the Ratings search box located in the left column.