Klarman Energy Pick Runs Into Credit Crisis Buzzsaw

Even the masters misstep from time to time.

Breitburn Energy Partners, LP (BBEP) has fallen 36% this morning as a result of the credit crisis. Find the company press release here but in a nutshell, the company has a provision in its credit agreements that subject it to redeterminations of its base borrowing amount. As a result, its credit line was recently reduced from $900M to $760M, with $717M currently outstanding. Another provision prevents the company from paying distributions to unitholders if the amount outstanding exceeds 90% of the borrowing base. As of today, that ratio stands at 94% and BBEP has suspended distributions as a result.

The banks reduced BBEP’s borrowing amount due to the massive drop in energy prices and the ongoing credit crunch. Never mind that the company has thoroughly hedged its 2009 and 2010 production, thus ensuring relatively robust cash flows over the next two years. Based on company guidance, BBEP will generate nearly $150M in free cash flow in 2009 but the credit crisis means the banks are taking no chances.

In a previous discussion of Baupost Group’s 13F filings, I noticed Seth Klarman adding to his Breitburn Energy Partners, LP (BBEP) position even as he sold off a similar stock, Linn Energy (LINE). From his Q3 2008 letter to shareholders, Klarman was quite positive on these holdings:

Amidst the chaos, we also added to a few equity positions that have been clobbered by particularly urgent sellers. Two publicly traded oil and gas partnerships [assumed to be BBEP and LINE], both heavily owned by Lehman Brothers, fell sharply immediately after Lehman’s bankruptcy filing, to levels where we purchased large blocks at mid-teens or higher yields based on current distributions that are largely locked-in for five years through hedges, and at prices roughly half the companies’ proven energy reserves.

I have been following BBEP in recent months and while some of Klarman’s bullishness on the stock still holds, the stock is problematic in light of current events.

As we now know, Klarman’s statement that current distributions were largely locked-in over the next few years via hedges is somewhat imprecise. For sure, BBEP’s cash flow is locked-in but its distributions were subject to liquidity risk. To bring the borrowing base amount limit back under 90%, BBEP needs to pay down roughly $36M of its credit facility. While this shouldn’t be a problem as the partnership paid out $28M in cash distributions last quarter, management warns that future distributions will probably be re-established at lower levels.

As for the company’s reserves, BBEP has written off some of its reserves due to the drop in energy prices. Taking their year-end reserves statement at face value, proved reserves dropped 37%. I view these lost reserves as “hidden” or “captured” reserves — if energy prices rebound, these reserves come back with nothing more than a few keyboard strokes. So this aspect of Klarman’s assessment is still valid but the company (and industry) needs energy prices to rebound in the next few years. Particularly, natural gas needs to come back to a reasonable level as Breitburn’s core asset, the Antrim Shale in Michigan, is uneconomic at $3.50 natural gas (mid $4′s is closer to break-even). They have adjusted their production mix to compensate for the divergence between oil and NG. 2009 production is slated to be 46% oil and 54% gas but natural gas comprises 75% of reserves so this production mix is not sustainable over the long term.

On a pure valuation basis, BBEP’s credit amendment doesn’t alter its intrinsic value. The partnership’s cash flow and assets are still secure. But unitholders are now in a position where they may have to pay taxes on earnings ($187M midpoint guided adjusted EBITDA for 2009) while receiving no cash distributions, which clouds the investment thesis somewhat.

Disclosure: no position in BBEP or LINE

10 Responses to “Klarman Energy Pick Runs Into Credit Crisis Buzzsaw”

  1. Davy Bui Says:

    Lots of additional insight on the yahoo message board:

    http://messages.finance.yahoo.com/Stocks_(A_to_Z)/Stocks_B/threadview?m=te&bn=53738&tid=1921&mid=1921&tof=1&frt=1

  2. Jae Jun Says:

    Thanks for the heads up. Will have to take a look at this one.

  3. Neil Says:

    Davy,
    What’s your estimate of BBEP’s intrinsic value? I ask to see if it’s worth investigating further.

    Cheers, Neil

  4. PlanMaestro Says:

    It is difficult ot put an intrinsic value on cyclicals. The estimates I have seen is that the company at the moment is valued between 30 and 45% of net asset value including hedges and ONLY PROVED reserves.

    Also the Yield FCF/Market Cap this year at current prices is around 30% and it should increase next year because the hedges are much better for 2010 and 2011.

    However, the main reason to buy this stock is that it has an inflation protected return for the next 3 years and you just can sit and relax and wait for oil and natural gas prices to explode!

    Oil and Nat Gas prices are currently at supply destruction levels. See rig counts or the efforts of OPEC to increase prices.

  5. PlanMaestro Says:

    And if you want to know more about the company. They are presenting today at the IPAA

    http://www.vcall.com/CustomEvent/conferences/IPAA/20090420/agenda.html
    http://twurl.nl/vhpqte

  6. Davy Bui Says:

    Thanks for the added comments, guys!.

    Plan, we’re on the same page as far as energy supply destruction. I’ve posted a bunch on that lately and would also note that in the review of the 4 major bear markets of the 20th century, oil emerged as the largest sector in every case except 1921, where it was the 2nd largest. At the end of the day, we still live in a physical world, not a virtual one, and you still have to move stuff and do work.

    Neil, I do have an intrinsic value number for the stock but for reasons to be announced later, I’m not going to divulge it.

  7. Neil Says:

    I guess I’ll have to do my own work then (no cheating :) )

  8. PlanMaestro Says:

    Well I suppose you are mortgaging the family silver to buy BBEP.

    A secondary point: With a 30% FCF/Market Cap Yield and no maturities it is pretty clear that the solvency and liquidity issues are WAY overblown. 97 M is the recent released released free cash flow with maintenance capex, and 130 M is the free cash flow with cut to the bones capex.

    Dividend/Distribution cuts can be great buying opportunities when the fundamentals are intact.

    twitter.com/PlanMaestro

  9. peter Says:

    Plan,

    Did you figure out the tax consequences for foreigners?

  10. The Enlightened American » Portfolio Performance +6.8% Through April 2009 Says:

    [...] Klarman Energy Pick Runs Into Credit Crisis Buzzsaw [...]

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