The Changing Face of Eagle Rock Energy Partners Doesn't Appeal to Many

The Changing Face of Eagle Rock Energy Partners Doesn't Appeal to Many

Eagle Rock Energy Partners is finally saying goodbye to its midstream assets, as it sells off a large part of its operations to Regency Energy Partners for roughly $1.3 billion (depending on closing conditions).

With this transaction, Eagle Rock is going the way of LINN Energy and BreitBurn Energy Partners; it is becoming a pure upstream MLP. Will this deal help Eagle Rock Energy Partners shore up its distribution, or is Eagle Rock's high yield destined to shrink?

Major cash infusion
Last quarter was rough for Eagle Rock as it couldn't keep paying out 22 cents a unit each quarter. Eagle Rock had to cut its quarterly distribution down to 15 cents -- a 10% yield -- so that it could maintain a coverage ratio above one, which was at 1.05x before the divestment. This hammered an already lagging stock price.

With the extra cash, Eagle Rock should be able to reduce its long term debt load of ~$1.2 billion. This enables for more future cash flow to be diverted towards payouts and growth projects, instead of paying down interest.

Another part of the deal that shouldn't be discounted is the $200 million in common units of Regency Energy Partners that Eagle Rock receives as part of the payment. Regency pays out a distribution of $1.88 per unit on an annualized basis, so if Eagle Rock owns ~8 million units, it will receive around $15 million per year in extra cash flow.

A large gap will force decisions to be made
After Eagle Rock Energy Partners' distribution cut, investors need to take a step back and look at what the future has in store for this MLP, especially as the stock has been hammered 33% this year due to shrinking distributable cash flow.

Now that Eagle Rock is a pure upstream based MLP, it desperately needs to grow its output. At 15 cents a quarter with 158.9 million common units to distribute to, Eagle Rock Energy Partners needs to be making at least ~$95 million in distributable cash flow a year to maintain its payout.

For 2013, Eagle Rock plans on spending $134 million on capital expenditures for its upstream business. In the first nine months of this year, Eagle Rock made $150 million in revenue from its upstream business with maintenance costs coming in at $40 million.

Extrapolating those numbers out, assuming everything remains constant, Eagle Rock should make $200 million in revenue from its upstream operations this year. Maintenance costs should come in around $53 million, which leaves $147 million to be devoted toward growth and distributions.

Factor out the $134 million in capital expenditures and Eagle Rock is generating only $13 million in distributable cash flow from its upstream operations (before adding in corporate costs) this year. Add $13 million to the $15 million from Regency Energy Partners, and Eagle Rock is short $67 million.

Selling off its midstream assets does give Eagle Rock some breathing room as it now has more capital to deploy to grow output. Unfortunately, until there is a balance between cash flow and capital expenditures, Eagle Rock is going to have to deplete its cash pile, borrow money, scale back its growth ambitions, or cut its distribution again.

A new direction
Now that Eagle Rock Energy Partners is focusing solely on oil and gas production, investors should look at what it has done so far. History isn't in Eagle Rock's favor, with oil and dry gas production for the first nine months of the year lower than last year. Only NGL production increased, but not by enough to offset the decline in oil and dry gas output.

The Cana-Woodford Trend and Golden Trend in the SCOOP, or South Central Oklahoma Oil Province, region has given Eagle Rock something to talk about. While production declined elsewhere, its SCOOP assets saw output rise by 46% year over year.

Output from SCOOP carries the second highest margins in Eagle Rock's upstream operations, and through 3-D seismic imaging, Eagle Rock will be able to continue to locate new locations to drill in deeper parts of the play. SCOOP is where Eagle Rock's future lays, and whether or not it is successful in the region determines where its distribution goes.

Another option
While Eagle Rock's distribution remains in the balance, Regency Energy Partners' payout of $1.88 on an annualized basis remains secure. With a distribution coverage ratio of 1.12x, Regency Energy Partners' acquisition will allow it to further cushion its payout.

This isn't the only purchase Regency Energy Partners is undergoing, Regency also spent $290 million buying midstream assets from Hoover Energy Partners. Additional assets will bring in additional distributable cash flow, which could justify a payout increase in the near future -- something the board of directors said they will recommend in 2014.

Foolish conclusion
Eagle Rock Energy Partners' is going to have to rethink its large distribution, as the financials don't add up. It could either pay out more now and post smaller output growth, or it could conserve cash while it expands its upstream operations. I would recommend the latter but still wouldn't be a buyer at these levels as the chance for a distribution cut remains high.

On the other hand, Regency Energy Partners' distribution has a bright future, with the chance of an increase coming soon. At $1.88 a year, Regency's common units carry a yield of 7.8%. I would much rather have security than a slightly higher yield that is unsustainable. In my next article I will dig deeper down into Regency's financials and why income investors should definitely look deeper into this MLP.

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