The Short Story:

PennTex (PTXP) is a small midstream MLP backed by deep pocketed NGP Partners with two gas plants and a gathering system in Northern Louisiana serving the prolific Terryville field in the Cotton Valley formation.  For years, vertical wells in this region have yielded mostly mediocre results, but with horizontal drilling, mile long laterals, and hydraulic fracturing are changing the game. PennTex’s sister company, the well hedged Memorial Resource Development (MRD) is using these techniques to develop Marcellus class wells in the Terryville without the infrastructure constraints of Appalachia. After last year’s IPO, PTXP is already down over 50%,  but yielding a relatively secure 11% covered by a minimum volume commitment (MVC) contract and a subordinated share structure. PennTex is basically an “earn while you wait” situation.  While 11% is not bad, only a modest increase in oil prices to $45-$50/barrel and $2.50 gas is required for PennTex to obtain the volume increases necessary to feed even higher distributions. Given PennTex’s secure distribution and future prospects, the yield on the distribution should reset to a more appropriate 7-8% yield once the winners and losers in the MLP space are sorted out and generate a corresponding share price increase as well.

Why does the opportunity exist now?

All midstream MLP’s are getting hammered in the MLP selloff, and most of them for good reason. If your midstream operation is servicing a high cost basin, or bankruptcy bound partners like Chesapeake, then your MLP’s value should be impaired. I will argue however that PennTex is the exception due to its strong distribution coverage. It is a case of the baby getting thrown out with the bathwater.

The stock price distortion is magnified for PennTex, because it is new and unknown, and because it is small.  PennTex is just a 400 million market cap company with an even smaller public float of 125 million. At this size, a little forced selling by a distressed seller (see over leveraged closed- end MLP funds) can go a long way to depressing the stock price.

What is the long-term opportunity?

Memorial Resource Development (MRD) is PennTex’s primary customer and the counterparty to the MVC. Fortunately, MRD is fully hedged for its production through the end of 2017.  Its primary asset is the Terryville field, a stacked play in the Cotton Valley formation in Northern Louisiana.

NGP partners directly and through affiliates owns 45% of MRD as well as PennTex’s general partner (GP), the Incentive Distribution Rights (IDRs) and 67% of PennTex limited partners (PTXP).   NGP could run MRD at break-even and still make good money processing MRD’s wet gas through PennTex.  This is critically important because when you own units in the MLP’s limited partner, you are at the mercy of the general partner to treat you well.

As a new MLP, the IDRs are currently set at zero, but the IDRs increase quickly to 50% with an 50% increase in the current distribution. In addition, at $1.60/year, the subordinated shares are converted to full shares.

Total Quarterly Distribution
Target Amount	Unit holders	GP (IDR holder)
Below $0.3163	100%	0%
above $0.3163 up to $0.3438	85%	15%
above $0.3438 up to $0.4125	75%	25%
above $0.4125	50%	50%

 Following the original IPO prospectus and MRD’s 2015 drilling schedule, the IDRs were on target to be at 50% by 2017.  With MRD announcing in January 2016 that it was reducing its drilling rig count from 8 in 2015 to 1 by Q2 2016, volumes may not be increasing as fast and the date to reach a $1.60/unit distribution will be correspondingly delayed. I say “may” and not “will” because MRD will still have 30 drilled, but uncompleted wells, available for completion by Q2 2016.  But eventually, if drilling does not resume at higher rates, volumes will definitely decrease.

If $50 oil and $2.50 gas is reached by 2018,  MRD will likely increase its rig count back to 2015 levels, and a $1.60 distribution or more would be a certainty shortly thereafter. Applying a  7% yield on the $1.60 implies a $22.58 share price and an annual return from capital gains and distributions would be approximately 27% per year.   More aggressive oil price projections would get you a much higher return.

The Terryville does not require $80 oil. Some of the best detail on MRD’s economics are in the April 2015 MRD Analyst Field Trip Presentation. The company offers claims a 200% IRR on Upper Red zone wells at, $60 oil and $3 gas, and a 122% IRR on the same wells with $50 bbl oil, and $2.50 MCF gas.  I don’t think you have to be an oil bull to expect close to $50 oil by 2018.  MRD shareholders may want $100 oil, but $50 is good enough at PNTX.

Given that these are all company supplied numbers, they probably do leave out corporate overhead among other expenses, but in any scenario, full scale drilling will return to the Terryville much sooner than say the Bakken or Eagle Ford with higher break-even points.  And with the Terryville only two hundred miles from the Henry Hub sales point, Terryville gas sales without a negative pricing differential.

How well is the current $0.27 distribution covered in case we see no growth for a few years.

PennTex needs 11 million in distributable cash flows per quarter to cover a $0.27 distribution and until it completed its second plant in October 2015, it was not covering its distribution. But after the plant came online, the minimum volume commitment increased the following quarter to its present 340 MMCF/D.

The estimate in the IPO prospectus (see page 62 below) for the quarter ending July 2016, includes a full quarter at the 340 MMCF/D MVC rate shows $13.7 million in revenue from the MVC, 3.5 million in revenue for volume in excess of the MVC, and 5.5 million in pipeline usage fees for a total of 22.6 million.  Against this, deduct 10 million in expenses, add back 3.7 million for EBITDA adjustments, subtract 1.9 for interest and maintenance capital and you get 16.6 million or coverage of 16.6/11 = 1.5x

Including “excess volume over MVC” if MRD is cutting back its drilling  is dubious  even if production in January 2016 is still 416 MMCFeD.  But excluding that 3.5 million only reduces distributable cash to 13.1 million and coverage still remains strong at 13.1/11.1 or 1.2x.

But wait there’s more.  PNTX has 40 million shares, and 20 million of NGP’s shares are subordinated.   Public shareholders don’t need PennTex to generate 11.1 million in distributable cash to be paid $0.27/quarter, 5.55 million would cover the subordinated shares.  We really have 2.4x coverage in case things get really bad.

And if you’ve read this far, I’ll share another secret.  The MVC goes up one last time to 460 MCF/day after July 30, 2016. This will increase committed revenue from $13.7 million to $18.5 million.   Frankly at 18.5,  I will expect a small distribution increase even if there is no excess production.

Risks:

Bankruptcy

Previously I wrote about Sanchez Production Partners (SPP) which has a weak, over-leveraged E&P partner, Sanchez Energy (SN). While my SPP share purchase was good for a quick couple bucks, I sold them at the end of 2015 to avoid another year of K-1 returns and more importantly because SN is likely as not to go bankrupt and I have no clue how the contracts between SN and SPP will hold up in bankruptcy court.

MRD is the counterparty to the minimum volume commitment which underpins PennTex. MRD also owns full hedges on its production through the end of 2017, so unlike many E&P peers, bankruptcy from low prices is not on the horizon. MRD’s senior debt is not due until 2022.

While I am not particularly bullish on natural gas or crude oil, but I do think natural gas prices will eventually have to increase to a price sufficient to make drilling for gas in North America’s best fields, such as the Marcellus and Terryville at least marginally profitable. For the past five years, E&P companies have continued to drill unprofitable wells after unprofitable well just to hold on to a lease agreement so that they can keep the right to drill more unprofitable wells on that land, but ultimately the financing for this nonsense will stop, and these producers will eventually go bankrupt or shift to a more profitable business model and stop drilling unprofitable wells.

The Terryville Field doesn’t turn out to be as wonderful as it appears.

While the best Terryville Field and North Louisiana Cotton Valley horizontal wells appear to be as prolific as top Marcellus class wells the future need not be as bright as the past.  Sweet spots are never as big as anyone predicts. Still the numbers in the April 2015 Analyst Day Presentation are definitely impressive.

And while one of the appeals of the Terryville field is that it is a stacked play, currently only the thickest sands in the stack (Upper Red) are near economic at current prices.  The least appealing sands in the stack may require $80 oil to work out (see analyst day presentation).

Still what we do know about the Terryville is pretty darn good. The proved and developed reserves as reported by Netherland, Sewell, and Associates show reserves based on Dec 2015 12 month SEC prices ($46.75 oil/$2.59 gas) show proved reserves of 1378 BCFe.  At the current 426 MMCfe/d rate gives a proved reserve life of 11.1 years.   “Probable” reserves are twice as high. And “Possible” reserves are even higher, but then “Possible” is a pretty low standard, so it should be high.  I was more impressed that the reserves held constant between year-end 2014 and year-end 2015, even though the SEC pricing deck for 2015 was nearly half the 2014 prices.  Lastly, management pointed out that the decline history is favorably exceeding the auditor’s projection, so we may see future upward revisions.

In any case, this is a real field producing, real gas with NGLs and MRD continues to buy more leases in the area committed to PennTex. Whether it is a just a good field and we collect just 11% and a little bit more or a really good field and we collect 11% plus a lot more, we will learn in time.

PennTex may be unable to attract financing for growth

The current high yield on PTXP shares prevents their use in selling shares to raise new capital for expansion or acquisition.  This is certainly a challenge for PennTex and all MLPs.

First, I don’t expect the yield to stay at 11%, but more importantly NGP has the resources to obtain alternative forms of financing such as convertible preferred stock.  In the Nov 15 conference call, management mentioned that it wouldn’t be prudent to go to the capital markets at this time (sell more units), but implied they had private market options too.

MLP partnerships issue K-1’s and I hate K-1’s

True, but at least this one only has operations in Louisiana, so this doesn’t require filing in 20 states.  PennTex does have a right of first refusal to build gas processing for NGP in West Texas, but since Texas, does not have a state income tax, it would not add to the paperwork.

No governance

The biggest risk of all is that you are purchasing units in a limited partnership is that the general partner can pretty much do whatever it wants.  In our case, NGP owns the GP, the IDRs and with 68% of the PTXP LP units owns more of PTXP than public shareholders do, so in theory would like to see the LP succeed.  Additionally, NGP Partners is a significant MLP player and it would impair its ability to do future deals if it treated unit holders unfairly. For instance, OZ partners own 10% of PTXP’s units.  While the big boys at NGP may not care about a retail investor, I don’t think they want to treat a future source of capital like OZ poorly.

Lastly NGP also owns 45% of MRD and MRD needs PennTex to process MRD’s gas.  And as previously mentioned, since NGP owns a higher percentage of PTXP than MRD but effectively controls both parties, NGP can optimize its earnings by having MRD’s gas processed through PTXP’s facilities.  This become especially attractive once the IDRs kick in at 50%.

Conclusion

Barring $15 oil lasting for 5 years bankrupting MRD when its hedges run out at the end of 2017, downside protection is solid, and even a modest recovery in oil prices should ignite a growth story. Until then, we will collect a reasonable secure 10% and wait.

Useful Links:
Memorial Resource Development MRD – Operational, Reserves and Guidance Update Feb 2016

Disclaimer:

The author owns shares in PTXP.  Occasionally this author is wrong and he may very well be wrong in this case as well. Do your own work.