• This post discusses why common unit holders of Eagle Rock Energy Partners, LP (EROC) should vote NO to the most recently proposed recapitalization. We have set up a website at www.fair-eroc.com where we explain why we believe unit holders should vote NO.
• That website discusses EROC’s current recapitalization proposal, while this post discusses EROC’s background, business and the stock’s potential total return if NGL prices stay roughly constant.

Eagle Rock Energy Partners, LP trades under the ticker EROC on Nasdaq. EROC is an oil and natural gas MLP.

We are holders of EROC common units. On January 14, 2010, EROC issued a preliminary proxy regarding a recapitalization transaction with its sponsor Natural Gas Partners (“NGP”), and the transaction will likely be voted on by public common holders at some point in the next 6 months. We urge common unit holders to vote NO to the NGP proposal, unless it is substantially modified. This post will explain why we think the current transaction is adverse to common unit holders’ interests, as well as discuss an investment in EROC in general.

We have set up a website at www.fair-eroc.com, where we explain why common holders should vote NO to the current transaction. If you are an EROC unitholder, please distribute the link to other public holders. The site and analysis will be updated as revised proposals or other relevant facts emerge.

Accounts managed by Kerrisdale currently hold EROC, and we may buy or sell shares at any time. We will not disclose our sale if and when we sell, and we will not necessarily disclose that we have changed our thesis if we discover something faulty with our analysis at a later date.

Our excel model, historical financials and various EROC analyses can be downloaded here.

Recapitalization

EROC owns various oil and natural gas assets, of both the midstream and upstream varieties, and it suspended its dividend in early 2009 due to declining commodity prices and a potential debt covenant breach in 2010. The proposed recapitalization aims to reduce leverage to avoid a covenant default.

On www.fair-eroc.com, we explain why we believe EROC unit holders should vote NO to the current proposed recapitalization. On that site, we go through three scenarios:

1) No recapitalization
2) Currently Proposed Recapitalization
3) A Fair and Appropriate Recapitalization

The aptly named “Fair and Appropriate Recapitalization” is our preferred course. It is very similar to the currently proposed recapitalization, but removes a $29m fee to EROC’s sponsor. If the currently proposed transaction is rejected by unit holders, we believe that the Board of Directors will be compelled to adopt a transaction very similar to our suggested “Fair and Appropriate Recapitalization”. If they don’t, we think they would be potentially breaching their fiduciary duty, and be exposed to lawsuits.

We are not going to rehash in this post our discussion of the recapitalization scenarios that is currently on www.fair-eroc.com. Instead, we’ll discuss EROC’s business and potential stock valuation.

Business Overview

Eagle Rock Energy Partners, LP is a master limited partnership engaged in three businesses:

(i) gathering, compressing, treating, processing and transporting natural gas; fractionating and transporting natural gas liquids (“NGLs”); and marketing natural gas, condensate and NGLs, which we will call its “Midstream Business”;
(ii) acquiring, developing and producing interests in oil and natural gas properties, which we call its “Upstream Business”; and
(iii) acquiring and managing fee mineral, overriding royalty and royalty interests, either through direct ownership or through investment in other partnerships, which we call its “Minerals Business”

Excluding hedges, the midstream, upstream and minerals businesses accounted for 59%, 32% and 9% of 2008 EBITDA, respectively.

The Midstream Business owns assets in five natural gas producing regions: (i) the Texas Panhandle; (ii) East Texas/Louisiana; (iii) South Texas; (iv) West Texas; and (v) the Gulf of Mexico. These five regions are productive, mature, natural gas producing basins that have historically experienced significant drilling activity. As of 12/31/08, Eagle Rock’s natural gas gathering systems within these regions represent approximately 5,200 miles of natural gas gathering pipelines with approximately 2,600 well connections, 18 natural gas processing plants with approximately 801 MMcf/d of plant processing capacity and 207,100 horsepower of compression. The Midstream Business averaged 450.8 MMcf/d of gathered volumes and 322.1 MMcf/d of processed volumes during 2008.

The Upstream Business has long-lived, high working interest properties located in four natural gas producing regions: (i) Southern Alabama; (ii) East Texas; (iii) South Texas; and (iv) West Texas. As of 12/31/08, these working interest properties included 321 operated productive wells and 142 non-operated wells with net production of approximately 5,600 Boe/d and proved reserves of approximately 40 Bcf of natural gas, 7.2 MMBbls of crude oil, and 5.6 MMBbls of natural gas liquids, of which 85% are proved developed producing.

The Minerals business is likely to be sold, so we are not going to focus on it. We will however say that it is a valuable asset comprised of a portfolio of royalty interests in various productive wells in 17 states. The segment will generate $14m to $15m of EBITDA in 2009, and keep in mind that 2009 suffered from what could very well be trough energy prices. As well, 2009 figures don’t include any lease bonuses, rentals or other one-time bonus payments, whereas 2008 benefited from $17m of such “recurring non-recurring” bonus payments. The minerals business has minimal capex / working capital uses. At 12x trough cash flow, we think that Black Stone is getting an excellent deal, and they’ve aggressively pursued this asset ever since EROC first indicated it might sell the minerals division. In the originally proposed restructuring, NGP had arranged to purchase this business for $135m, an extremely low price, but Black Stone’s persistence and unsolicited proposal shortly after the initial recapitalization announcement prompted the board to recommend selling it to Black Stone.

EROC was essentially created in 2006 when Natural Gas Partners, a $7bn energy-focused private equity firm formed the partnership as a monetization vehicle. NGP and management own the publicly traded partnership’s general partner, all subordinated units, and about 26% of the common units. The general partner is entitled to an increasing share of cash flow as specific dividend benchmarks are met, and these are captured through what are called “Incentive Distribution Rights”.

After going public in 2006, EROC completed more than half a dozen acquisitions totaling over $800 million, including multiple deals involving oil and natural gas production assets and fee mineral and royalty interests. As a result, EROC has become a hybrid MLP with midstream natural gas assets, upstream oil & gas assets, and fee minerals / royalty interests. The margins generated under some of EROC’s gathering and processing contracts, particularly its keep-whole and percentage-of-proceeds contracts, fluctuate based on the price of natural gas and NGLs and, in some cases, the relationship between the price of natural gas and NGLs. Its upstream assets are directly levered to energy prices. EROC attempts to hedge its commodity price exposure through the use of various financial instruments.

In the second half of 2008, the rapid decline of commodity prices had adverse impacts that ultimately led to a rise in forecasted leverage and a cut in the Company’s unit holder distribution. Cash was redirected towards reducing debt.

Per its partnership agreement, when EROC suspends its common distribution, all quarterly distributions under $0.3625 per share are accumulated as arrearages. The Company must repay these arrearages to common holders before subordinated holders get any distributions. Because the Company suspended its distribution in early 2009, $1.01 of arrearages have accumulated through to September 30, 2009. Unless commodity prices surge, subordinated holders are unlikely to receive any distributions over the next several years, which explains NGP’s eagerness to do a deal that replaces their subordinated units with newly issued common units.

Financials

We have attached our quarterly excel model of EROC here. Please note that this is our internal model at Kerrisdale Capital, using publicly available information and our own internal assumptions. Most notably, our projections do not match the Company’s projections. Our EBITDA comes out higher than the Company’s base standalone model, as can be seen by the following comparison:

The differences are due to numerous reasons. We don’t have any reason to believe that our model is more accurate than the Company’s. And really, we build models to better understand the business drivers of our portfolio companies, and are fully aware that our assumptions and profit forecasts may be wrong. We don’t have access to the same detailed information as the Company does, nor have we spent as much time analyzing EROC’s underlying trends as its CFO has.

At the end of the day, our EBITDA forecasts are not terribly different from the Company’s. In our valuation analyses below, we use the Company’s projections.

Valuation

MLPs trade on dividend yields, to a large degree. Based on the Company’s projections, EROC would have $82m of distributable cash flow in 2010 and $89m in 2011, in a standalone base case. If the transaction is approved, 2010 and 2011 DCF would be $76m and $104m. The dramatic difference in 2011 is due to higher interest costs in the standalone case following a 4Q 2010 covenant breach, based on the Company’s assumption that interest rates would rise 250bps.

The Company’s new distribution policy will establish a conservative baseline distribution that will be expected to be lower as a percentage of total distributable cash flow than many other MLPs. The rationale for this is that EROC’s underlying assets are exposed to more commodity price risk than other MLPs.

The Company has projected a $0.40 – $0.60 annualized distribution if the current transaction is approved. In our analysis, we assume that distributions begin at $0.60, rising to $0.75 in 1Q11 and rising to approximately $0.85 – $0.95 in 4Q11. These amounts are less than 75% of distributable cash flow in each relevant period. In 4Q11, we assume a distribution equal to 70% of distributable cash flow. These are fairly conservative payout ratios.

If the recapitalization transaction is rejected and no modified recapitalization occurs, we estimate a 60% cumulative 2-year gain by purchasing EROC at Monday’s closing price of $6.31, IF management decides to re-instate a regular distribution at the approximate 4x leverage that the Company would have at the end of 2011.

If the current recapitalization transaction is approved, we estimate a 81% 2-year total return.

If the currently proposed recapitalization is rejected, and management chooses to do a modified recapitalization where they sell the Minerals business and do a rights offering, but don’t pay the unwarranted $29m fee to NGP, we estimate an 87% 2-year total return for common unit holders.

Commodity Price Risk

EROC is a commodity business. Both the upstream and midstream businesses have exposure to energy prices, and, specifically, EROC is highly levered to natural gas liquids prices. NGLs refer to ethane, propane, iso butane, normal butane, ethane and pentane, and the pricing of these products drive the company’s earnings.

Arguing that EROC should generate attractive returns as long as NGL prices stay constant is a bit like arguing that EROC should generate attractive returns as long as the coin I flip lands on heads. Forecasting the direction of the NGL price deck is tough. Unlike other commodities (natural gas and crude oil) that have a somewhat transparent relationship between supply and demand (at least when compared to NGLs), fundamentals for natural gas liquids are driven by a complicated interplay of a host of hard-to-predict factors. NGL supply, demand, and prices are driven by markets that function independently of NGL fundamentals.

On the supply side, NGL supply is largely a function of the quality and level of natural gas production, rather than being responsive to NGL demand. This is because NGLs must be extracted from natural gas in order to meet pipeline specifications. In contrast, domestic demand for NGLs can fluctuate based on a number of drivers, including the overall demand by petrochemical companies, which is driven by economic activity; NGL exports, which are driven by ethylene production levels abroad and global demand for ethylene derivative products; and the economics of using a light (NGL-based) versus a heavy (crude oil based) feedstock in petrochemical steam crackers to produce ethylene and other products.

All of this said, NGL prices have historically been driven by crude oil prices moreso than the overall supply / demand dynamics of the NGL market. According to a Wachovia report in April 2009 (“Cracking the Code on Natural Gas Liquids”), NGL prices exhibit a higher correlation to crude oil prices than to NGL supply and demand imbalances. Wachovia tracked benchmark ethane and WTI prices since 2001, and noticed a 0.93 correlation between the price of ethane and crude oil. The reason is that light-feed NGL components compete with crude oil feedstocks (naphtha and gas oil) in the petrochemical industry, which is the primary end market for NGLs. If oil prices increase 50%, other crude refinery byproducts like naphtha and gas oil will follow directionally, and as those byproducts become more expensive relative to NGLs, ethylene producers will opt for a higher percentage of NGLs in their feedstock mix and NGL prices will rise. And vice versa.

EROC’s upstream business is also tilted towards oil vs natural gas, with more than 60% of 2008 upstream gross profit coming from oil and NGLs. On the natural gas side, EROC’s natural gas short position is generally offset by its gross profit from the natural gas production in its upstream business.

So it’s really oil / NGL pricing that drives EROC’s earnings. The question of whether crude trades at $60 vs. $80 vs $100+ a barrel in 2011 will probably have a bigger impact on EROC’s stock performance than how investors vote on the current recapitalization. In its crudest form (pardon the pun), an investment in EROC is just one of many ways to invest in oil.

Conclusion

Common unit holders should vote NO to the current recapitalization proposal outlined in the January 14, 2010 proxy.

Per usual, this post does not constitute investment advice or a recommendation of any sorts. We may buy, sell or short any of the stocks mentioned at any time. We may be wrong; it won’t be the first or last time.

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