The Business

Atlas Resource Partners operates two business segments: oil and natural gas production and a fee-based partnership management.

The oil and gas production business consists of ownership interests in about 9,000 oil and natural gas wells located across the Northeast and Midwest, including the Appalachian Basin, the Illinois Basin and Denver-Julesburg Basin.

The Appalachian Basin stretches across Ohio, Pennsylvania and West Virginia. These states have produced oil and natural gas since the energy industry’s early years. In fact, the very first commercial well drilled in the US was located in Pennsylvania and completed in 1859.

The shallower plays in this region are well-understood, and these mature fields have predictable production and decline rates. Natural gas produced in the Appalachian Basin also tends to trade at a premium to prices on the New York Mercantile Exchange because of the play’s proximity to population centers in the Northeast, a key end market for the commodity.

More recently, producers in the region have turned their attention from shallow wells drilled to the Marcellus Shale and the even deeper Utica Shale. Drilling in the Marcellus and Utica formations requires horizontal drilling to increase the well’s exposure to the play’s productive segments and hydraulic fracturing to improve the reservoir rock’s permeability.  

Although US natural gas prices continue to hover at depressed levels, the fairway of the Marcellus Shale boasts the lowest production costs of any unconventional gas play in the country.

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Source: Goldman Sachs, Range Resources Corp

Much of the development in the Marcellus Shale and Utica Shale has focused on natural gas, but both formations yield significant amounts of high-value natural gas liquids (NGL) in their western reaches. The Utica Shale consists of three distinct windows: an oil window to the west, an NGL-rich window and a dry-gas phase where Ohio borders Pennsylvania. The presence of these higher-value hydrocarbons boosts wellhead economics.

Atlas Resource Partners has interests in 221 gross wells in Pennsylvania, 207 of which are vertical and 14 of which are horizontal. At last count, the company also had an additional 24 wells that have been completed and are scheduled to enter production in the first half of 2012. Sixteen of these new wells are horizontal completions that target the shale formations. The company is also drilling two additional wells targeting the Marcellus Shale in West Virginia and two wells in Pennsylvania.

The MLP has interests in a total of 2,100 wells in Ohio, the majority of which are mature wells targeting shallower formations. Atlas Resource Partners plans to target the Utica Shale in future drilling efforts and has opened up three field offices in the Ohio to support that expansion.

In the Illinois Basin, the partnership has 100,000 net acres in the biogenic gas window of the New Albany Shale play in southwestern Indiana. There are two kinds of natural gas: biogenic and thermal. Thermal gas is created from natural underground heat reacting with hydrocarbon deposits. For this reason, fields of varying depths often produce natural gas in the deeper, hotter portion of the play and oil or NGLs in the shallower, cooler intervals.

Biogenic gas is created by microbes breaking down organic material and seldom contains NGLs and other hydrocarbons. These fields are often quite shallow.

The MLP’s assets in the Denver-Julesburg Basin target the Niobrara Shale. Thus far, producers have primarily targeted this emerging play’s oil window, which is found in basin’s western reaches in Colorado and Wyoming. Atlas Resource Partners’ acreage in eastern Colorado, western Nebraska and Kansas primarily produces natural gas and offers less attractive economics.

In 2011 Atlas Resource Partners produced 35.9 billion cubic feet of natural gas equivalent per day, about 87 percent of which was natural gas. Given elevated oil and NGL prices, liquids accounted for almost 27 percent of the MLP’s 2011 revenue from oil and gas production.  

The company’s overall hydrocarbon production has declined over the past three years from 41.8 million cubic feet of natural gas equivalent in 2009. Waning production, coupled with weak natural gas prices, have led to a more than 40 percent contraction in this business segment’s revenue.

Atlas Resource Partners also forms investors partnerships through which individuals can add exposure to oil and gas wells in a particular field or several plays. The MLP usually invests in these partnerships alongside individuals, contributes some acreage and acts as the manager and general partner.

Atlas Resource Partners usually takes a 15 percent to 31 percent stake in these investment partnerships. In addition, the MLP receives another 5 percent to 10 percent interest as partial compensation for acting as GP. The company also receives additional fees for drilling wells and other services. In exchange for these fees, Atlas Resource Partners subordinates a portion of its ownership stake in each partnership, a practice that means the MLP foregoes some of its annual distribution if individual investors don’t receive a minimum rate of return–usually about 10 percent.

By taking on subscriptions from individual investors, the firm can finance a good portion of its drilling and completion costs. The fees Atlas Resource Partners receives from investors provide a stable revenue stream that doesn’t fluctuate with commodity prices.

Shortly after Atlas Resource Partners’ spin-off from Atlas Energy, the MLP announced the acquisition of 200 natural gas wells and around 277 billion cubic feet equivalent of natural gas reserves from Carrizo Oil & Gas (NSDQ: CRZO) for $190 million. The acreage involved in the transaction is located in the Barnett Shale, the first major gas-producing unconventional field developed in the US. Prior to inking the deal, the MLP’s proven reserves totaled about 167.6 billion cubic feet of natural gas equivalent; the acquisition more than doubles the size of the MLP’s reserve base and roughly doubles its annual production.

Investment Opinion

The main headwind facing Atlas Resource Partners is its heavy exposure to natural gas in a market where natural gas prices are depressed and likely to remain so for at least the next 2 to 3 years. The US is just exiting one of the warmest winters on record and unusually high temperatures have reduced demand for natural gas as a heating fuel. The result: natural gas in storage currently sits at a seasonal record and is running nearly 60 percent above the five-year average for this time of year.

Even worse, natural gas injection season — the time of year when the US typically starts adding more gas to storage – has started nearly a month earlier than normal in 2012. This raises the risk that US gas storage will be physically maxed out this coming autumn before winter heating demand begins to kick in again.

And, the weak outlook for gas has deeper roots than a single warm winter. US gas producers are, in effect, a victim of their own success in finding and developing vast new sources of natural gas production such as the Barnett, Marcellus and Haynesville Shale fields. A surge in output from these plays has resulted in a glut of gas in storage in recent years and has kept a lid on any price advances. The outlook for natural gas isn’t likely to improve much over the next few years, at least until the US is in a position to ramp up meaningful quantities of liquefied natural gas (LNG) exports in the latter half of this decade.

Weakness in gas prices has been and will continue to be a headwind for Atlas Resource Partners. Prior to its Carrizo acquisition, the company had hedged just under 50 percent of its total projected 2012 production. At the time of its spin-off, Atlas projected that the MLP would require $52.9 million in annualized earnings before interest, taxation, depreciation and amortization (EBITDA) to actually cover its $1.60 annualized minimum distributions. Moreover, the MLP indicated at a 10 percent change in unhedged gas prices would reduce EBITDA by about $4.4 million.

What worried us was that the company’s distribution projections at the time of its spin-off were based on prevailing gas prices at the end of September last year – check out my chart XX for a closer look.

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Source: Bloomberg

This chart shows the NYMEX-traded Henry Hub natural gas futures price curves as of the end of September last year and at the end of March this year. These curves simply show the prevailing prices for natural gas futures for the period from April 2012 through to the end of 2015. As you can see, gas prices are far lower today than was the case last September due, in part, to the unsustainable surge in gas in storage due to the warm winter.

May 2012 futures prices for gas were trading at over $4/MMBTU on September 23, 2012, roughly double where the same futures were trading as of the end of March. That represents a significant hit to Atlas Resource Partners’ EBITDA for 2012.

The Carrizo deal has ameliorated the outlook for the MLP. While the acquired properties are primarily gas-focused, the big advantage is that Atlas Resource Partners grabbed these properties at a fire-sale price of about $4,219 per thousand cubic feet of production per day and $0.69 per thousand cubic feet of reserves. That’s about a 50 to 60 percent discount to recent acquisitions closed in the same region. This cheap sales price may indicate that producers are finally recognizing that with gas prices so depressed, valuations for such properties are falling fast.

Atlas Resource Partners has also said that it intends to hedge 100 percent of available production related to this acquisition for the first full year and 80 to 100 percent of production in years 2 to 5 following the deal. Since Atlas was able to acquire these quality properties for a song and hedge its production for years into the future it has essentially locked in some cash flows from the deal over the next few years.

Since the deal was so large relative to its existing production base, Atlas Resource Partners’ hedge position now looks a lot better than it deal a few weeks ago – based on its production rate in late 2011, the MLP is now about 90 percent hedged over the next 12 months and has significant hedges in place covering 2013, 2014 and 2015. 

In its presentation to discuss this acquisition, management significantly boosted it distribution guidance over the next few years.  Atlas now believes it can raise its quarterly distributions to a range of $0.85 to $0.90 per unit in the second half of 2012 compared to prior estimates of just $0.80 per unit. In 2013, Atlas believes it can pay a full year distribution of between $2.25 and $2.40 per unit up from prior guidance of $2.10.

Management also laid out a path to future growth via acquisitions. If you assume the firm is able to make 5 additional natural gas acquisitions on similar terms (or more smaller deals) over the next few years, management believes it can expand its payout to around $3.06 per unit almost double the minimum distribution rate of $1.60 per unit annualized. Since its debt to EBITDA ration remains under 1.0, the MLP does look to be in a position to raise additional debt capital to fund such deals if it finds attractive prospects.

But while there’s a lot to like about the Barnett Shale acquisition and management’s ambitions to expand by purchasing gas properties at cheap prices, there are a lot of “ifs” in this strategy. For one thing, Atlas isn’t the only MLP that’s identified the potential to buy gassy production at dirt cheap prices as a path to future growth. MLP Profits recommendation Linn Energy (NSDQ: LINE) also recently bought gas producing properties on the cheap and has used hedges to lock in production. There’s certainly no guarantee that Atlas will be able to make similar deals at such attractive prices in future if Linn and other bargain hunters become more active.

Moreover, while Atlas is heavily hedged over the next few years the company still has significant natural gas exposure and ongoing weakness in prices is still at least a modest headwind.  We tend to prefer MLPs with more balanced exposure between oil and natural gas. 

If Atlas Resource Partners does hit the high end of its 2013 distribution guidance, the MLP would yield about 8.6 percent at current prices, well above the average MLP in the Alerian MLP Index. But, Linn has a better hedge position and more oil exposure and could easily yield 8 percent in 2013 if it increases distributions as we expect. And recent portfolio addition Mid-Con Energy Partners (NSDQ: MCEP) already yields over 8 percent but has no significant gas exposure whatsoever.

We’re adding Atlas Resource Partners (NYSE: ARP) to the MLP Profits How They Rate coverage universe as a “Hold.” The MLP has a safety rating of zero.