This Partnership Confirmed Its Contrarian Strategy in a Big Way

Legacy Reserves (NASDAQ: LGCY), a master limited partnership, or MLP, recently made a big, gas-oriented acquisition of property in the Piceance Basin in a deal with WPX Energy (NYSE: WPX). This acquisition signified a new strategic partnership between Legacy and WPX because Legacy acquired a working interest in the Piceance acreage that can be ratcheted up over time. 

The initial deal was for a 29% working interest in 276 billion cubic feet equivalent of proved reserves, 83% of which is natural gas. Net production is estimated to be 63 million cubic feet per day, with a reserve-to-production ratio of 12 years.

The deal was executed for $355 million in cash and 10% of incentive distribution rights, with the possibility of 20% incentive distribution rights should WPX continue to drop more assets down to Legacy. In plainer English, WPX can exchange more working interest rights to its Piceance properties, and in turn will get the rights to more of Legacy's distributions. This deal is expected to be immediately accretive despite the newly minted incentive distribution rights given to WPX.

Drilling for natural gas in the Piceance Basin. Source: Wikipedia

But isn't oil better?
At a time when most upstream MLPs are rushing to acquire oil-producing properties while de-emphasizing natural gas, it seems a bit peculiar to see Legacy going in the other direction. But the contrarian strategy is oftentimes the one that works out best in the end.

During the company's latest conference call, management confirmed that its strategy was not to designate a percentage of production as oil or gas, but to acquire properties that were the most accretive and carried the best value. Since many North America-based corporations are eager to get gassy assets off their balance sheets, Legacy was able to pick up a working interest in the Piceance for a reasonable price.

Source: Investor relations

The above chart shows just how relatively big this acquisition is. Production from the new Piceance acreage will account for almost a third of total production. Piceance acreage will account for over a third of the partnership's total reserves, too. This acquisition brings the partnership's total production to 47% oil, 46% dry gas, and 8% natural gas liquids. 

Because this deal really marked the beginning of a new strategic partnership, we should expect more deals between Legacy and WPX in the future. There are plenty more deals to be had: WPX has significant acreage in the mature, gas-rich San Juan Basin of New Mexico and yet more high-margin horizontal drilling acreage in the Marcellus shale, both of which Legacy may at some time be interested in acquiring a working interest in.  

Some final thoughts
Legacy finished this quarter with distributable cash flow at exactly 1 times the partnership's generous 8.6% distribution yield. That actually puts Legacy at the high end of its peer group. However, Legacy's hedging policy is rather weak compared to that of other upstream MLPs: Relatively little production is hedged past 2015. If you believe that oil and gas prices will go higher, however, Legacy may be the best choice among upstream MLPs for that same reason.

Overall, Legacy's contrarian 'value-oriented' strategy may prove to be the right one in the end, especially if natural gas prices reach and remain over $5. In such a case, Legacy would not only have more drilling inventory, but its net acreage would also have more value.