Constellation Energy: A Good Trade for a Natural Gas Rebound

Sep. 8.09 | About: Sanchez Production (SPP)

A small-cap natural gas pure play that is selling for 23% of its Net Asset Value (NAV). The opportunity provides a huge margin of safety and an extremely compelling upside.

Company

Constellation Energy Partners (CEP) was formed by Constellation Energy Group in 2005. In Nov 2006 CEP was taken public. Constellation Energy Group still owns 28% of CEP, although they are looking to divest and looks like will sell their stake.

The company’s current assets include natural gas and oil reserves in the Black Warrior Basin in Alabama, the Cherokee Basin in Oklahoma and Kansas, and the Woodford Shale in the Arkoma Basin in Oklahoma. NatGas accounts for 99% of its reserves.

For tax purposes the company is a MLP.

Industry

Everyone has read the headlines about NatGas selling at 7-year lows. Although if you listen to the management team of most NatGas companies, it is clear that prices will rebound into the 7-10 range in 2010 and even higher in 2011.

From EOG's most recent conference call:

Mark Papa [CEO]:

Our view of the North American gas and oil markets is consistent with our previous earnings call, except that we've become more bullish regarding 2010 and 2011 gas prices. We still expect North American gas prices to remain quite low through year-end.

As you know, we've historically devoted a lot of work to developing domestic gas supply models and we think our current model is the most granular and best we've ever built. It's telling us that December 2009 domestic production will be 4.8 Bcf a day lower than year-end 2008 and this deficit will deepen further throughout 2010. When added to the Canadian supply drop of at least 0.8 Bcf a day, we expect the gas market to turn sometime early in 2010 almost regardless of what happens to LNG imports.

Everybody seems to be focusing on the supply growths from new horizontal plays, but the 800 pound gorilla in the room is Texas vertical gas production. This represents the largest single block of production in the U.S. 16.3 Bcf a day in December '08, and the rig count here has fallen from 450 rigs in January 2008 to 145 rigs today [Aug 4 '09].

Our model shows production from this large segment of domestic production will fall from 16.3 Bcf a day at year-end '08 to 13.2 Bcf a day by year-end '09 and then 11.6 Bcf a day by year-end 2010 down 4.7 Bcf a day over two years. In my opinion, this is the most important well population that people should be focusing on if they want to understand what's going to happen to gas supply over the next 24 months.

In order words, NatGas prices are bound to go up in 2010 and 2011. All the near term concerns about storage don't impact NatGas' future prospects.

Reserves

As of Q2 '09, CEP has total proven reserves of 232 Bcfe, with 99% of it as natural gas. It owns 3 reserves: Black Warrior Basin (111.6 Bcfe), Cherokee Basin (115.7 Bcfe), and Woodford Shale (5.1 Bcfe).

As of Q2 '09 the average daily production was 48MMcfe. So the company is producing 18.25Bcfe per year. At that rate the company has over 12 years of production reserve. This is definitely not a growth company, but it has plenty of years left of production.

The company does not intend to spend much capital on new drilling, not until the commodity market recovers. This will allow the company to redirect the cash flow to pay down debt.

Production Costs

The company's production costs are about $3.1. The company is not the most efficent in production costs but it is right around average w/ the industry. At current NatGas prices the company is at a loss with its production costs. The hedges that the company has protects it in the current market. As the market rebounds their non-hedged production will be profitable and increase cash flow.

Hedges

The management has shrewdly hedged its production for the next 5 yrs. The hedges are in the $7-8 range, allowing the company to create stable cash flow. The company hasn't hedged its entire annual production but a large chunk of it is hedged for the next couple of years

2009 - 6 Bcfe - $8.39
2010 - 12 Bcfe - $8.19
2011 - 10 Bcfe - $8.46
2012 - 9 Bcfe - $8.34
2013 - 8 Bcfe - $7.33
2014 - 6 Bcfe - $7.03

With the annual producton of 18 Bcfe, the company is likely to produce 9 Bcfe in the last 6 months of 2009. The company has hedged most of that production in the $8 range. So the company's cash flow for the rest of 2009 will be extremely stable. With the annual production of 18 Bcfe, the company has hedged over 50% of its production in 2010 and 2011. This should allow the company to easily ride out the currently low NatGas prices and wait for more realistic market prices. The management team has stated that it purchased more hedges at the right price. We expect the company to hedge more of its production as the market prices recover.

Debt

The company has $220M oustanding on its $225 of its borrowing base. The company initially had a borrowing base of 265M. The base was reduced to 225M which caused the outstanding amount to be greater than 90% of the borrowing base. The company has been forced to place a temporary distribution suspension on its dividend.

The debt matures on Oct 2010. The company will likely generate 50-70M between now and Oct 2010. The company also has 16M of cash on hand. The company has made paying down the debt a priority. If the company redirects a majority of its cash flow and the current cash towards debt paydown, the company will likely have around 150-170M in debt at Oct 2010. The debt load will be miniscule when compared to the company's expected proved reserves of 210 Bcfe at Oct 2010. The company will easily able to refinance and roll forward its debt. Although the interest rate on the debt might go up, we don't expect the higher interest rate to have much impact on the cash flow. We expect the lower principal amount to easily mitigate any increased interest rate.

Cash Generation

Compared to the company's cash generation, the company is extremely undervalued. The company had adjusted EBITDA of 17M in Q2 and 17.3M in Q1 of 2009. The adjusted EBITDA in the most recent quarters:

Q2 09 - 17M
Q1 09 - 17.3M
Q4 08 - 18M
Q3 08 - 18.8M
Q2 08 - 20.5M
Q1 08 - 17.5M

The 2008 numbers are higher than 2009 due to non-hedged sales at much higher prices. For Q3 and Q4 of 2009 we expect the company's EBITDA to keep decreasing because of the non-hedged sales will be at depressed values. Although given that it has most of its 2009, 2010, and 2011 production hedged, we expect the company to still make mid-teens in cash flow per quarter.

As for CapEx, the company spent 25M this year on getting new rigs placed. We think the CapEx will be less this coming year since with low NatGas prices it doesn't make sense for management to increase or keep production at current rate. Even if you expect 25M in CapEx, you are looking at around 35-50M of FCF.

Valuation

Based on the company's 232Bcfe of proven supply, the company's NAV is $13/share. At the current share price of $3, this is a huge margin of safety on a company w/ hard assets. If we expect the NatGas prices to hit $6-7, you are getting the company for around 20% of NAV. Talk about dirt cheap.

There is plenty of talk about storage running low and it might cause NatGas prices to go well below the $2.80 range. This is absurd irrational 'noise'. Also, the $13 NAV.

The likelihood that NatGas stays below $3 is a worst case scenario: depression economy + storage of NatGas stays at a high + production stays at peak levels + commercial/residential demand doesn't rebound. I think the worst case scenario is unlikely to happen or presist for a long period of time. CEP's hedges protect the company and buy time until the market rebounds.

Risks

Present value of reserves is calculated with the price assumption of current strips for the future years (most of them at 6+). If gas stays at this level 3 years in a row they could be in problems or if strip prices fall of a cliff (depression scenario). With strips < $4 the NAV is negative.

The biggest fear w/ the stock is the debt level. The $220M of borrowing against the borrowing limit of $225 is scary although the debt is not due until Oct 2010. Also, the company has $16M of cash to provide some cushion. Finally, the company can monetize its hedges or some of its NatGas reserves in a worst-case scenario where the company needs near term cash. We believe the extremely discounted share prices provide a huge margin of safety in a Yellowstone like scenario.

The temporary suspension of distributions is something income-sensitive investors will not welcome. Although for value investors we will happily exchange the company paying out dividends for using the cash to payoff its debt. Also, it is likely the company's suspension is temporary and that the company will pay out dividends in the near future. We expect the company to be well below the 90% of borrowings by Q4 of 09 (it can easily happen at end of Q3). The distribution payout doesn't impact our investment thesis (although it would be nice to get the dividends). At current share price to NAV, the shares are an easy 5-6 bagger.

Disclosure: Long CEP