Constellation Energy: A Good Trade for a Natural Gas Rebound 18 comments
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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
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On Sep 08 10:17 AM Mad Hedge Fund Trader wrote:
> fgnmm, Just when I get comfortable with my view on Natural Gas, I
> get a scratchy, reverberating cell phone call from one of the major
> formations telling me that I’m being way too bullish. Gas won’t bottom
> at $2. The free fall will continue until it hits $1. National storage
> will be completely full imminently top out, and when it does, the
> producers will have to shut down completely. Since these guys are
> leveraged up the wazoo, this will trigger a string of bankruptcies,
> and the majors will fall like dominoes. A hedge fund bust won’t define
> this bottom, as these guys are all playing from the short side. UNG
> can’t step in as a buyer of last resort, as the SEC won’t let it
> issue more stock, and the current shares are trading at a ridiculous
> 20% premium. One thing we do agree on is that the bottom will look
> ugly, whatever the spark is. You often get Armageddon type views
> near market bottoms, but this guy has been dead on right until now.
> Well, it takes two to make a market. Conclusion: keep NG nailed to
> your screen, as the widow maker is where the volatility lives.
HardToLove
On Sep 08 10:43 AM H.J. Huneycutt wrote:
> This comment was kinda interesting the first time I read it. Not
> so much now that the user has plastered it over several articles
> over the past several days. In fact, it would appear that he just
> automatically posts it in every natural gas related article without
> any thought.
so then it is a question of how long we stay in the $1 range and what happens to CEP during that time. w/ CEP's hedges we can expect the company to easily survive 2 yrs. the company's current production is 16B per year and hedges for 2010 are 12B and for 2011 are 10B. so even if the company takes a loss of $3 on the remaining unhedged supplies, it is still making plenty of $ on the hedged production.
On Sep 08 10:43 AM H.J. Huneycutt wrote:
> This comment was kinda interesting the first time I read it. Not
> so much now that the user has plastered it over several articles
> over the past several days. In fact, it would appear that he just
> automatically posts it in every natural gas related article without
> any thought.
Good post Pakiya.
In any case, I advise you to perform this same analysis on EROC and XTEX, also natural gas related, also in the $3's, also suspended, and also screaming bargains.
Pakiya, you appeared as the third most active contribution to VIC. Was this idea really that controvertial?
It's not clear what management means when they say "distributions will remain suspended until after such time that debt levels are reduced and market conditions again warrant resumption of capital spending at maintenance levels", but I think it's a safe bet their will be no distributions until the October, 2010 debt maturity is handled.
What might distributions going forward be? Difficult to say, but management initially reduced dividends after all the 2008 turmoil to match the 2009 guidance, and those numbers are pretty much on target. The distribution rate was 52 cents on an annual basis.
From the 10-K
"The reserve-based credit facilities limit the amounts we can borrow to a borrowing base amount, determined by the lenders in their sole discretion. The borrowing base will be re-determined semi-annually, and may be re-determined at our request more frequently and by the lenders in their sole discretion based on reserve reports prepared by reserve engineers, together with, among other things, the oil and natural gas prices existing at the time. The lenders can unilaterally adjust the borrowing base and the borrowings permitted to be outstanding under the reserve-based credit facilities."
On Sep 08 05:24 PM plan.maestro wrote:
> I do not think that he missed it. It is right there in paragraph
> DEBT. However, I am not so sure about the 50-70M in free cash flow.
> My number is closer to 35-40M per year at this natgas prices.
>
> Pakiya, you appeared as the third most active contribution to VIC.
> Was this idea really that controvertial?
i doubt the bank will do anything detrimental to the company's operations. CEP's hedges guarantee strong cash flow until 2012. so there is no reason for banks to do anything stupid.
remember the paying down of debt increases shareholder equity. so if CEP redirects all cash flow to pay down debt, it doesn't harm the equity holders. also, its proven gas reserves means it has plenty of assets to pay off debt (in case CEP is forced to sell its assets).
Regarding the paying down of debt increasing equity, how does that happen? Cash (a current asset) is used to extinguish debt (a current/LT liability). D/E is lowered but that does nothing for shareholder equity.
On Sep 10 09:09 PM Pakiya wrote:
> remember the paying down of debt increases shareholder equity. so
> if CEP redirects all cash flow to pay down debt, it doesn't harm
> the equity holders. also, its proven gas reserves means it has plenty
> of assets to pay off debt (in case CEP is forced to sell its assets).
Interesting idea...my primary concern is that CEP's NAV is overstated as it is based on internal estimates regarding assumptions about future natural gas prices. A few analysts I respect, who specialize in the mlp industry, say that under their calculations management is assuming forward nat gas prices in the 9-10 range. Not very conservative.
As I see it this idea rests on the margin of safety provided by CEPs tangible assets...otherwise its a pass. I guess my question is what builds your conviction that the NAV estimate is dependable? Have you spoken with management about their inputs? Also, if you have time I would greatly appreciate a quick breakdown regarding how you calculate CEP's marginal cost of production. Are you just taking the numbers management is providing?
Thanks again
let's run some back-of-envelope numbers on the cash flow. last quarter, quarter ended June '09, the company made around 17M of EBIDTA. the gas prices in the Apr - June period weren't high, i believe they were in the $6-8 range. lets assume the gas prices are around $5-8 range for July - Dec '09 and then for 2010 and 2011. the company has hedged around 60-70% of 2010 production and around 50% of 2011 in the $7 range. for July '09 - Dec '09, i think over 70% of production is hedged.
so it is not too far fetched to expect the company making $17M of EBIDTA each quarter from July '09 - Dec '11. That is roughly $170M of EBIDTA in that period. take into account the cash they have on hand at June '09, $55M. so a total of $225M in cash at Dec '11. they have debt around $220. so let's say they make enough money by Dec '11 to pay off all the debt by Dec '11.
at the current rate of production the company has 12 yrs of reserves. so by Dec '11, you have 9 yrs of reserve left.
it costs the company $3.10 to produce the gas. so at current market cap of $88M you are getting 9 yrs of NatGas production w/ your cost of $3.10. so you can now put your projection for gas prices for 2012 - 2020 and compute what cash flow the company might produce. i think at $88M you are getting a huge discounted price for 9 yrs of production.
i haven't accounted for CapEx, increases in production costs, and other unexpected expenses that might impact cash flow. so if you been extremely conservative and say that instead of getting 9 years of production, you get 7 yrs (let's say the 2 yrs of production makes up for CapEx, increased production costs, and other expenses for July '09 - Dec '11). even 7 yrs of production for $88M is a huge discounted price. you don't need gas prices to hit double-digits for a multi-bagger return.
remember the company was paying $.56 dividend per quarter. if the company reinstated dividends at let's say $.30 per quarter, you are getting your money back in 3 yrs. and the company has a production life of 12 yrs. i see a solid 2-3 bagger at current prices and potential for much more if the gas prices hit double-digits.