EXCO Resources: A Highly Leveraged Bet On A Natural Gas Price Rebound

| About: EXCO Resources, (XCO)

With natural gas hovering at 10-year lows, many traders including myself are looking for an effective way to play what could shape up to be a formidable rebound. On a call Tuesday afternoon, Doubleline Capital founder Jeffrey Gundlach revealed that he is buying up natural gas assets. He described the trade as comparable to "investing in gold in 1997".

To understand this, let's look at what happened to gold in 1997. The price of gold per troy ounce fell steadily throughout the year from $360 to $290. Similarly, from January 1st of this year the price of natural gas has cratered from $2.975 per MMBtu to below $1.950 as of April 17th. In both circumstances, the commodity began to trade below its corresponding production value.

History does tell us that a situation like this will eventually correct itself, as evidenced by the surge in the price of gold in the past 10 years. Unfortunately, most traders end up capitulating at or near the lows and miss the sharp comeback rally. The bottom in the most recent gold super-cycle was formed in the fall of 1999, whereby prices sharply rebounded off the lows on the road to eventual recovery and then frenzy.

Accordingly, the bottom for gas is very possibly right around the corner. The greatest factor to support this thesis is the constant decline in natural gas rigs as reported weekly by Baker Hughes each Friday at 1:00 PM Eastern. This report tells us that the current number of natural gas drilling rigs operating in the US has dropped a whopping 57% from its peak in September 2008. In the past year alone the rig count has dropped from 885 to 624. This is a real and significant decrease in supply.

As hedges begin coming off the books and the once pricey leases begin expiring, you will see the rig count numbers drop even more dramatically to the point where supply and demand will meet a more realistic equilibrium closer to the historic oil to natural gas price ratios of the past decade.

Already the market knows this and is anticipating an imminent upward move in natural gas prices. Nymex futures for December of this year are trading over $3 per MMBtu. This represents a premium of over 50% from today's prices. To me that is a very hefty price to pay.

I would also avoid investing in the very popular day trading vehicle known as the United States Natural Gas Fund (UNG). I would steer clear of any long position in this ETF due to the killer contango that is best explained here. For these reasons, I am intent on exploring other potential ways to capitalize upon a sustained natural gas price recovery with a mid to long-term investment horizon.

Closing at a meager $5.89 on Tuesday, EXCO Resources (XCO) has dropped considerably from its $21.03 high from last May. The company's fortunes were a polar opposite only one year ago. That is, following a failed $4.36 billion takeover bid by the CEO, Douglas Miller, T. Boone Pickens and two of the large shareholders, Ares Management and Oaktree Capital Management. Now fast forward to January 20th of this year, and Douglas Miller is forced to liquidate 1,896,691 shares of XCO at $7.85 by a margin requirement. Apparently, he used these shares as collateral in a financing commitment in a takeover (this time successful) of a chain of North Texas liquor stores.

Although this entire string of events plays out like a comedy of errors, there is still a potentially interesting opportunity in XCO stock that is now trading near 5-year lows. Longs point to the 13.7% stake in the company that has been recently accumulated at significantly higher prices by famed steel and energy tycoon, Wilbur Ross. On March 5th, Ross was appointed as a director of the company and has an unusual deal in place whereby he has agreed not to buy more than a 20% stake until February of 2013.

This may suggest that some sort of takeover deal is in the works. Adding more speculative fuel to the fire is Douglas Miller on the 4th Quarter earnings call. On this call he suggested multiple times that he believes that the share price does not reflect the value of the company and he hinted at the possibility of a deal in the works.

I call XCO a highly leveraged bet on a natural gas price rebound due for a number of reasons. While they are hedged at 40% of production in 2012 at a somewhat respectable $5.27/mcf, they are barely hedged at only 5% of 2013 natural gas production at $5.99/mcf. Also, their reserves are 97% natural gas. CK Cooper reported in February that given the current prohibitive natural gas pricing environment, that it is possible that the EXCO proven reserves are worthless. The debt load at $1.9 billion is also relatively heavy given their potentially limited future cash flow. Capex will have to be scaled back significantly.

However, on the bright side EXCO owns a midstream provider called TGGT Holdings. The company has reportedly been in talks to sell 1/3 of TGGT for upwards of $400 million to a private infrastructure fund. Although, on April 9th Michael Hall, an analyst with Robert W. Baird & Co., stated in a research report that the deadline EXCO set for talks with this fund has passed with no deal announced.

While the market sold off the stock into this report, it is possible that EXCO, despite desperately needing cash to avoid running afoul of debt covenants, has a better offer on the table. Although it is also distinctly possible that this private buyer is no longer interested in the asset, and/or the $1.2 billion valuation put on it by the company. Accordingly, a large part of any sound investment rationale into EXCO would have to be the belief that they are indeed working behind the scenes on some deal of substance for TGGT.

With all that said, this is about as pure as a play that you can get on natural gas. Barring a pricing rebound, EXCO could fail. However, if prices are to turnaround, as the empirical evidence and the futures market suggests, this stock could rally quickly off the lows. In a situation of rapid natural gas price recovery, EXCO may very well be able to stay within their debt covenants and investors could potentially reap huge rewards as all of the vast assets of the business, including TGGT, can be optimized for full value.

Longs can take solace in the fact that less than 18 months ago an investor group comprised of insiders felt so strongly about the asset values and future prospects of EXCO that they attempted to take the company private at nearly 4 times the current market capitalization. During this time natural gas was trading at about double today's prices. Given the sharply decreasing future supply dynamics of the commodity, a double from these levels is not an unrealistic price target for gas prices in the near future.

Accordingly, XCO stock is currently is trading as more of a call option. It may expire worthless if debt covenants are breached and a TGGT and other asset sales are forced at fire sale prices. However, on the other hand it could also double or triple in price on any sudden and meaningful natural gas pricing recovery, proper monetization of the TGGT asset, or possible takeover bid.

In conclusion, it would be prudent to exercise caution if considering an investment in XCO stock. Most recently, on March 15th, Jefferies & Company downgraded EXCO from Hold to Underperform and lowered their price target from $7 to $4 citing "natural gas weakness, deteriorating liquidity, a light 2013 hedge position, and too few meaningful organic oil growth opportunities."

None of this I can really argue with. Furthermore, no other analyst, despite many having significantly higher price targets than the current trading range, have come to the defense of XCO stock. It will certainly be interesting to see how this one plays out. I will be looking to take a shot at this in the low $4 range, if it gets there.

Disclosure: I am long Natural Gas Futures - May 12 (NGK2).