By now, everyone knows that the price of Natural Gas (NG) has plummeted over the last few years and, with it currently hovering around $2 per mCfe in the spot market, it is wreaking havoc on companies that are exposed from the long side. One of those companies is EXCO Resources (XCO) and a recent article in Seeking Alpha, titled "EXCO Resources: A Highly Leveraged Bet On A Natural Gas Rebound," did a great job in highlighting their exposure to NG prices.
Our own analysis, based on EXCO's presentations and public SEC filings, estimates that every $1 change in future NG prices affects the net asset value of their holdings by $20-$25 per share. This particular number needs to be handled with care as it doesn't factor in optimizing production in a low price (i.e., non-profitable) world, which is close to where we are today. It is also important to note that it is not the change in the spot NG price but the change in prices over the whole "strip" looking out over the next 10-years or so.
Using CME NG futures as a guide, the market is looking for NG prices to slowly grind higher over the next few years and reach $4 in 2015. It is expected that prices beyond 2015 will be more in line with global NG prices when the US begins exporting liquefied NG. The major reason for the current depressed price is well known - a warm winter and a large excess of NG already in storage at the start of the so-called "build season" when production exceeds consumption to prepare for the following winter.
Currently, there is about 2,500 bCfe in storage, well above the norm for this time of year. It should be said, however, this is not the first time we've started the build season with excess inventories (e.g., 2006 ). One silver lining is that the rate of increase in NG inventories is much slower for where we currently are in the build cycle. From the recent bottom, on March 9th, we've only accumulated 179 bCfe compared to 340 and 297 bCfe in the last two years coming off of the bottom. So while inventory keeps growing, from already elevated levels, there is suggestive evidence that production is slowing down.
The most recent estimate (2010) by the US Energy Information Administration (EIA) is that we have the capacity to store over 4,400 bCfe, although more conservative pundits put the number at 4,100. The EIA storage estimate is two-years old and from 2008 to 2010, an additional 200 bCfe was created suggesting current capacity is probably in the neighborhood of 4,500. Given the likely increase in natural gas demand - the last time prices plummeted, from '08 to '09, demand increased 3.8% the following year - and the expected decline in production, the risk of "overflowing" the storage capacity seems bearable. Of course, all bets are off if we have a cool summer and end-user electricity demand never appears.
So where does this leave XCO? We'll, the good news is that they generate a lot of cash flow. We estimate their 2012 EBITDA will conservatively be $400mn with about $325 in free cash flow. So, in terms of making interest payments on their debt in 2012, things look fine. The problem is in their CAPEX and the outlook for 2013. Last quarter, they forecast $450mn in 2012 CAPEX and this will be a substantial cash drain leading to a potential breech of their leverage ratio covenant on their credit line. The $1.6 bn credit line, of which $1.2 bn is used, is from a consortium of banks and, most likely, it has been packaged and wrapped into a marketable security. We believe EXCO will avoid breeching covenants, if at all possible, and, if they do, we do not think the holders will force payment.
Of course, one never knows, which is why EXCO needs to aggressively manage its balance sheet. They will need to trim CAPEX as well as sell assets in order to delever. The recent no-news surrounding the attempt to sell off part of their equity in TGGT, a midstream NG company they co-own, did not give the market much heart. Management will have address these issues forcefully on the upcoming conference call, on May 2nd, if investors are to keep the faith.
The following year, 2013, will be the real issue. With NG prices forecast to be about $3.25 / mCfe, EXCO will have to be more aggressive in their expense and CAPEX reduction (we think CAPEX will have to be sub $250 mn). They may have to sell the remainder of TGGT, and, most likely, eliminate their dividend. All this to retain an acceptable leverage ratio (net debt/EBITDAX).
From a debt holder's perspective this is not a bad thing; the reason the covenants are there is to persuade management to be prudent and curtail the risk of default. This can also help the common shareholders too although they face the risk of dilution through a potential recapitalization. EXCO has minimal production hedged in 2013 so they will be fully exposed to NG prices and, at current prices, EBITDA will decline to the low $300s. So, barring an increase in NG prices in the near term, some aggressive balance sheet management will be needed over the next two years for EXCO to remain viable. Given the impressive list of investors on the long side of this company, with some now on the board, there is a good chance, in our view, that management will act in the best interest of bond and share holders.
The short-term news coming out of EXCO will not be good. Their credit line will be reduced, there is a good chance of the dividend being eliminated, and there will a big hit to their tangible book value mostly because of an archaic valuation method. Also, we would not be surprised by a credit downgrade from the agencies. Investors will not be given any good news over the next 3-6 months. While adjusted net income may hold in this quarter, as they fully monetize their 2012 hedges, this will come back out during the remainder of the year and there will most likely be a loss ex-items for the full year.
However, if management does the right thing, and aggressively manages the balance sheet, their prospects down the road are tremendous. If natural gas prices ever get back to the $5+ level, this stock will turn out to be a deep value play with 20+% returns baked in. This is not a sure thing, and currently EXCO bonds trade at a deep discount near 11% in yield - not exactly investment grade - so the market is in the "show-me" mood. Well, we will get that chance with the upcoming earnings announcement and conference call.
We actually like EXCO's bonds. In addition to their credit line they have $750mn of publicly traded bonds that mature in September of 2018 and bear a 7.5% coupon. The bonds trade below par and, as mentioned, yield around 11%. It is callable but, with the current deep discount, those odds are slim to none. We believe that EXCO's generous cash flow and the cautious credit line covenants reduces the risk of default and is under appreciated by the market. A delevering of the balance sheet is good for bond holders.
If management doesn't do the right thing, the recovery value on the bonds should be quite good given the underlying assets. Finally, there is no risk of being "frozen-out" at a low ball price, like there is with the common. In fact, we think this is the main risk for the common stock - the stock price gets beaten down to $3 and minority investors get forced out at $5. While maybe we miss out on the potential home-run with EXCO common stock if NG prices rebound, the safety of swinging for a double while collecting a coupon from their bonds is fine by us.
Disclosure: We have a small position in XCO common and a more modest position in the XCO 7.5s of 9/18