Natural gas prices (NYSEARCA:UNG) have surged recently in response to colder than normal winter weather. As natural gas prices have moved up, so have the stock prices of natural gas producers, including Quicksilver (NYSE:KWK) and Ultra Petroleum (NASDAQ:UPL). However, the stock price of the most levered natural gas play that I am aware of has actually declined substantially, likely due to tax loss harvest selling. This offers what seems to be a very attractive opportunity, albeit with a risk of permanent capital loss.
First, here is a chart of the abnormal cold weather. Note the higher than average "heating degree days" recently. This chart does not reflect the most recent winter storms of this past week, which will show further higher than normal heating degree days (which translate to more use for natural gas).
As weather driven demand for natural gas has increased, prices have responded significantly (indicating short term high price elasticity of demand, which implies a tightly balanced physical market). This price movement can be seen in the chart below.
The price surge has been continuing in real time, with the natural gas ETF UNG up ~25% in the past month.
Investors seem to be "playing" this movement in gas prices by bidding up the stocks of Ultra Petroleum and Quicksilver, among others (incidentally, "gas price strip," the long term price for gas, is moving up in concert with the short-term price, which is material to natural gas producers who are daily sellers into the market). Here is a chart showing those two stocks along with the gas price ETF, UNG:
As can be seen, Quicksilver stock has outperformed both Ultra Petroleum and UNG. This is likely because Quicksilver is substantially more leveraged, with higher debt to EBITDA and debt to cap than Ultra. It logically follows that, given both of their substantially gas-weighted asset bases, that if gas prices are surging, KWK would rise more than UPL. And UPL seems to have been moving roughly in line with UNG.
Looking at this from a 3-month perspective illustrates the power of leverage even more dramatically. KWK is up over 70% in the past 3 months, while gas prices are up 10% and UPL is barely flat.
Observing this effect, one might think that the most leveraged natural gas stock that I am aware of, Geomet (NASDAQ:GMET), might have traded up even more. But despite natural gas prices surging and leveraged natural gas producer stock prices like KWK skyrocketing, GMET has actually fallen substantially over the past few months.
Usually when a stock diverges so substantially from a logical path like this, a short time spent digging into the fundamentals and recent news explains the divergence. However, in this case, after some research, it appears the downward movement may not have fundamentally driven. And after further asking around, it became apparent that it had in fact been driven primarily by a technical reason, aggressive tax loss harvesting. I will explain both the fundamentals and why it was logical and highly economical for some of the largest shareholders to sell stock at $0.05 even if they thought it might be worth $0.25.
Some narrative background: Geomet Inc. is a coal bed methane natural gas producer, with properties in West Virginia and Virginia. It went public in 2006 at $11 per share, and at the time coal bed methane (CBM) was considered a leading gas resource, similar but at a smaller scale to shale gas over the past few years. Coal bed methane has competitive finding and development costs, but it is inherently more expensive to produce once developed than both conventional natural gas and shale gas. Due to this production cost disadvantage, CBM producers like Geomet were challenged as shale production rose and natural gas prices crashed. Geomet and others had to scale back drilling and focus on cutting operating costs wherever possible, and producers that were leveraged like Geomet suffered dramatic stock price declines as their solvency was threatened.
Geomet survived primarily due to a large hedge book that locked in natural gas prices for years at much higher than market prices. However, due to poorly timed acquisitions and the gas price taking longer than anticipated to recover, Geomet was forced to sell some of its properties in early 2013 and is in the process of selling its remaining properties.
Now for some fundamentals: Geomet has approximately 94 bcf of reserves, ~$68 million in net liabilities and ~$60 million in preferred stock outstanding at par value. It is currently marketing all of its reserves for sale, and is accepting bids by December 12th. Geomet sold CBM properties that are roughly equivalent to its current properties in May for $1.47/mcf. The price for natural gas is currently at ~$4.30 per mcf, which is higher than it was when the last property sale went through. Assuming a similar price per mcf, Geomet could get ~$138 million for its properties. Net of the liabilities and assuming full repayment of preferred stock at par, this could yield approximately $0.25 per share, which is 5x the recent $0.05 per share price.
I am not the only person who can do this math. As a family office investor asked me when I showed him a great investment deal I had lined up, "why are you so lucky?" First, obviously it is important to test the assumptions I am making. Is $1.47/mcf conservative in a rapidly rising $4.30/mcf gas price environment? Probably. Is the net liability number correct? I checked another analyst's work and it matched. The selling agent is expert at selling such properties, and actually sold Geomet's other properties in May. And the preferred most recently traded for $8.75, which is a relatively small discount to par, implying the preferred holders may think there is some amount of recovery likely for the common stock.
Here is the 1 month chart of the preferred stock, interestingly it has traded up as natural gas prices have risen.
So if there is no error in the math and if there is a reasonable expectation for a ~$0.25 per share liquidation value for GMET, why has the stock traded down to $0.05, despite surging gas prices and even GMETP rising? The answer is apparent both from further qualitative research I did as well as from the long term stock chart.
Here is the long term stock chart, from IPO until December 11, compared to the S&P 500:
If you were unfortunate enough to have owned GMET from 2006 or 2008, you had a loss of over 99%. And this year there was a massive market rally, a continuation of the recovery since 2009. Many investors have realized significant capital gains. As the end of the year approaches, they are selling their losers to offset those gains. With an over 99% loss, GMET is a prime target for such selling.
Beyond just general tax loss harvesting, GMET has been a good target for such selling for a couple of reasons. The following is not hypothetical, I spoke with a formerly large holder who explained their logic for liquidating their position recently, and it was roughly for the following reasons.
If an investor bought GMET for $10 per share in 2006, that investor is sitting on almost $10 per share in losses. With a 50% tax rate (using round numbers to illustrate the point), every share of GMET the investor sells this year at $0.05 saves them ~$5 per share in taxes. There is a time value of money component to selling this year versus next, because getting a $5 deduction this year is worth more than getting a $5 deduction next year, and it is likely worth more than $0.20 to an investor to get that deduction this year. And there is a capped upside component. Previously, investors might have thought that if they held on long enough, GMET could have recovered to $1 or more. But because GMET is liquidating now, while I could be overly conservative and GMET could sell its properties for a value that yields $0.50 per share, it is very unlikely to get $1 per share or more, and seems most likely to get ~$0.25 per share net of liabilities and preferred. This means that if an investor was holding out for $1+, they may no longer be interested in holding the stock. Also, if an investor were making the decision to sell now for tax losses or wait until January (and the 2014 tax year) to find out the outcome of the sales process, the $0.20 difference in expected recovery may be outweighed by the benefit of realizing the tax loss this year.
So in short, Natural Gas prices are rising, driven by colder than normal weather. Natural gas producer stock prices are rising too, and the higher levered stocks, like KWK, are rising more. And GMET, despite being very highly levered to natural gas prices, and despite an in-process liquidation with a likely liquidation value ~5x its current price, GMET has traded down, due at least partially to aggressive tax loss harvesting. I have bought more GMET recently due to this discrepancy, but it is a micro cap stock and is subject to substantial risks. The actual liquidation price could be lower than my estimates, which could lead to total loss of my investment. And there are numerous other risks. However, I found the potential to earn a 5x return over a short period of time compelling enough to take some risk of permanent capital loss. Caveat emptor.
Disclosure: I am long GMET. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I am also long GMETP. I may buy or sell any positions mentioned with no further notice.