Constellation Energy Partners CEP
September 01, 2009 - 2:15pm EST by
pakiya1101
2009 2010
Price: 3.10 EPS N/A N/A
Shares Out. (in M): 23 P/E N/A N/A
Market Cap (in $M): 72 P/FCF N/A N/A
Net Debt (in $M): 220 EBIT 0 0
TEV ($): 0 TEV/EBIT N/A N/A

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Description



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. On top of it, the NAV is computed assuming NatGas sells for $2.41 MMBtu, an extremely conservative look at NatGas price.

The write-up does not go into details since the huge discount to NAV is absurd and I don't want to complicate the thesis with 'noise'. If you are interested in details please contact me via email.

Company

Constellation Energy Partners 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.


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 the 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."

From Chesapeak Energy's most recent conference call:

Aubrey McClendon [CEO]:
"So by holding some production off, we certainly did benefit by basis coming in. Of course, as Marc mentioned, the basis story is a really important one. We have had bad basis for the past two years or so. We have been long gas, industry has been long gas and short pipe. We're getting ready to move into a world where we going to be long pipe and short gas and so we have already seen basis differentials really, come together in the last few months.

I think the second thing is, given where storage is it was our analysis that we are going to be full up on storage by the end of the year. As we get closer to that, pipeline pressures are going to increase and that is going to cause involuntary curtailments. I think our view was that there was no reason for us to voluntarily curtail gas, when pretty soon, everybody is going to start involuntarily curtailing gas and so, we didn't see any reason to take it on the chin for the team, more than we did and instead, we will just let the system work, to spread the pain across the whole industry here over the next couple of 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 into 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.


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 hedge its entire annual production but a large chunk of it is hedged for the next couple of years

2090 - 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 hedge 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 until more realistic market prices. The management team has stated that it purchase 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 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 suspension will be in place atleast until the debt outstanding is greater than 90% of borrowing base.

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 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 rollforward 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.


Valuation

Based on the company's 232Bcfe of proven supply and at NatGas prices of $2.41, the company's NAV is $13/share. At the current share price of $3.1, 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 assumes $2.41 as NatGas prices. Even if you drop NatGas prices much lower than the sub-2 range, you are still getting a huge discount at current share price.


Risks

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 in provide some cushion. Finally, the company can monetize its hedges or some of its NatGas reserve 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 dividends is something income-sensitive investors will not welcome. Although for value investors we will happily exchange the company pays out dividends for using the cash to payoff its debt. Also, it is likely the company's suspension is temporary and that company will payout dividend 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 dividend payout doesn't impact out investment thesis (although it would be nice to get the dividends). At current share price to NAV, if the shares are an easy 5-6 bagger.

Catalyst

Catalyst
- Mr. Market realizing the absurd discount to hard assets
- Pay down debt in the next couple of quarters
- Restart dividend payout

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    Description



    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. On top of it, the NAV is computed assuming NatGas sells for $2.41 MMBtu, an extremely conservative look at NatGas price.

    The write-up does not go into details since the huge discount to NAV is absurd and I don't want to complicate the thesis with 'noise'. If you are interested in details please contact me via email.

    Company

    Constellation Energy Partners 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.


    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 the 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."

    From Chesapeak Energy's most recent conference call:

    Aubrey McClendon [CEO]:
    "So by holding some production off, we certainly did benefit by basis coming in. Of course, as Marc mentioned, the basis story is a really important one. We have had bad basis for the past two years or so. We have been long gas, industry has been long gas and short pipe. We're getting ready to move into a world where we going to be long pipe and short gas and so we have already seen basis differentials really, come together in the last few months.

    I think the second thing is, given where storage is it was our analysis that we are going to be full up on storage by the end of the year. As we get closer to that, pipeline pressures are going to increase and that is going to cause involuntary curtailments. I think our view was that there was no reason for us to voluntarily curtail gas, when pretty soon, everybody is going to start involuntarily curtailing gas and so, we didn't see any reason to take it on the chin for the team, more than we did and instead, we will just let the system work, to spread the pain across the whole industry here over the next couple of 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 into 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.


    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 hedge its entire annual production but a large chunk of it is hedged for the next couple of years

    2090 - 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 hedge 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 until more realistic market prices. The management team has stated that it purchase 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 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 suspension will be in place atleast until the debt outstanding is greater than 90% of borrowing base.

    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 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 rollforward 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.


    Valuation

    Based on the company's 232Bcfe of proven supply and at NatGas prices of $2.41, the company's NAV is $13/share. At the current share price of $3.1, 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 assumes $2.41 as NatGas prices. Even if you drop NatGas prices much lower than the sub-2 range, you are still getting a huge discount at current share price.


    Risks

    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 in provide some cushion. Finally, the company can monetize its hedges or some of its NatGas reserve 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 dividends is something income-sensitive investors will not welcome. Although for value investors we will happily exchange the company pays out dividends for using the cash to payoff its debt. Also, it is likely the company's suspension is temporary and that company will payout dividend 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 dividend payout doesn't impact out investment thesis (although it would be nice to get the dividends). At current share price to NAV, if the shares are an easy 5-6 bagger.

    Catalyst

    Catalyst
    - Mr. Market realizing the absurd discount to hard assets
    - Pay down debt in the next couple of quarters
    - Restart dividend payout

    Messages


    SubjectRE: NAV
    Entry09/01/2009 06:32 PM
    Memberpakiya1101

    of their website from conference call presentation:

    http://phx.corporate-ir.net/External.File?item=UGFyZW50SUQ9MTI5MjF8Q2hpbGRJRD0tMXxUeXBlPTM=&t=1

    Slide 8


    SubjectRE: RE: NAV
    Entry09/02/2009 12:09 AM
    Membernantembo629

    does the company have a redetermination on revolver coming up in October? how much do you think it could get cut if so


    SubjectNAV not using $2.41 gas...
    Entry09/02/2009 09:22 AM
    Memberbanjo1055

     

    You state several times that the NAV is calculated using a gas price of $2.41, but I believe you mistakenly picked up the CEP share price of $2.41 from the bottom of the slide.  The gas prices used to generate the company's NAV, according to the footnote, are the company's "internal estimates of forward market prices".  This results in their PV-10 "at forward market" of $464m... however, they also calculate an SEC "standaridzed" PV-10, which uses a gas price of $3.885 (higher than current prices) and which results in PV-10 of just $103m.  Isn't it pretty clear that their internal price deck assumes a sharp recovery in natural gas prices, making this investment a highly leveraged play on the commodity? 

    Another issue - CEG currently provides administrative services to CEP, but this ends in December 2009.  CEP has said the net result will be an increase in costs.  Is this factored into your valuation?  Do you know the magnitude of the increase in overhead? 


    SubjectConstellation
    Entry09/02/2009 11:04 AM
    Memberissambres839

    You mention that they want to sell their 28% stake in the company. Any idea when they would want to unload this? Why not just wait for this big sale? It could really pressure the stock.


    SubjectRE: NAV not using $2.41 gas...
    Entry09/02/2009 03:38 PM
    Memberdoggy835

    Indeed, with $3+ op cost PV-10 with 2.41 gas would be negative. Without the hedges these guys would be worthless. Seems like the hedges pretty much cover the debt and the common is a call option on NG prices.


    SubjectRE: RE: NAV not using $2.41 gas...
    Entry09/02/2009 05:24 PM
    Memberutah1009

    I cant figure out how this stock ever mustered its prior valuation.  It made no sense whatsoever.  Used to trade at +15x cash flow and $2.50 ev/reserve.  CEP almost had a market cap of $1 billion at one point.  Insane.  CBM companies are by definition awful.  I give you: GMET, PINN, DBLE, NGAS, and of course QRCP.  All disasters, all hopelessly dependent on high gas prices.  These guys are gonna get their base redetermined at a lower rate, they'll monetize hedges, then they'll pray like mad that the price of gas rises.  Multiple ways to lose, only one way to win.


    SubjectRE: RE: RE: RE: RE: NAV not using $2.41 gas...
    Entry09/03/2009 12:36 AM
    Memberad188

    BBG -- multiple game changer opportunities, in the currently out-of-favor Rockies

    WMB -- nat gas holding cos are always ignored by the "next basin" crowd, but WMB is very cheap (STR/NFG too)

    MMR -- either a 10x-er, or nothing --- anybody knowing JimBob from Freeport/Grasberg days knows what I'm taking about

    I agree with utah's comments, and woul dfurther add that E&P inside MLP structure is totally flawed


    SubjectRE: RE: NAV not using $2.41 gas...
    Entry09/03/2009 08:42 AM
    Memberutah1009

    With the criteria you laid out I'd just own MCF and forget all the rest.  MCF has the best risk/reward of any gas levered E&P I know of right now.  Even if gas goes to $1 (entirely possible for front month at some point) MCF is fine because they dont have to spend any money on new drilling and their one field's production wont be in decline for anther 3-4 years.  When other companies (conventionals and especially shale operators) stop drilling that means production will decline, but that's not the case with MCF.  Even under really dire circumstances of $2 gas throughout 2010 MCF would be generating about $2.50/share in free cash flow and there's no silly redeterminations or maturities to worry about.  And what about gas at $8 you ask?  Because of the leverage involved with a field like theirs cash flow would skyrocket to $18/share.

    BBG, WMB, STR, NFG, and MMR all have their merits (well, maybe not NFG and MMR, heh heh) but you've got all sorts of other stuff that could muck it up.  MCF has the best downside protection of any E&P.


    SubjectRE: RE: RE: RE: NAV not using $2.41 gas...
    Entry09/04/2009 02:26 PM
    Membermpk391

    Historically, MCF has been the low cost producer by being good at exploration: i.e. fewer dry holes and larger average discovery size vs most peers.  In other words, by having low finding costs.  To a lesser extent, they've benefitted from low development costs as most wells have been in the shallow waters of the GOM or onshore S. Texas where there's plenty of existing pipeline infrastructure to tie into.  On the downside, you have to deal with hurricanes and their wells are pretty deep (15K+ feet).  Drilling cost increases at a higher rate than depth once you get down that far.

    Today, I'd argue they're low cost simply due to the low LOE and G&A costs per mcfe of the huge Dutch and Mary Rose discoveries.  Odds are slim that MCF will ever make another discovery that big, so the bulk of the NAV will likely remain in these producing reserves, rather than in the exploration program.

    That said, I'd expect exploration results to be lumpy but good over time as the same team is still picking the targets.  MCF has been giving up increasingly more of the economics on new drills to this team (JEX) as time goes on.  Still, the overwhelming question for shareholders re: exploration is simply "did they find any gas or not?".


    Subjectnat gas basket
    Entry09/09/2009 10:56 AM
    Membertomahawk990

    another levered play on nat gas (for a basket) is PQ.  the balance sheet leverage and relatively high operating costs are both good to give you maximum leverage to rebound in gas prices.  they have good 2009 hedges so you have some runway to ride out the supply glut given implosion in prices.  i own the 10.375% bonds as i am confident these are money good.  it is not convertible so obviously the stock would be the lever to the nat gas thesis.

    random aside, i think the CHK bonds present about the worst risk-reward bond i have seen in a while.  i am short the 9.5% which yield 9%.   they have 21% of 2010 hedged but have been taking hedges off as Aubrey is a huge risk taker.  have $554mm in cash and got $1bn from PXP and have $460mm available on $3.5bn line but may burn $200mm in 2H09 and will drill, drill, drill with every penny they have lying around.  trades over par so no worry on takout.  in fact, as far as m&a, they could be a buyer which if financed would be great for short bonds.  low likelyhood of getting paid but low downside and could get paid huge if Aubrey goes bust again.


    SubjectRE: Author Exit Recommendation
    Entry08/27/2010 06:34 AM
    Membermaggie1002
    Pakiya, I am curious for why you are closing your recommendation.  Thanks in advance.
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