Description

This is an annuity investment for energy chickens (me!) and a bet on the decline rates of 52 natural gas wells in Greene County, Pennsylvania.

In my search for small caps that might benefit from the fabled “January Effect” I found a gas-weighted energy trust that has been caught in the recent energy selloff. It has traded lower every month during 2014. The general partner liquidated their remaining holdings in the trust in 2014. The distribution has gone down every quarter for the last 2 years. Investors are exhausted. This is ugly.

However, this is really not a business but an annuity and the valuation work is largely done for the investor in the annual 3^rd-party reserve audit. Normally, using these reserve reports to value active energy companies doesn’t work because management can reinvest cash in bad projects or use reserves as collateral for leverage. However, in ECT’s case management can’t touch the cash – so it is a nice dcf starting point. At the end of 2013, the NPV of the cashflows was worth $5/share (10% discount, $3.70 natural gas). Since the $5 per share valuation was made on Dec. 31, 2013, they’ve distributed $1.18 in cash and natural gas prices have been flat - but the share price has been chopped in half (from $7 to $3.50). Meanwhile, recent production declines have not been nearly as sharp as in prior years.

This NAV, as calculated from the reserve audit, has always said “sell” but for the first time ever it looks like share price will be lower than the NAV.

There are some other catalysts that make this a timely trade:

1. Energy focused portfolios have gotten shuffled because of oil price declines. This is a baby, not bathwater. If you owned an oil focused E&P that required $70+ oil prices to be profitable then the fundamentals of that business changed – the $70 was needed to cover both finding costs and production costs. That is not the case for ECT because there is no exploration, no oil, and no accumulated debt. All we have to worry about is costs associated with ongoing production of natural gas (which happen to be only 70 cents/mcf for ECT). They sell only natural gas into nearby gas-consuming markets. The dynamics of North American natural gas supply & demand have matured (unlike shale oil stranded all over the place, etc.). Best of all, we don’t worry about them going belly-up if we have a stretch of $2/mcf gas prices. The expensive part of this proposition was already paid for when investors funded this at $20/unit (ipo price) and they drilled all those expensive wells – what we have now is gravy.

2. There’s a finite economic life so the discount can’t persist forever - I thought Bowd’s self-liquidating CEF was a clever idea despite the low rating. In that way this is similar. The trust automatically closes down in 15 years. The general partner gets half the assets and has rights of first refusal to buy the remaining assets. I don’t know if there is upside here but it is possible that acquiring companies could pay more on a “flowing boe” basis than for reserves NPV, plus, the way they’re selling these assets at the end of the trusts life opens the market up to private business valuation – which could only be better than the stock market valuation from the perspective of the trust investor (afterall, it will be trading in the stock market up until that day so you can always take the public market price). And in 15 years the decline rates will be very flat so the valuation will be easier.

3. Big distributions! Heck, the cash-on-cash payback period for this investment is under 5 years if natural gas prices stay where they are and decline rates don’t subside.

4. The declines appear to be slowing but this is where the uncertainty comes in. They haven’t drilled a well in 3 years and their production peaked over 2 years ago thus the steepest part of the decline curve has passed. The bulk of shale gas declines happens the first 3 years. Southwest Pennsylvania, where these wells are located, suffers from the steepest decline rates of all the Marcellus play - 90% decline in production after 3 years. At this price Mr. Market is pricing for an ongoing 12% annual decline rate. Even the anti-fracking people say decline rates will be 8% per year at this juncture after the initial steep declines. However, if you apply a less steep decline curve then you get an NPV as high as $9/share. Here are some possible scenarios – None account for the terminal value (liquidating half the remaining assets after 15 years):

Mr. Market implies this unrealistic scenario in the current price:

12% straight-line ongoing decline in production

$3/mcf realized price

$.70/mcf production cost

10% discount rate

NPV $3.50/unit (current market price)

When you look at how excited Mr. Market was to fund this vehicle when gas prices were $8/mcf and the IRRs on the wells were 600%, compared to now after 2 years of steep production declines and $3/mcf gas … you understand how Mr. Market got depressed on this.

Here are some other possible decline rates:

$3/mcf realized price

$.70/mcf production cost

10% discount rate

NPV $8.61/unit

Here’s a scenario with very steep decline and lower gas prices:

$2.50/mcf realized price

$.70/mcf production cost

10% discount rate

NPV = $4/unit

Here is the bull case in a nutshell. These are the actual production volumes since production peaked. They drilled their last well in November of 2011 so the worst is over – now is the time!

Quarter:  Production:  Description?:

Risk:

The managing partner, Energy Corporation of America, is the operator and has no skin in the game. Theoretically, they can do bad things like increase operating costs or shut-in production. They are not a publicly traded firm. I hope they behave decently so they can access the capital markets again.

Catalyst

Less steep declines than the market is expecting