Natural Gas Stocks

Many large cap natural gas stocks jumped today on news that ConocoPhillips (NYSE:COP - News) is in talks to buy independent natural gas producer Burlington Resources Inc. (NYSE:BR - News) for more than $30 billion. I´ve struggled to find good small cap natural gas stocks because all the stocks are way up or are simply too speculative. However, if you are so inclined to play the natural gas game, here is one natural gas pick I´ve bought and think still represents a decent gamble.

The stock is Exploration Co. of Delaware Inc. and the symbol is TXCO. I´m in at about $6.25.

Important Note: Buyer Beware of my O&G Picks. I am no expert on oil and gas exploration and I´m just making decisions here based on some back of the envelope calcuations I can glean from public filings. I´d appreciate any insights from more knowledgeable investors. Please leave your comments below.

In any case, I tend to view natural gas and oil producer/exploration stocks, much like biotech stocks, with the exception of course that there is no FDA in the O&G Sector. Not many people, other than a few insiders really know what is "in the ground", and even these insiders can´t really know what a given well will really produce.  If you have read any of the literature lately concerning peak oil, natural gas supplies etc., you can see that even the "experts" can´t agree on much of anything. Despite all the uncertainty, I still think you can make some money in this sector by sticking to small cap O&G stocks that have low-downside risk based on public valuations.

So why does TXCO have low downside:

• On September 1, 2005, TXCO sold approximately three percent of its proved reserves and 19% of its existing production agreement to EnCana Oil & Gas (USA) Inc. ("EnCana") for $80 million. Encana (ECA) is one of the worlds largest natural gas companies. This details of this sale are bit more complex than can be written up here, but suffice to say that this sale gives huge credibility to TXCO. I´m somewhat confident ECA did its due diligence here before forking over $80 million. So even if TXCO sold its most valuable assets, you need to assume that its remaining reserves and production is somewhat valuable. That gives the stock support and you know you are not buying a "castle in the air" type of stock.
• With the Encana sale, TXCO eliminated all of its debt and preferred stock. A debt-free O&G exploration company is quite rare. It also eliminates a major financial risk from TXCO.
• With the Encana sale, TXCO also used funds to terminate derivative contracts on natural gas for November 2005 through April 2007, requiring a cash payment of approximately $9.9 million that substantially offsets the accrued derivative obligations recorded in the first three quarters of 2005. From what I understand TXCO´s derivative/hedging contracts locked the company into much lower natural gas prices. So with the elimination of these contracts, TXCO is essentially unhedged and can benefit from the high natural gas prices.
• Recently, one of TXCO´s larger shareholders sold stock to an underwriter for about $6.06 per share. The underwriter was looking then to resell these shares at about $6.40.

So bottom-line is that in TXCO we have small cap oil and gas exploration company with a pristine balance sheet, a stellar large cap partner, and a public valuation of shares not much below the current price. All that adds up in my mind to low downside risk.

 So what´s the upside here:

To get an upside price for the stock, one would need to analyze TXCO´s existing reserves and drilling programs. However, I´m far too lazy to do this properly. So I´ll only say that with the elimination of unfavorable hedges and interest expenses, the company can have huge, huge earnings growth in 2006. Of course the earnings growth does not really matter without an analysis of reserves, but earnings momentum always attracts a crowd. Furthermore, somewhat simplistically, if the company sold 3% of its proven reserves and 19% of its existing production for $80 million, one has to assume that the rest of the company is worth at least a couple of hundred million (just look at the proved reserves on the balance sheet to see why I say this).

The risk here of course is that the company sold its only true valuable asset to ECA and the rest of the company is pretty much worthless. But I´m willing to bet that is not the case, if institutional investors were buying the stock at $6.40. There is also a risk that natural gas prices will plummet in 2006, but that question is debatable and I think we´ll have high prices at least thru winter, which is more than enough time to make some money here.