How to Bet on Higher Natural Gas Prices

A version of this article ran in Morningstar Opportunistic Investor in early July, at which time GMX Resources shares were trading around $9.50. Despite the recent runup to around $13.00 per share, we think GMX's shares are still undervalued and worth keeping on your radar screen. For timely notification of investment ideas and analysis like this, pleasesign up for a free one-month trial to Opportunistic Investor.

 GMX Resources  is a small but fascinating natural gas producer. On many metrics, it's among the cheapest natural gas producers in our coverage universe. It has a fair bit of debt and gas prices are slumping, so the market is justifiably afraid, sending the stock down nearly 90% from its 2008 highs. However, we have a different take. We think GMX has a high-quality and valuable asset base, and although it carries some risk, these risks are manageable, and we'd be more than amply compensated by its home run potential.

Company Overview
GMX is pretty simple to understand as it essentially has only one meaningful asset--a leasehold of around 45,000 net acres in East Texas. Historically, GMX's drilling activity has been concentrated on the Cotton Valley Sands. But below the sands sits a geological formation called the Haynesville Shale. While still a relatively young play, the Haynesville Shale is among the top plays in the U.S. from a rate of return (ROR) perspective--the play appears economical even at benchmark prices as low as $4 per thousand cubic feet (mcf).

GMX has 42,300 net acres in the Haynesville, 38,000 of which are 100% operated by the company. Most industry activity has been focused on the Louisiana side of the play, but GMX's acreage is entirely in East Texas. This area has lower pressure and heat than the Louisiana side, resulting in shallower decline rates and lower completed well costs (a positive). However, initial production rates and expected ultimate recoverable reserves estimates in East Texas have typically been much lower. That said, RORs in East Texas should still be among the best in the country.

A couple key factors differentiate GMX from its fellow Haynesville players, especially those in Northern Louisiana. First, GMX is not in danger of losing any of its leases due to inactivity. This is a huge advantage that lets GMX drill when it wants, where it wants, instead of scrambling to keep its leases alive. Second, the firm owns a gas gathering system that should have adequate capacity to handle the expected production growth for the foreseeable future. In other areas of the Haynesville, the lack of infrastructure is constraining drilling and production rates. Having infrastructure in place allows GMX's wells to begin producing almost immediately after they are drilled. Finally, GMX's average royalty rate of around 20% compares favorably with the 25% or more being paid by many competitors. Lower royalties let GMX keep a greater percentage of the revenue stream, resulting in higher returns.

Natural Gas Prices
It's no secret that natural gas prices are in the dumps due to the slowdown in industrial production, mild weather, consumer conservation, and strong domestic supply growth. Liquefied natural gas (LNG) imports are higher than last year and inventories are very flush. While the next several months may be a rocky ride, we think prices should be higher than the current $3.50/mcf by year-end due to demand from the winter heating season, increased industrial activity (hopefully), and--most importantly--declining domestic production.

Even though natural gas prices started declining in the third quarter last year, longer-term rig commitments and drilling programs prevented a quicker industry response. Consequently, supply remained robust in the first half of 2009 as wells drilled in the fourth and first quarters started producing. Production in some regions has already begun to decline, and we fully expect industrywide production to be declining by around the end of the third quarter as the drop in drilling activity takes hold.

If the entire industry were to stop drilling today, many industry experts predict domestic production to decline between 25% and 35% in the first year following the stoppage. The underlying decline rate, a physical characteristic of every oil and gas well, forces producers to constantly reinvest in order to just keep production flat. Once production rolls over, this steep decline rate should take hold and be tough to reverse.

Even though this drop in supply should drive natural gas prices up, we don't expect a sharp recovery in rig count as more-leveraged producers continue to pay down debt and larger producers take a measured response to the higher prices. Furthermore, ramping up activity cannot be done overnight. It can take months to mobilize rigs, equipment, and personnel.

Valuation
We think GMX's assets are being undervalued by the market and the main source of hidden value are its Haynesville assets.

First things first, ignoring the value of the Haynesville rights, we believe GMX is worth around $10 per share. Our analysis is primarily driven off the value of GMX's Cotton Valley reserves provided in 10-K based on natural gas prices of $5.75/mcf in perpetuity. Its other assets, which include its midstream assets and hedge book, provide some nominal value as well.

Now let's focus on the Haynesville, the key source of uncertainty. Acreage in the Haynesville has traded hands at anywhere between $1,500 and $30,000 per acre in the past year--with  SandRidge's   May sale on the rump end. Given the size and location (same county, due west of GMX's properties) of the asset package, the SandRidge transaction may be the best comparable transaction we have. However, we believe GMX's assets are worth significantly more than what SandRidge received. First, SandRidge's transaction occurred amid very low commodity prices, and the firm was a motivated seller as it needed capital to develop its core assets in West Texas in order to meet a future obligation. Plus, given that its leasehold is largely contiguous, we think GMX's Haynesville acreage is more attractive to potential bidders.

What could the Haynesville be worth? The potential value could be immense. While we might not see prices of $30,000/acre for some time,  EXCO Resources (XCO) sold a portion of its Haynesville rights for around $15,000/acre on June 30, by our calculations. However, the bulk of EXCO's acreage sits in Louisiana. $15,000/acre represents around $30 per share of value to GMX. At even $5,000/acre, the Haynesville rights are worth around $10 per share versus a $12.25 share price for GMX currently.

How Are We Going to Get There?
It's easy to say that GMX is worth a lot more than its current trading price, but how are we ever going to realize any of the upside mentioned above?

First, the market is concerned about the firm's leverage and its ability to survive low gas prices. But we think the picture isn't so dire. After the recent equity offering in May, combined with its hedge book and its revolving credit facility, the company has sufficient liquidity to execute its drilling plans over the next couple of years with no debt maturities until July 2011. The impending sale of GMX's midstream assets will go a long way to sewing up its financing strategy as well.

As GMX drills successfully, a virtuous cycle forms. Production and reserves increase, improving liquidity and ability to carry debt. As cash flows and the financing picture improves, equity issuances get easier, too. All this in turn gives the firm even more capital to expand drilling, which feeds on itself.

Cost reductions--in personnel, energy, rigs, and everything else--should also be a tail wind. We have lots of good anecdotal information from producers that costs have come down, but we'll see more tangible evidence of this when the industry reports second-quarter results. I don't think investors or analysts have given firms enough credit on this front yet.

Finally, well results should also be a catalyst for the firm. We expect the firm to release well results throughout the remainder of year, which will be significant because the company should be refining its drilling and completion techniques. For example, using longer laterals should allow GMX to show improvement over its initial wells. Further confirmation of the Haynesville shale's viability in Texas from competitors drilling in the area should also have a positive impact on GMX.

If GMX or its competitors report poor well results, the stock will likely trade down. If that happens we'll have to evaluate if the poor results were one-time in nature and the problems correctable, or if the results were an indication of the quality of GMX's assets. If the latter, our thesis is likely busted and we would strongly consider selling out of our position.

The other key risk is a prolonged weakness in natural gas prices. That being said, we believe the company is sufficiently funded for the next couple of years especially if the midstream deal closes as expected. Covenant violations are not a concern either. This should allow GMX to get its Haynesville operations off the ground and generating cash flow. Finally, as we said before, the Haynesville shale is profitable even at very low gas prices. So even in a bad case scenario, we think that GMX can prove up its Haynesville assets sufficiently to support a valuation higher than the current stock price. The ability to limit to our downside and have the opportunity to make several times our money is very attractive to us.

Disclosure: Justin Perucki and Opportunistic Investor co-editor Michael Tian own shares of GMX.

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