Description

Abraxas, an extremely overlevered oil and gas producer, was the subject of a VIC writeup in June at $3.40 (also a report in Barron's last January) and has fallen roughly 70% since. Please refer to the earlier report which I believe was entirely correct in its analysis, for details about the Company's reserves. The basic argument then and now is that this is a classic value play based on reserves in the ground. Although the Company is unprofitable (profitable before interest expense) at today's gas prices and has all the cyclicality of a business dependent on commodity markets, inherent value is determined by reserves and a long term view of the strategic value of North American supply. Higher prices, which are generally treated as a given by the industry, would be an bonus. The intrinsic value of this Company is many times the current price (forget about today's miniscule capitalization), and that value is likely to be realized in less than a year.



First some background on why the share price has collapsed:



· The price of natural gas is depressed - presently around $2.80/mcf vs $10/mcf less than a year ago. Although Abraxas is largely a gas play, the oil price reduction and potential OPEC price war with Russia have also adversely affected gas prices All the gas companies have seen a fall in their stock prices.

· Gas in storage is near record levels. The U.S. weather has not yet been cold enough to convince the gas market that an overhang won't last through the winter into all of 2002.

· Weak economy, particularly post September 11, with implications for reduced gas consumption.

· Abraxas has a negative net worth ($16 million), a market capitalization of only $33 million and $270 million of debt. One can argue that the enterprise value is down only about 20% in the last 6 months per the factors above, but that because of the high leverage, the loss in total market value has disproportionately affected the share price.

· Management credibility is low because of the excessive debt and past inability to rein in acquisition impulses. Skeptical investors have a "show me" attitude.

· Enron's problems have scared some investors away from the natural gas sector for the time being.

· Tax selling and capitulation. As a result of the Company's debt for equity swap in 1999, the conversion of CVRs into additional stock and the purchase of the remaining shares of Grey Wolf this fall, there are now 30 million shares outstanding versus 6.8 million shares in 1999. Most of the additional shares are held by ex-bondholders who are not that interested in the upside potential of the stock. It appears that some of the holders, possibly anticipating a re-enactment of 1999 when the stock was delisted and went below $1/share, have been aggressively dumping in the last few weeks. This despite a generally upbeat conference call on November 15 reviewing 3rd quarter results. Abraxas management has indicated to me that a holder of 1.5 million shares has been a constant seller in the last week or so.



The positives:



· Trace465's June analysis is sophisticated and shows an intimate knowledge of the Company's prospects and potential reserves, which are huge. I have talked with enough people in the industry to conclude that Abraxas' reserve position is more or less as stated in Trace's VIC report (the same report was posted on the Yahoo chatroom board). Credit Lyonnais and CIBC, both long term followers of Abraxas, have recently opined an asset value of $4.50 - $6/share, and have recommended purchase even though the Company is forecast to lose $20 million in 2002. CIBC's report of November 15 shows a net asset value (using $18 oil and $3 gas, escalating 3%/year) of $3.48/share based on existing reserves and $9.73/share if probable reserves are included (report available on the Abraxas website).

· Despite well completions at about twice the level of 2 years ago, overall U.S. natural gas reserves are only marginally higher. In other words, new gas supplies have been harder to locate and wells are depleting more rapidly. In such an environment, Abraxas reserves, all of which are in the U.S. and Canada, are very attractive.

· As a corollary to the above point, rig counts are way down and drilling budgets have been curtailed industry wide. At the very least, these factors will lead to a quicker rebound in gas prices. Additionally, managements may rationalize a purchase of reserves in one fell swoop as a quick and easy substitute to curtailed drilling programs. Abraxas' properties are large enough and have enough potential to take years to develop fully.

· The oil and gas business is consolidating with Conoco and Phillips being the latest example. I count another $48 billion of oil and gas mergers for the first 10 months of the year. Abraxas is a logical candidate to be absorbed since they don't have the capital to develop their holdings.

· Concerns about energy self sufficiency and Middle East disruptions add to natural gas's environmental appeal.

· Abraxas is surprisingly well known -listening in on the recent conference call, one couldn't help but be impressed by the widespread interest in the Company. In addition to Wall Street types, many large oil and gas companies are aware of ABP's potential. EOG is a partner with Abraxas in Texas and owns 3% of the stock; Devon is a partner in the Ladyfern. development; Murphy and Apache own contiguous acreage at Ladyfern, to name a few. There are no takeover defenses and management has been concerned about getting their stock price up (see Bob Watson's 8/2/2001 Wall St Transcript interview). The bondholder representatives hold a majority of the board seats and have no objections to a sale.

· Abraxas has sold $30 million worth of reserves this year at an average of $1.40 mcf. Using the same figure, their 240 bcf of remaining reserves would be worth over $2/share after paying off debt. This gives no value to probable or potential reserves, or the $100+ million of tax loss carryforwards.

· Management has stated that they hope to sell $50 million- $100 million of non-strategic reserves by the middle of next year and use the money to pay down debt. They expect to replace the sold properties with properties in development and maintain 240 bcf of total reserves. Asset sales coupled with debt refinancing (under active consideration) could halve the Company's $32 million net interest expense. That kind of saving would be used to drill more wells to ramp up production and profitability.

· A 13-G filed at the end of October indicated that an individual who has been an Abraxas director since 1992 owns 4.4% of the stock and that some of the 1200 clients of his investment company own another 1.5%.

· A recent filing shows that the CEO owns 1.3% of the stock and has options on another 1.4 million shares, most of which are exercisable at $5.

· Management announced at the November 15 conference call that they had pooled 4500 of their Ladyfern acres with a like amount of acreage from unnamed parties. The market seemed to ignore this bit of information but it is potentially significant. Although Abraxas' interest will be diluted from 1/3 to 1/6 on 4 wells and to 1/3 and 3/8 on another 2 that will be drilled this winter, the arrangement protects the integrity of their fields from drainage from nearby acreage (a discovery well is about 3 miles to the south). Maybe more importantly, one can assume that the pooling of resources was with Apache and/or Murphy, both of which have made major discoveries at Ladyfern. Abraxas should benefit from the technical expertise gained by its partner(s) and validates the value of Abraxas' holdings.



Summary:



Yes, this is a potential takeover situation, but it's better if it happens later than sooner. Trace465 argued in June that selling pressure from the CVR holders (they had made their money and wanted out) had knocked the stock down from $5 and was abating. Since then, the price of gas has deteriorated significantly, the Grey Wolf buyout took much longer than expected (more sellers not wanting to hold ABP shares), the weather has been warm with a large overhang of natural gas in storage, natural gas stocks in general have declined in price and the economy has weakened. It appears that some of the major ex-bondholders gave up on a turnaround and have dumped their shares. Even if the situation is more complex, the intrinsic value of this company is considerably more than $1.20. At today's price, one can wait for good things to start happening.

Disclosure:


I began buying at $3.20 and have added all the way down to $1.05 with an average cost somewhat above $2.

Catalyst

Management has made a number of statements about selling assets and refinancing debt. Any major steps in these directions would increase credibility and enhance confidence in the long term asset value.



End of tax selling.



I subscribe to the view that the low stock price could have attracted a strategic buyer - there has been enough volume for someone to accumulate a 5% position. A 13-D/G would be a spark. However, it appears that no one wants to make the first move since it would just set off a bidding war. If cash ran out (debt doesn't come due until 2003 - 2004), management would publicly put the company up for sale.



Major results at any of the six Ladyfern wells that will be drilled beginning in December.



A couple of weeks of much colder than normal weather this winter.



Middle East related problems.