Description

Castle Energy is a stock that trades significantly below its tangible book value, has a clear catalyst to unlock shareholder value, and offers very favorable risk/reward characteristics. The negatives of the story are that the stock does not have much volume, and they are involved in some litigation with Chevron.

Castle was in the production and exploration business with interests in wells in 14 states, and five wildcat wells in Romania. In September 2002, it sold its entire domestic and oil and gas properties to Delta Petroleum. In September 2002, it sold all of its Romania interests. As a result of these sales, Castle now owns no operating assets or engages in any business activities.

Current Castle assets are 9.948 million shares of Delta Petroleum shares ($59 million), $12 million cash, and a few other misc. holdings. The total value of Castle assets is approximately $75 million. The market cap of Castle shares is $39 million, which represents a 50% discount to tangible book value.

Delta Petroleum is another stock we own, and feel it to is undervalued. In addition to its own assets which we deem to be quite valuable, it is one of the energy companies which have claims from the funds paid to drill off the Santa Barbara coast in the early 1980s. This claim was purchased from Conoco. Conservatively speaking, they should receive at least $100 million, and have only 23 million shares outstanding. While this dispute has been ongoing, it seems to be coming to a head, as the judge in case last week demanded that the government provides the court with the state of the settlement, a timeline for closure, and probability for ending the dispute. This is due January 8th, and the court has said they will set a trail date soon, if they are not satisfied that this issue is coming to a rapid conclusion. If the matter goes to trial Delta could get considerably more (perhaps $300 million with related costs, interest, punitive damages, etc.), as there is no question that they are owed the funds. In addition to their other assets, Delta has an interest in the Rocky Point drilling project, which has been doing extremely well. While we think Delta shares are undervalued, for the purposes of valuing Castle conservatively, we are using the current share price of $6.

So, with the current Delta share price, Castle's total assets are about $75 million, they are burning about $5 million a year, which is mostly legal, costs, and has a 3.4% dividend.

In terms of a clear catalyst, Castle has publicly stated that their intention is to distribute the assets to the shareholders, and close the company down as soon as the Chevron matter is resolved. This stands to reason, as there currently is no ongoing business activity at the company, and there are only three employees.

The tricky part of the story is the litigation with Chevron. We believe that the Chevron's suit is completely without merit, and will be thrown out, or Castle will settle for a small amount, perhaps $2-3 million.

The dispute has to do with an old refinery in Indiana called The Indian Refinery which Texaco (now merged with Chevron) owned for almost the entire term of the refinery which was built in 1905. In 1989 Texaco sold it to the Indian Refinancing Limited Partnership (IRLP) which is a subsidiary of Castle Energy. In 1995 IRLP sold the refinery to another partnership, which subsequently dismantled it as part of the liquidation plan. The problem is that in 1998 the EPA declared the Indian Refinery as a superfund project, and the estimated cleanup costs are in the range of $100 million to $150 million. Despite only owning the property for five years, Texaco has sued Castle for cleanup costs, and said they were indemnified by Castle from these costs themselves.

We feel the case is completely without merit, and even if Chevron were successful, they would only receive a tiny judgment. If the total cleanup costs were $200 million, IRLP only owned the refinery for 6% of the term, and would have a liability of $12 million less the roughly $10 million already contributed towards the clean-up. So, the liability would only be about $2 million.

Most importantly, there are a great number of legal precedents stating that corporations are not liable for the actions of its subsidiaries. The most famous is US vs. Bestfoods which has been upheld many times. The case is far into discovery, and unless a settlement is reached, which we think is a real possibility, it will be tried before a judge (not jury) in late 2004. Most likely Castle will move for summary judgment in the early Spring, and we think there is a good chance they will be successful. Furthermore, Chevron has settled a similar case with MG for $800k.

In sum, Castle Energy represents a unique opportunity to acquire tangible assets at a significant discount, with a clear catalyst. While there are always uncertainties related to litigation, we think Castle represents a
terrific risk/reward opportunity. In the meantime, shareholders can collect a 3.4% dividend.
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Catalyst

Castle has publicly stated that their intention is to distribute the assets of the company to the shareholders, and close the company down as soon as the Chevron matter is resolved. This stands to reason, as there currently is no ongoing business activity at the company, and there are only three employees.