Description

Quest Energy Partners (QELP) is an interesting long opportunity as an overlooked natural gas E&P in the 8th inning of a significant corporate turnaround.  Importantly, the current market price does not fully appreciate the magnitude of recent credit agreement amendments. While I realize that Coalbed Methane (CBM) natural gas isn't sexy, I believe QELPs asset base fully supports its debt load, which creates a lot of leverage through the equity to a valuation re-rating.

QELP (and its sister company QRCP) are in the 8^th inning of a restructuring that began in the Fall of 2008 as the company began an investigation into accounting irregularities associated with a kickback scheme and outright theft by the CEO and CFO.  This, along with the weakness in gas prices, caused QELP to drop by 90%+ as bankruptcy appeared likely.  However, QELP/QRCPs bank group, led by RBC, supported the company with a series of amendments over the past 12 months which allowed the company to avoid bankruptcy and restate financial statements for the last 3 years.  On 12/17/09, the lenders gave the company the ultimate source of breathing room by pushing the major credit facilities out to a March 2011 maturity, contingent upon QELP, QRCP and QMLP(private) merging into one company, Postrock.  While QELP has nearly doubled, I think the Postrock assets are still created attractively through the equity and valuation will re-rate as QELP completes the merger into Postrock.

Within the next 2 months, it is expected that QRCP and QELP shareholders will vote to exchange their shares for shares in Postrock.  1 share of QRCP will receive .0575 shares of Postrock while 1 share of QELP will receive .2859 shares of Postrock.  (At one time, there was an attractive arbitrage by shorting QRCP and buying QELP, but this has substantially corrected at this point).  Postrock will have ~8.1mm shares outstanding upon completion, along with ~$300mm of net debt (325mm gross, 25mm cash).  By my calculations, buying QELP at 2.80 creates a Postrock share for $9.79 and Postrock's equity for 79.3mm for a total EV of ~$380mm (similar for QRCP at .60).  Below I will try to make the case that this Enterprise is worth at least $500mm (if not $600mm), resulting in an equity valuation of $200mm+ or more than 2x where Postrock is created today.

There is a ton of good information in this lengthy Postrock prospectus, including that the company has already received an offer of between 400-450mm for all of Postrock (which I believe sets an informal floor valuation for Postrock - currently at EV of 380mm).  Management declined to accept this offer on the basis of valuation.  Link: http://www.sec.gov/Archives/edgar/data/1473061/000095012309071606/d68961a1sv4za.htm

Postrock's Asset Base

#1) Postrock's core asset is a substantial acreage position (~540,000 acres) in the Cherokee Basin of Kansas and Oklahoma.  This acreage is primarily prospective for Coalbed Methane (CBM).  CBM development is relatively low-risk as geology is well understood and fairly expansive over Postrock's acreage (dry holes are extremely rare).  CBM wells are characterized as extremely shallow (500-1,500 ft) and therefore cost only ~75-90k to drill and complete with a basic water-based fracture stimulation (frac).  However, wells are not particularly robust and therefore operators have to drill hundreds of wells to build up a significant presence.  Accordingly, midstream operations become very important as the cost of hooking up a well to existing pipes can be $20-50k depending on the length of the pipe.  It is important for operators to benefit from economies of scale by increasing drilling density on acreage positions to maximize utilization of fixed pipe costs.  Postrock should be in a prime position in the basin as the largest operator with 2,400+ wells and 2,000+ miles of pipeline installed.

With regards to production profiles, CBM wells typically initially produce water with gas production steadily increasing over the first 12 months (dewatering phase).  Subsequent to peak production, wells have relatively flat decline curves (more methane is released as pressure decreases as opposed to conventional wells where less methane is released as pressure drops) although they can have relatively high operating costs as compression is added to a field in order to get gas into higher-pressure takeaway pipelines. (Note: the 12-month dewatering phase causes a cash flow mismatch given the upfront capex of a well, unlike conventional wells which produce their maximum production rates immidiately upon completion)

For a summary of reasonable well assumptions (which drive a substantial portion of my valuation model), I like the Admiral Bay Presentation: http://www.admiralbay.com/

I chose a touch more conservative set of well assumptions after speaking with management of a couple of local operators.  Summary of assumptions:

Well Cost (drilling, completion, pipe, allocated saltwater-disposal wells): $135,000

Operating Costs/Month: $750

Gathering/Compression Costs: $.80/mcf

Severance Tax: 7% of revenue

Peak Production Rate: 50mcf/day

Gross EUR (15-year life): 155mmcf - this uses an 8% decline rate after peak production @ 12 months

Net Revenue Interest: 82%

Using these assumptions and assuming realized wellhead gas prices of $6.00, I calculate that a well realizes a pre-tax IRR of ~29% and has an NPV of $60,000 (@15% discount rate).  At $5.00, these figures are 19% and $17,000.  I consider $5.00 to be the absolute floor at which new wells make sense to drill and therefore if you're view of long-term natural gas prices is below this, I would ignore any value I assign to Proven Undeveloped well locations (although existing production will still have substantial value).

After this (long-winded) analysis, I use the above model to value both existing wells (remaining production) and new well locations which Postrock might be able to drill.

To value the existing production base (currently ~ 57mmcf/d), I created a simple walk-through model to analyze the last 3 years of new wells drilled and modeled each year's production "wedge" to come up with an EBITDA forecast based on hedged and market-based production volumes and the costs laid out above.  Importantly, Postrock's existing hedges have substantial value and create significant visibility for EBITDA over the next 3-4 years.  Hedge specifics can be found here: http://qelp.publishpath.com/Websites/qelp/Files/Content/166910/2009-07-06-Hedges-QELP.pdf

Another important consideration pertains to the basis/differential between Southern Star Hub natural gas prices and NYMEX natural gas prices.  Historically, Southern Star (where QELP sells gas into) was at a substantial discount ($.50-$1.00) to NYMEX due to takeaway capacity problems from West to East.  Recently this has abated due to increased takeaway capacity and has even gotten to the point where Southern Star gas traded at a slight premium to NYMEX late last year.  I think it is reasonable to assume that this basis will be less than it historically has been (I assume .25) due to the more balanced supply and demand for West-to-East gas transportation.

The summary of my "blow-down" existing production/EBITDA model is:

 The Present Value (@15%) of this EBITDA stream is ~$235mm @ $6/mmbtu NYMEX gas;  @$5 gas, PV-15=$200mm (hedges mute gas price downside). As a check, as of 12/31/08, Postrock's proved developed reserves were 137Bcf - typically <$2.00/mcf is considered conservative for a proved developed reserve in the ground.

#2) In addition to these existing wells (2,400 wells on 332,000 acres), Postrock has 225,000 undeveloped acres.  On this undeveloped acreage, Postrock has ~1,500 potential well locations, of which ~600 are Proved Undeveloped.  @ $6.00 NYMEX gas, using the wells assumptions above, each undeveloped location has a PV-15 of ~$50,000 and therefore, assuming 1,500 locations, I attribute $75mm of value for these locations.  Importantly, at $5 NYMEX, these locations are marginally economic and therefore I attribute no value.  One source of substantial upside for Postrock is that, to date, the majority of wells have been drilled on 160-acre spacing, while competitors (such as Admiral Bay) have had success at 80-acre spacing.  Assuming this spacing is economical, this could increase the potential locations by a factor of 2-3x.  This optionality is excluded from my current valuation for the sake of conservatism.

#3) Quest Midstream Partners' (private) core asset is an inter-state pipeline, the KPC pipeline, which runs through Oklahoma and into Kansas City and Wichita.  This 1,120 mile long line has capacity of 160mmcf/d and was purchased for ~$135mm in November 2007.  KPCs cash flow is partially supported by long-term firm commitment contracts, however the pipeline is nowhere near fully utilized.  Management has plans to increase cash flow by offering customers storage along the pipeline, however I exclude this potential revenue source as it is unproven whether these storage capabilities are needed by customers.  Valuing this asset is imprecise but Postrock's S-4 indicates that the KPC pipeline does $20-30mm annually in EBITDA, which lends support to my assumption of $125mm of value.  Another data point to note is that Tortoise Capital Resources (TTO) has a stake in QMLP and has the equity marked at $100mm, implying that they believe there is substantial value above and beyond the $122mm of debt which QMLP will contribute to Postrock (I conservatively assume the assets barely cover the debt).

#4) Postrock's final asset is a 45,000 acre position in West Virginia, some of which is prospective for the Marcellus Shale.  Quest acquired this position from Postrock for ~$130mm, which was a ridiculous valuation for acreage which included a lot of marginal Marcellus potential (mainly Ritchie County, WV).  Management has indicated about 8,000 acres (100 well locations) are highly prospective for Horizontal Marcellus drilling (mainly Wetzel and Ritchie County, WV), while the remaining acreage will only have value as shallow sands/conventional development (which probably needs $6+ gas to work).  Currently Marcellus acreage in the area is going for >$3,000/acre (and my NPV models support valuations 2-3x that).  With this in mind, I assign $50mm of total value for all 45,000 acres.  While Marcellus development could be lucrative, it's not clear when the company will get to fully develop it, although the total acreage package clearly has some value.  I think haircutting the $130mm purchase price by 60%+ is quite conservative.

In summary, my valuation for Postrock is:

A couple of valuation points:

1) Maintenance CapEx: virtually all is included in the operating expenses of the wells and pipelines;  if any crept up it could be a couple million/year in the pipeline division

2) G&A Expense: while this is not an employee intensive business, Postrock should have a $5mm/year run-rate of administrative expense which could be thought of as a $25-40mm asset or liability (depending on whether you think management is adding value or not)

3) Pre-tax analysis: the above analysis is generally pre-tax which I think is reasonable given that Postrock will have ~$200mm of NOLs (I assume they are able to structure it such that some, if not all, of these survive the merger)

4) New Management is well regarded within the Cherokee Basin and I think they are well incented to follow-through and ensure the company is maximizing shareholder value after the painstaking process of restating all of the financial statements.

Finally, a couple of valuation checkpoints, to help get more comfortable with the myriad of assumptions made above:

1) Management EBITDA estimates: in the Postrock S-4 management lays out forward looking EBITDA estimates showing Postrock can easily clear $100mm of EBITDA going forward... based on a number of assumptions they lay out (but my valuation is <5x EBITDA) - The majority of EBITDA should translate into Cash Flow as Capex requirements are not high.

2) Book Value: Postrock's book value will be ~175mm and is likely understated due to marking reserve valuations down due to sub-$5.00 gas prices as of 12/31/08.

Risks: A few risks stick out in my mind, first and foremost being the risk that upside will be curtailed somewhat by a share issuance/dilution.  Another risk revolves around the fact that the banks have cashflow on lockdown and the company will be aggressively delevering for the next year or two.  However, I think both of these are well compensated for in the current price and institutional investors who revisit this story will look into 2011-2012 and the asset base which will be remaining.

For your side-pocket investment fund or PA, I think Admiral Bay Resources (ADB.TO or ADBRF) is dirt cheap (4.5mm market-cap, 30mm debt) for 130,000+ Cherokee Basin acres + some Marcellus acreage + the best geologist/management in Cherokee Basin; similar valuation profile as QRCP; They have to work through an agreement with current creditors but management has assured me that creditors are not interested in foreclosing and I got the sense that current equity will retain a majority of the value in this company... 

Catalyst

- Completion of Postrock merger within the next 1-2 months

- Coverage picked up again by both buy-side and sell-side (as liquidity returns to Postrock shares)