September 23, 2009 - 8:57am EST by
2009 2010
Price: 0.23 EPS $0.00 $0.00
Shares Out. (in M): 37 P/E 0.0x 0.0x
Market Cap (in $M): 9 P/FCF 0.0x 0.0x
Net Debt (in $M): 270 EBIT 0 0
TEV ($): 280 TEV/EBIT 0.0x 0.0x

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Technically this is not an option with the code "TXC+OQ" - but it might as well be.  My simple question to you, fellow VIC members, is what kind of upside would you need to compensate for a stock with a good chance of going to zero?  100%?  500?  1,000%?  I am going to make a case that TXCOQ could return 5,000%, perhaps even 10,000%.  Managing expectations is obviously not my strong suit.


TXCO Resources is a very cheap option with an asset whose value is still increasing.  The company is currently in chapter 11, but if the company can negotiate a sale of this asset at what I think is a fair price, the company would easily be able to make all claimants whole with plenty of value left for common equity holders.  That being said, this is a crappy company in almost every respect.  They're an E&P that's barely grown reserves.  Management has made two bad acquisitions and ramped up capex at the worst possible time.  They've raised equity on 9 separate occasions during the last 6 years.  Their legacy assets are lousy and the CEO has gotten paid an absurd amount over the last few years.  Pretty much what you'd expect from a silly microcap E&P.  But I'm not here to sell you on them as an operating company with a business plan.  This is the story of a company with an asset that despite not generating cash flow, has increased many times in value since it was acquired.


Eagle Ford Shale


This is the asset that can save this stock. The Eagle Ford Shale is relatively new gas play located in South Texas, it's only got a handful of completed wells so far although those wells have been surprisingly good and the geology is well understood because of a long history of E&P operations in the region.  Many companies previously targeted shallower formations such as the Edwards Reef Trend in this area, but with the explosion of shale in the last few years the Eagle Ford is the new new thing.  Petrohawk has been leading the way in exploration with the most wells drilled and the results keep getting better, continually surpassing expectations.  They only announced the discovery in the middle of last year, even though people have known about the actual shale for years.  Initial wells, although few, were impressive, but that's typically the nature of productive shale plays, they're relatively easy to understand.  The most recent wells they drilled had initial production (IP) rates between 10-13 mmcfe/d which are pretty big for shale wells, only the core of the Haynesville Shale (the super-hot and overrated shale play in Lousiana...google for info) is consistently better.  And these latest wells have shown significant improvement over the first ones drilled.  Wells are looking like they're about 5 bcfe of reserves (EUR) so far, although I wouldn't be surprised to see that trend upward, as usual for young shale plays.  All indications are pointing towards the Eagle Ford being a home run play.  There are really four things that set the Eagle Ford apart from the rest:


  1. The high liquids (NGL's, or condensate) content of the wells dramatically improves the economics.  NGL's are priced off oil (albeit at a discount) rather than gas, thus improving the revenue stream from the well.  So far NGL's comprise about 15-25% of total hydrocarbon production, so that even at $3/mcf gas operators are actually realizing ~$4/mcf on an equivalency basis.  As pure gas wells the Eagle Ford is attractive with $1.15/mcf net (adjusts for royalty) F&D costs, but the NGL's drive that down to $.90/mcf while producing higher value products not found in most gas wells.  Thought of another way, a ~$5 million dollar well gets you ~4.3 bcf of net gas and you get ~160 thousand net bbls of NGL's for free.  Without the liquids the Eagle Ford is a good shale play but with the liquids it's the best in the country.  The wet areas of the play are still being defined.
  2. The costs are low compared to the size of the wells.  Current well cost is about $4.5-5.0 million but operators expect this to decline to $3.5-4.5 million as experience increases - this is perfectly normal for shale plays.  Assuming 4-5 bcfe gross EUR's that equates to a net F&D cost of $.80-1.20 which ranks among the best plays in the US.  This cost compares to about $10 million to drill a Haynesville well currently.  The main reason for the difference is that the drilling time is half the Haynesville because the formation is shallower and it's not overpressured, which complicates drilling.  I estimate that wells have 40-50% IRR's even after accounting for acreage, G&A, interest expense, tie-in cost, etc (most companies exclude all that pesky other stuff in their pro-formas).
  3. It's looking increasingly likely that the wells wont experience the extremely sharp first year production declines that are found in the Haynesville.  Because the reservoir isn't overpressured operators are seeing more moderate decline curves which will help increase the recoverable reserves as the drilling technique and location selection is refined.
  4. Infrastructure is in place to handle lots of processing and takeaway capacity.  The growth of this play wont be constrained because of pipeline problems (Fayetteville) or liquids processing (Marcellus).  Put all of this together and the early indications are that the Eagle Ford might be the most profitable shale play in the US.


TXCO has 337,000 net acres in the Eagle Ford through JV agreements with EnCana and Anadarko in deals they signed in late 2007 and early 2008 before the play had received much attention.  The Anadarko agreement allows TXCO to earn a 50% interest in the deep rights (includes Eagle Ford and Pearsall Shale) on Anadarko's 349,000 acres based on certain drilling commitments which have all been met.  TXCO partnered with Saint Mary Land & Exploration 50/50, so TXCO's interest is 25% while Saint Mary is drilling the final wells.  The EnCana agreement is similar, again calling for TXCO to drill a handful of wells in order to earn additional acreage.  Right now TXCO owns about 225,000 acres, although with various lease expirations it's a moving target.  TXCO also has some acreage they own outright with a 100% working interest.  In the aggregate though, this is one of the largest acreage positions prospective for the Eagle Ford, and to give TXCO's leases credibility consider that they're surrounded/partnered with Anadarko, EnCana, ConocoPhillips, and EOG Resources.  Not exactly a list of dumb companies.


The one big problem is that TXCO's acreage is farther west than where Petrohawk has had their stellar results.  The good news is that the shale is known to extend west across TXCO's acreage, but we really don't know exactly how economic it'll be until there are more wells down.  Several wells have been drilled with so-so results, although this is largely attributable to the completion technique (short laterals, only 5 fracture stages) rather than the quality of the rock.  Rosetta Resources recently completed a well to the west of Petrohawk with an IP rate of 5.2 mmcfe/d, which is a nice result.  The location is still east of TXCO's acreage but it helps further prove the play works as you move west.  Anadarko has also moved a rig into to the area to start drilling Eagle Ford wells.  If they hit some good wells this should very directly benefit TXCO because the wells are likely in the JV (TXCO wont be participating, for obvious reasons).  Another possible encouraging sign about TXCO's acreage is that the Eagle Ford is found at shallower depths, which improves drilling times and also might mean that this turns into an oil play.  Several industry contacts have confirmed to me that indeed they think there could end up being a nice oil zone in TXCO's acreage, which in today's market will generate more excitement than gas.


Other Assets


Along with the Eagle Ford, TXCO's also has exposure to the Pearsall Shale.  This is a formation that's found below the Eagle Ford, only a couple of horizontal well results exist and they're not great, although they've been consistently improving as companies begin to locate natural fractures in the shale through 3D seismic data.  The play has been a bit of an enigma so far but it's showing just enough signs to keep people interested.  TXCO drilled a well to the Pearsall which IP'd at 16 mmcfe/d and had to be shut in because of the high flow rate - a good well.  Still, there have been more than a few bad wells which have put people off.  If this play works, the Eagle Ford acreage becomes much more valuable because of the additional pay zone below it.


The San Miguel tar sands project is something that should give you an idea of how dumb the management of this company is/was.  There is a prospective oil sands play located in Texas, if you can believe it.  TXCO has a 50% interest in 84,000 acres and management estimates 7-10 billion bbls of....oh who am I kidding this play is a joke.  Why these guys ever though it would be a good idea for a $100 million market cap company with no expertise in oil sands and hundred of thousands of great shale acreage to throw money at one of the most high-cost capital intensive energy projects on earth is beyond me.  I guess they just liked using the words "billion barrels of oil" in their investor presentations.


There are some other parts of the company but they're really not important to the thesis.  Luckily 70% of the production is oil.  In my valuation I give a major haircut for these assets.


Financials & Bankruptcy


Management levered up the company to buy unproductive and high cost assets before oil crashed.  I don't want to give you the impression that this was just a case of ill-timed leverage, because the assets were never great in the first place.  On 5/17/09 TXCO filed for voluntary bankruptcy.  TXCO has to file a reorganization plan with the court by 10/14/09 and other committees can submit their own plans after 11/13/09.  I cant imagine much else TXCO's plan could say other than "we're going to monetize the Eagle Ford - please give us time".  Lonquist & Co has been hired to value to non producing properties while Global Hunter Securities has been hired to find a buyer.


After the plans are filed the next big date is 2/1/10, which is the maturity of the DIP.  This is admittedly approaching fast, but I think that if good wells start getting reported around TXCO refinancing or extending the DIP shouldn't be a huge problem.  But there definitely needs to be some more valuation markers that Lonquist can point to to give the creditors some comfort that the longer we delay, the more likely a recovery will be. 


The three main components of debt are a $150 million senior note owned by BMO, $95 million in preferred stock, and a $32 million DIP loan.  They are still burning cash right now at a rate of about $1 million per month but that's only because they're spending the final amount of their capex budget on the Saint Mary well completions.  There is no equity committee yet but that could change.


If you think an exit from bankruptcy is fantasy I would highlight the recent events of Pilgrim's Pride (PGPDQ) to illustrate that a significant recovery in equity is entirely possible...maybe it's just a sign of the times.  The gist of the story was that there was a turnaround in the fundamentals of the business while it was in chapter 11 and a large buyer showed up who took out all debt holders at par.  Stock went from a low of $.14 to currently almost $8.00.  Another possibly encouraging event is SandRidge Energy's acquisition this morning of Crusader Energy, which was in chapter 11.  While Crusader does not have overlapping assets with TXCO, it's nonetheless a positive development that there are buyers for distressed assets.  Then again, maybe it's not encouraging because the equity got wiped out, of course Crusader didn't have +300,000 acres prospective for the Eagle Ford...



There's no complicated model here, this entire thesis boils down to the value of Eagle Ford acreage.  It's early in the play but there are several guideposts we can use.  First there's the price the operators are paying for new leases.  In May, Saint Mary reported that acreage was going for $500-1,000 while Petrohawk reported paying about $500/acre.  This probably isn't a great measure right now because acreage is getting increasingly difficult to acquire and it would be impossible to put together a package of several hundred thousand acres (size gets a premium) through leasing.  We can still use $500/acre as a decent floor value, but at this price the equity is still worthless.  I think the value is substantially higher than $500/acre though.


So what do people pay for economic shale plays anyway?  Below is a list of transactions for mostly nonproducing acreage in the Haynesville, Marcellus and Eagle Ford. I think that as other operators prove up the play, acreage prices will move sharply higher, I would think easily to the $2,000-5,000 range as in the Marcellus.  Of course, no two deals or acreage packages are alike and I caution that we're still not sure about the quality of TXCO's acreage in comparison to Petrohawk's, but you can see that the market is clearly willing to pay up for decent shale acreage.  There have only been two deals in Eagle Ford so far and they're both very small, mostly because nobody wants to get out of the play yet, either via JV or outright sale.  I think that the Marcellus deals will hopefully be more representative of Eagle Ford after confidence is gained that the acreage is productive.  But considering the Eagle Ford is even more economic than the Marcellus, much high acreage prices could be justified.  You can also see that size gets a premium which should help TXCO get a good price in the event of a sale.



Buyer Date Acres Price Price/Acre
Magnum Hunter Sep-09 3,621 2,350,000 649
Reostar May-09 13,000 5,500,000 423
      Average 536
Buyer Date Acres Price Price/Acre
BG Group Jun-09 84,000 1,300,000,000 15,476
NFR Energy Jun-09 22,000 58,000,000 2,636
Plains Exploration Jul-08 110,000 1,650,000,000 15,000
      Average 11,038
Buyer Date Acres Price Price/Acre
Fortuna Energy Sep-09 35,000 192,000,000 5,486
Chesapeake Energy Sep-09 37,000 212,000,000 5,730
Enerplus Resources Aug-09 116,000 406,000,000 3,500
Williams Aug-09 44,000 41,000,000 932
Statoil Nov-08 600,000 3,400,000,000 5,667
Antero Resources Sep-08 114,000 347,000,000 3,044
Quest Resources Jul-08 70,600 142,000,000 2,011
XTO Energy Apr-08 152,000 600,000,000 3,947
      Average 3,790


Generally, the Maverick Basin is starting to heat up, with more rumored data points of some good oil wells in the neighborhood and guys like Chesapeake buying some acreage (Aubrey McClendon is probably losing sleep over the fact that he might be left out of the best shale play in the country, I could easily see him having interest in TXCO).


Here is my quick analysis on what the equity could be worth.  I'm not doing anything fancy here, just taking the recent financials and combining them with the forecast provided to the DIP lenders, so for the liabilities I'm showing what I think they'll be at 12/31/08.  For the PV10 I only give them credit for PDP's, nothing that's non-producing, which comes out to a 64% discount on 12/31/08 PV10 of $137 million (22.5 bcf @ $1.00 and 3.5 mmbbl @ $8.00).  I've also maxed out the DIP loan to $32 million even though they're likely to only draw on $25 million.  But if they can get a good price for the Eagle Ford all of this stuff becomes rounding errors, which is why I think TXCO is so interesting.



      Acreage Price   Value (millions)
  Acres   Low Mid High Great   Low Mid High Great
Eagle Ford Shale 337,000   500 1,000 1,500 2,500   168.5 337.0 505.5 842.5
Pearsall Shale 313,000   50 75 100 100   15.7 23.5 31.3 31.3
PV10               50.0 50.0 50.0 50.0
Bank Debt               -150.4 -150.4 -150.4 -150.4
Preferred               -94.5 -94.5 -94.5 -94.5
Trade Payable               -68.0 -68.0 -68.0 -68.0
Other Payable               -21.2 -21.2 -21.2 -21.2
DIP               -32.0 -32.0 -32.0 -32.0
Cash               4.0 4.0 4.0 4.0
Other Assets               29.1 29.1 29.1 29.1
Remaining Equity               -98.9 77.5 253.8 590.8
Shares Out 37.0           Equity Value per Share -2.67 2.09 6.86 15.97




We need two things to get this to work.  First we need the Eagle Ford to start getting proved up west of Petrohawk's acreage.  I think this is good possibility based on conversations with operators, the high quality companies involved (Anadarko, EnCana, Conoco, EOG), technical data such as old logs, and early drilling results.  But who knows, maybe it's a dud around TXCO's acreage...I don't think this will be the case, but it's possible.  Without some good data points this is a zero.  Second we need a buyer of TXCO's interest in the JV's (or the whole company).  And of course we need this all to happen in the next several months.  But if these things happen the return for equity holders could be epic.  I'm not saying it's going to happen, but I think it's pretty rare just to find a case where this kind of upside is at least possible under some reasonable assumptions.  Thought of as an option I think it's very cheap and worth risking the capital.



Additional Eagle Ford data points;

Positive bankruptcy developments;

Sale of Eagle Ford;

Sale of company;

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