6/13/08

Quicksilver: A Stock to Continue Benefiting from High Energy Prices?

As energy prices have been soaring recently, and are expected to remain high at least through 2009, according to the June 10th report of the Energy Information Administration, I thought I'd write about a small, leveraged company in the sector that could beat the market over the short term.

Quick Silver Resources (KWK) is a natural gas and oil explorer and producer headquartered in Fort Worth, Texas. It focuses on getting natural gas and oil out of unconventional places like tight sands, coal beds, and fractured shales. The company owns property in Texas, Wyoming, Montana, and Canada (mostly in Alberta). As of 12/31/07, about 78% of the company's reserves were in Texas, and another 21% were in Canada.

In its most recent quarterly results, KWK reported a 78.6% jump in earnings year over year on a 35% increase in revenues. The growth was the result of increased production and higher oil and gas prices. Over the last five years, the company has grown its sales at an average annual rate of almost 38%. Quicksilver is expected to continue its strong performance, with 2008 earnings projected to nearly double those of 2007, as long as oil and (especially) natural gas prices stay near where they are today. Daily production of natural gas last quarter was about 211 MMcfe (million cubic feet equivalent), a year over year increase of almost 13%. Management says it expects daily gas production to be from 225 to 235 MMcfe for the rest of the year.

Because liquefied natural gas transport is still in its early stages, domestic natural gas producers like Quicksilver have an advantage over foreign producers, which have trouble getting their products to the US market. Moreover, domestic producers (based in the US and Canada) face less political risk than competitors developing properties in, for example, the Middle East or Eastern Europe. What separates KWK from some other domestic producers is its unconventional properties. Tight sands, fractured shale, and coal beds have fairly stable production and longer asset lives than conventional properties. This also lowers the firm's risk.

From an investor's perspective, another good thing about Quicksilver is that management has a large stake in the company. Members of the Darden family, who sit on the board (including Glenn Darden, president and CEO--his brother, also a board member, recently purchased a few more shares at around $41 per share), own around 34% of the company's stock. Excluding the Dardens, other managers control a combined 1% of the company's stock. Apart from his significant stake, Glenn Darden is also a skilled manager with over 20 years of experience in the industry.

And now for the risks Quicksilver investors face.

The company does not pay a dividend. (This isn't really a risk, but I like companies that pay you to invest in them.)

The company has not generated positive free cash flow for some time. Free cash flow is expected to remain negative for the foreseeable future. The reason that Quicksilver's capital spending outpaces the cash it brings in is because of its growth strategy of aggressive acquisition and development of unconventional properties with borrowed funds. While this strategy has worked so far, it may not in the future.

If natural gas prices fall, the negative free cash flow risk could be exacerbated. As Quicksilver already relies on outside financing for its operations, it will be hurt if it cannot obtain credit at rates it is used to. The company already has over $1 billion in debt, and has recently obtained a new $1 billion revolving credit facility. For purposes of comparison, revenues for the trailing 12 months are just over $600 million.

Mitigating this risk in the short term is Quicksilver's sale, in November 2007, of assets in Kentucky, Michigan, and Indiana. Along with last August's successful IPO of Quicksilver's master limited partnership Quicksilver Gas Services (KGS) of which KWK owns almost 73%, the company obtained enough cash to be financially flexible in the near term.

Another risk Quicksilver faces is tougher competition. In the past few years, a whole slew of new companies entered Quicksilver's space. Moreover, Quicksilver may be hurt significantly if it experiences problems in its exploration or development of new land. Problems resulting from exploratory and development failures will be exacerbated by debt.

Like other companies in the space, KWK faces the general risks of labor problems, equipment problems and rising costs, environmental disasters, and tougher government regulations. There is also the risk that oil and natural gas prices (and KWK is especially reliant on natural gas) will tumble. Given Quicksilver's leveraged growth strategy, lower natural gas prices would probably hurt it more than its competitors.

To summarize, Quicksilver's prospects are largely determined by natural gas prices and its success in exploring new properties for development. If its past, in terms of exploration and production, is any indication, KWK will do well in finding new land to develop. Further, natural gas prices are projected to remain at current levels in the near term.

If interested in Quicksilver, you may also be interested in the iShares Dow Jones US Oil and Gas Exploration and Production Index Fund (IEO) or the S&P Oil and Gas Exploration and Production ETF (XOP). The two ETFs provide a more diversified approach to exposing your portfolio to oil and gas exploration and production.

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