Doubling Down on EXCO

It's easy to fool yourself into thinking you were too early getting into a stock instead of admitting you were just plain wrong. But at the risk of making that rookie mistake, I've added to the beaten-down position I have in exploration-and-production play EXCO Resources (XCO).

XCO shares are down a crushing 40% since I featured them in my Nov. 17 column. I was clearly much too early betting alongside legendary investor Wilbur Ross that progress towards a rational energy policy in the U.S. would (no, should) acknowledge this homegrown fuel's potential in a long-term energy plan. With its reliance on sales of natural gas, EXCO has suffered along with common sense by the inability of the Beltway Boys to get out of the way of making the U.S. less dependent on foreign energy sources.  

The travails of XCO make fundamental sense given the political backdrop. EXCO felt the squeeze of dramatically lower natural gas prices in the fourth quarter and reported a larger-than-expected loss for the final three months of the year. EXCO shares were already on the ropes before this earnings event and have since stayed downtrodden along with the price of natural gas.

Total oil-and-gas production was up 58% compared with last year, as operations in the Haynesville shale fields were more successful in the last quarter of 2011. For the full year, oil-and-gas production rose by more than 60% to record levels.

Unsurprisingly, EXCO's increased production has not been enough to offset the widespread impact of plummeting natural gas prices. Fourth-quarter losses amounted to $0.78 per share, compared with a loss of $0.34 a share in 2010. After adjusting for non-cash derivative gains and losses, EXCO had an operating profit of $0.09 a share. The consensus Wall Street estimate was for adjusted profits of $0.17 a share, even though the depression in natural gas prices was impossible to miss.

Industrywide, natural gas production is being curtailed or shut down completely at many E&P companies. In the key Haynesville shale fields alone, the rig count has dropped from the peak of 186 rigs in operation in the second quarter of 2010 to just 85 currently. Total gas rigs in operation in the domestic market are below 700, down from more than 800 at the end of December.

While this makes for a difficult short-term operating environment, EXCO's management noted that lower prices are not only creating new demand for natural gas that will help balance the pricing, but it creates more attractive acquisition pricing as well. CEO Douglas Miller told investors that the company intends to continue pursuing acquisition opportunities in natural gas, natural gas liquids and oil in both shale fields and locations that are more conventional. Nonetheless, EXCO will be reducing its own natural gas drilling operations because of the weak pricing environment. EXCO's rig count in the Haynesville field will drop to nine rigs from 22. In the Marcellus shale, the count will drop to three rigs from four for 2012.

That's consistent with management's focus on managing their balance sheet and cash flows during the period of weak commodity pricing for natural gas assets. EXCO's revised capital budget for 2012 is more than 50% less than spending in 2011, as management moves to conserve cash until pricing improves. These are smart moves that show management is fully capable of dealing with the weak environment and outlook for natural gas.

I'm not the only one who's bullish on EXCO. Wilbur Ross and Oaktree Capital Management's Howard Marks both increased their stakes in its sagging stock since I've been in it. I should also point out that I've been in a hole with Ross before: In 2009, I fell deep in the red betting on International Coal. To my discredit, I was shaken out. Ross stayed the course and reaped serious profits as that energy company was sold two years later for a price nearly 700% higher.

I feel strongly enough about the long-term prospects of natural gas to get shaken out of XCO at this point, but one prominent insider had no choice but to sell into weakness. It was very disconcerting to see a large $9.2 million insider sale by Miller in January. Although the Form-4 clearly stated in the footnotes that it was an "involuntary sale effected by a lender to satisfy certain margin loan requirements," I frankly wondered whether that made the sale more or less troubling.

While forced, the sale still indicates that Miller seriously misjudged the state of the natural gas market and its effect on XCO. Considering that I follow insiders specifically because they are supposed to have better insights into such important, stock-moving metrics, I found no solace in his sale being forced. The margin call was reminiscent of the same misjudgment made by Aubrey McClendon at Chesapeake Energy (CHK) in October 2008. At least McClendon could blame the financial crisis.

In the end, I've viewed Miller's embarrassing margin call as more of a sign of just how unnaturally low-priced natural gas is right now. A year from now, I expect both nat gas and XCO to be priced much higher than today.

At the time of publication, Moreland was long XCO.