On January 15, 2018, EXCO (EXCE, Financial) filed voluntary petitions for a court-supervised reorganization under Chapter 11 of the U.S. Bankruptcy Code to facilitate a restructuring of its balance sheet, which was saddled with expensive transportation and other contracts. On November 5, 2018, EXCO filed a restructuring plan, stating that holders of the 1.75 lien term loans would receive 82% of the new common stock of the company, subject to dilution by a management incentive plan. However, this plan did not come to fruition due to the company’s inability to raise enough capital and an amended plan of reorganization was offered to the creditors on April 10, 2019.
Based on the valuation analysis by EXCO’s investment banking firm, PJT Partners Inc., under the amended plan, the 1.75 lien term loan holders would receive 38.8% of the new common shares, resulting in a recovery of 27 cents on the dollar or 27% (given the total principal outstanding for the 1.75 lien term loans was US$742.2 million).
In early July of 2019, the company emerged from bankruptcy and the 1.75 lien term loans were converted into 28.38 equity shares for every $1,000 in par value, after netting out certain adjustments. We received 1,518,570 shares of EXCO in the Fund.
Looking back on this investment, we underestimated how long the price of natural gas would stay low for, and how low it has been relative to the price of oil. Historically, there had been a strong relationship between the prices of oil and natural gas. Thinking about the two fuels in terms of energy equivalency, 6,000 cubic feet (6 mcf) of natural gas has the same amount of energy content as 1 barrel of oil. In the past, this 6 to 1 ratio guided the relationship between oil and natural gas prices, but for the last few years the ratio between prices had gone up to as high as 50 to 1.
In practical terms, there are always frictional costs and time needed to convert from oil to natural gas. In a free enterprise society, businesses are always adapting and they are looking for the most cost-effective way of running a business. This includes individuals too. We have seen how solar energy and electric cars have replaced a portion of fossil fuels for their energy consumption. In time, if the ratio of oil to natural gas prices is in excess of 10 to 1, there will be new efforts to use more natural gas at the expense of oil and the historical equilibrium will be restored. The historical ratio of 6 to 1 can be stretched to maybe 10 to 1, but 50 to 1 is asking too much.
Lo and behold, most investors felt that the ratio of 6 to 1 was totally broken. There was a new paradigm of 30 to 1. But on April 20th the price of oil fell into negative territory. You had to pay someone to take the barrel of oil from you. Unbelievable! The ratio had dropped below 6:1 to 0:1, albeit temporarily.
The crash of the oil sector has made us quite bullish on the natural gas sector. So much irresponsible money had been poured into the oil sector which indirectly impacted the natural gas industry. When you drill for oil, the by-product you get is natural gas. The excess production of shale gas through fracking is one of the main reasons why natural gas prices have stayed at such a low price for so many years. With capital withdrawn from the oil industry, distressed oil and gas producers will cease production and the excessive supply will shrink over time.
On the demand side, another market that is opening up for natural gas is Asia, which could be an important export market of U.S. natural gas in the form of liquefied natural gas (LNG). The price of natural gas can compete directly with the price of coal and natural gas has much lower environmental impacts compared to coal. China, S. Korea, Japan and Taiwan are shuttering coal plants and replacing them with natural gas plants. In time, we believe LNG prices will rise as demand for it rises exponentially. Since EXCO is mainly a natural gas producer, we remain optimistic about its future over the long run. Compared to its peers, the company is also better positioned given its post-bankruptcy cost structure.
From Francis Chou (Trades, Portfolio)'s Chou Associates Fund 2019 annual letter.
