There is No Mess when Buying this Energy Underdog

Matthew is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

I didn’t see that one coming!  If you are like most investors you’ve seen your hard earned money come crashing down with some high flying stock that you were sure was going to be the next big thing.  Whether it was accidental investing cleverly portrayed in commercials or just plain greedy over allocation, it’s hard to watch a stock just fall apart and put a ding in your portfolio.  It almost makes you want to avoid these stocks altogether.   Unless, of course, you are taking an approach that has less clean up required by following the approach in my “No Drip, No Mess” Portfolio. 

The main thesis is that we’ll be taking the dividend income earned on stocks in the portfolio and combine it with options income to buy growth stocks.  To date the portfolio has earned no dividend income as the portfolio just holds three stocks at the moment.  What we’ve been able to do is generate enough option income to purchase a one percent stake in a company that’s much more risky than anything else in the portfolio but that’s ok, it’s not costing us a penny of our original capital.  Let that sink in for a moment, we’re buying a stock with the risk practically removed. So with the messiness removed, let’s buy an energy underdog that I think has plenty of room to run.

I’ve been watching Rex Energy (NASDAQ: REXX) for a while and I think this underdog has the potential to fetch investors a healthy long term gain.  With a market cap of just over half a billion dollars, it is tiny compared to others in the industry. In fact, portfolio holding Linn Energy (NASDAQ: LINE) typically buys what would amount to at least two companies the size of Rex Energy per year. 

What excites me about Rex is their position in the Marcellus and Utica Shale coupled with the good economics on the wet gas portion of their portfolio.  With $3.75 NYMEX natural gas and $100 NYMEX oil, Rex can generate $3.95 of net income per mcf after all gathering, transportation and operating expenses.  While both those commodity prices are higher than current spot prices, Rex is very well hedged allowing them to continue to profit, to the tune of $56 million of projected cash flow from the end of the first quarter through the end of the year.  As you can see, they can make money even as prices continue to fall.

Rex has done a good job to ensure they have enough liquidity to continue their drilling program while shifting the program toward their liquids rich acreage.  The recently completed sale of the 28% stake they own in Keystone Midstream to MarkWest Energy Partners (NYSE: MWE) for $120 million not only gave them a nice cash injection to their balance sheet, but they also had their borrowing base increased by $10 million to $265 million and are actively marketing their Rockies Assets to further strengthen their liquidity.  This gives them a lot of financial flexibility to pursue their capital projects going forward as they’ll still have around $236 million in liquidity even after finishing their 2012 cap ex program of $116 million. 

At their current run rate they have about three years of liquidity before they’ll need to either start to cut back on their drilling program or find other sources of cash if commodity prices don’t increase.  I, however, think that prices will increase, especially in the liquids that Rex is increasingly drilling for as I see two catalysts on the horizon.  While it will be a while before it is built, Royal Dutch Shell’s (NYSE: RDS-A) cracker plant to be built in Southwestern PA is right in the sweet spot of Rex’s acreage.  As this plant starts taking deliveries from Marcellus and Utica producers, it should provide a bit of demand uplift, which potentially will take prices up with it.  Additionally, crackers on the Gulf Coast to be served by the ATEX Express being developed by Enterprise Products (NYSE: EPD) and other pipelines going to East Coast refineries all will help provide the infrastructure that is needed to get the energy to where it will be used.  There is a lot to like about the prospects of Rex and I am excited to add shares to the portfolio.

So far the portfolio has generated $865.66 of option premiums that we’ll use to buy Rex.  Since we are just a little bit shy of the amount needed for a full 1% position and with shares right around $10 a share we will take advantage of the implied volatility in the puts to write them just out of the money.  The September $10 puts should get us around $125 for the one put we’ll write giving us just about enough cash to fund our 1% position.  As always, if we're not assigned on the first try, we’ll of course try again shortly after expiration if shares haven’t wandered too far.  Once we get shares I plan on holding them until the company is either acquired or it is valued too richly to justify.  While I don’t expect Rex to roll over and play dead, even if they do it won’t do much damage to the portfolio.    

latimerburned owns shares of Linn Energy, LLC and Enterprise Products Partners L.P. The Motley Fool has no positions in the stocks mentioned above. Motley Fool newsletter services recommend Enterprise Products Partners L.P.. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. If you have questions about this post or the Fool’s blog network, click here for information.

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