CRK: High-Cost Gas Producer With Excess Debt

seekingalpha11-22

Comstock Resources (CRK) faces elevated breakeven costs and negative free cash flow, necessitating additional debt to fund operations amid low natural gas prices.Despite a 44% stock rally since April ...

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Denis Shevchuk I’ve written about natural gas exploration and production (E&P) company Comstock Resources (NYSE:CRK) on multiple occasions here on Seeking Alpha starting with a bullish piece way back on March 10, 2021, titled “Comstock Resources: A Leveraged Play on Gas Upside.” That call proved prescient as, per Bloomberg, the stock soared just under 245% from publication through CRK’s ultimate peak on June 7, 2022. In my April 26, 2023 article, “Comstock Resources: 2023 Will Be Messy,” I turned bearish, citing the company’s elevated free cash flow breakeven costs, a measure of the average price of natural gas CRK needs to generate positive free cash flow in a particular quarter. As I’ll explain in just a moment, I’ve been broadly correct about CRK’s cost structure and the need to take on additional debt to fund capital spending (CAPEX) at gas prices below $3.00 to $3.25/MMBtu. However, since my bearish April 26, 2023 piece, CRK’s stock is up about 44% including dividends, rallying despite the negative free cash flow fundamentals. While CRK has rallied since my sell call, one aspect of my thesis was that there are other natural gas E&Ps with better fundamentals than CRK and more upside potential. That call proved correct – for example, I highlighted Southwestern Energy in a bullish piece published on May 4, 2023 “Southwestern Energy: Undervalued Natural Gas Company.” SWN went on to rally 52.25% through the close on September 30, 2024, when Chesapeake Energy’s all-stock deal to acquire SWN closed. On October 1, 2024, the combined entity was renamed Expand Energy (EXE) and, according to Bloomberg, SWN shareholders who held shares of EXE received as part of the deal have been amply rewarded with the stock up an additional 20.5% since that date. While my bearish calls on CRK since the spring of 2023 haven’t gone according to plan, the company’s fundamental outlook remains challenged into the first half of 2025. Indeed, as I’ll explain in a moment, I believe the stock would be trading in the mid-single digits were it not for two related tailwinds. First, Comstock remains a popular and crowded target for the bears — the elevated short interest in the stock makes CRK vulnerable to periodic squeezes where short sellers scramble to buy to cover their bearish positions, driving the stock higher. Second, according to the latest Form 4 filing with the SEC, entities associated with Jerry Jones, the billionaire owner of the Dallas Cowboys, controlled over 208 million shares of CRK , equivalent to more than 71% of outstanding shares. Jones has added to his position in CRK in 2024, including via a $100.5 million private placement of the stock back in March. Jones’ hefty financial interest in CRK lowers the company’s float of shares available for trading, making it even more vulnerable to short squeezes. In addition, Jones’ continued support for the stock and majority ownership stake raises the very real potential for a take-private deal for CRK where he would acquire the minority outstanding position. Let’s start with the fundamentals: CRK’s Breakeven Costs are Elevated The financials of the shale exploration and production (E&P) business are straightforward. E&Ps spend money to drill new wells and maintain existing wells and related infrastructure, there are costs associated with processing raw natural gas and pipeline tariffs to move that gas to market. And, of course, there are the normal corporate expenses associated with most businesses like general and administrative (G&A), interest costs and taxes. The revenue side is entirely related to commodity prices – since virtually all CRK’s production is natural gas that means when the price of natural gas rises, so do CRK’s revenues. Like most producers, CRK also has some hedges in place to help shelter its cash flows from fluctuations in commodity prices; when prevailing gas prices are low, as they’ve been in recent quarters, settlements related to these hedges kick in some additional cash flows. So, I like to build a simple production and cost model for the E&Ps I follow and here’s a summary for CRK’s results revealed in earnings releases over the past 5 quarters:   CRK Quarterly Free Cash Flow (CRK Quarterly Earnings Releases)There are three sections in this table. The top section, highlighted in green, summarizes CRK’s quarterly production of hydrocarbons in millions of cubic feet equivalent (MMCfe). In Q3 2024, the last quarter for which we have CRK’s results, the company produced some 133 billion cubic feet of natural gas and just 13,000 barrels of oil. Natural gas accounts for 99.94% of CRK’s total production on an energy-equivalent basis, so in practice that’s the only commodity that matters for CRK. The second section of my table lists all CRK’s costs. Capital Spending (CAPEX) primarily represents the cost of drilling, completing and putting new natural gas wells in CRKs acreage into production. In Q3 2024, these costs – exploration and development (E&D) CAPEX—represented 85.6% of total spend. CAPEX also generally includes costs related to midstream capacity – pipeline, gathering line and processing – expansions, and some costs related to acquisition of new acreage. Lease Operating Expenses (LOE) are the costs associated with maintaining existing, producing wells. And, as I outlined earlier, gathering, processing and transport expenses represent pipeline tariffs paid to move natural gas to market and process/treat raw natural gas for sale. Production and Property taxes are paid to the states – in this case Texas and Louisiana – and are based on revenues received from produced volumes. I’ve listed all these costs, and general corporate expenses like G&A, in terms of $/Mcfe – that’s the cost per thousand cubic feet of gas produced each quarter. The third section of my table is the most important. The “breakeven” cost line item represents the sum of all the expense line items I highlighted in the blue cost section of my table. In short, if the realized price of natural gas is above the breakeven price listed here, CRK will cover its costs and produce positive free cash flow in that quarter. Unfortunately, natural gas prices have not been above CRK’s breakeven level in any of the past 5 quarters—that’s Q3 2023 through Q3 2024 inclusive. I’ve included the realized price for gas volumes CRK sold in each quarter both including and excluding hedges – as you can see, even with the benefit of hedges, CRK’s costs have consistently been higher than the revenue it’s able to generate for gas sold. That’s why the company’s reported operating free cash flow, also listed in my table, has been negative in every one of the 5 quarters on my chart. In total, CRK has reported $473.4 million in negative free cash flow from Q3 2023 through Q3 2024 inclusive. Free cash flow (FCF) is a crucial metric for evaluating E&Ps. It represents the cash CRK has left over each quarter after paying all of its corporate, CAPEX and production expenses. Free cash flow is the amount of cash CRK has available to pursue shareholder-friendly actions such as share buybacks, debt paydown or dividends. Negative Free Cash Flow, Rising Debt When an E&P doesn’t produce enough revenue to cover its cash costs, that’s known as a cash “outspend.” Companies must fund outspends each quarter or they’ll run out of cash to continue operating. Historically, that’s done through a combination of cash on the balance sheet, the sale of new debt or the sale of new equity (stock). CRK has primarily relied on debt to fund its outspend as well as the $100.5 million private equity placement with majority shareholder Jerry Jones outlined earlier:    CRK Free Cash Flow and Net Debt (CRK Quarterly Earnings Releases)This table shows CRK’s reported free cash flow from operations each quarter as well as the company’s total net debt outstanding as of the end of each quarter. As I explained, the company’s total negative operating free cash flow has been $473.4 million over the last 5 quarters, met largely via a $385.8 million increase in the company’s net debt position as well as that $100.5 million equity private placement with Jerry Jones last spring. No End in Sight Unfortunately, there’s no end in sight for CRK’s flood of red ink. Take a look at management’s cost and production guidance for the current quarter of 2024 (Q4 2024):   CRK Breakeven for Q4 Guidance (CRK Q3 2024 Guidance Update)CRK’s latest guidance shows exploration and development (E&D) CAPEX for Q4 2024 of $225 to $275 million (midpoint of $250 million), a sharp increase from the $185 million it spent in Q3 and $221 million in Q2 2024. Meanwhile, as you can see, the company is looking for natural gas production to fall to around 121.5 billion cubic feet equivalent in Q4, down from 133.2 billion in Q3 and 130.95 billion in Q2 2024 as I reported above. During the company’s Q3 earnings conference call hosted at the end of October, management explained the increase in capital spending is due to the timing of new wells being put into production – the company now expects to drill and complete 43 net wells this quarter compared to 38 to 39 wells previously. That’s not unusual in the E&P business as the timing of well completions can cause CAPEX to shift from quarter to quarter. However, early in 2024, CRK announced a series of measures aimed at reducing its cash outspend through a period of lower natural gas prices including reducing its active rig count from 7 rigs to just 5, reducing its fracturing spread count from 3 to 2 and suspending its dividend. Reducing the rig count and fracturing activity does bring down CAPEX and reduces the company’s breakeven costs; however, eventually lower CAPEX also translates into falling output. The company’s reduced Q4 2024 production estimate is a sign that’s happening. As management put it during the Q3 2024 conference call: “As you can see, even for Comstock, we've actually had -- even though we cut our activity back in the first quarter, it's not really to the fourth quarter that we really start to see the decline.” Source: CRK Q3 2024 Earnings Transcript So, the biggest problem I see from CRK’s Q4 2024 guidance isn’t the jump in CAPEX due to well timing, but the fact production is now falling due to the CAPEX cuts CRK made early this year. That’s pushing up costs in production terms ($/Mcfe). The bottom line: Based solely on drilling-related CAPEX, CRK would need natural gas price realizations of about $3.38/Mcfe in Q4 just to break even on a free cash flow basis.  Unfortunately, per Bloomberg, the average daily closing price of natural gas so far this quarter has been just under $2.68/Mcf, far too low for CRK to generate free cash flow. CRK does have some offset in the form of hedges – about 700 million cubic feet equivalent per day of output hedged using swaps at a price of $3.54/mcf, representing just over half the company’s Q4 2024 production at the midpoint of guidance. However, if we assume CRK sells half its Q4 output at the quarter-to-date calendar strip price of $2.68/Mcf and half at the $3.54/Mcf hedge price, the company’s realized gas price after hedges comes to around $3.11/mcf, implying meaningful cash flow outspend again for Q4. In every quarter of 2025, CRK has hedged 545 million cubic feet of gas per day using a combination of swaps and collars set at around $3.50/Mcf. That represents around 40% of gas production at the Q4 2024 rate of 1,350 MMcfe/day outlined earlier. However, look at the current price curve for natural gas futures:   Natural Gas Futures Curve (Bloomberg)This chart shows current gas futures price for delivery in every month of 2025 and 2026. The average price of gas for delivery in every month of next year – known as the 2025 Calendar Strip – is currently at $3.31/Mcf and for 2026 it’s $3.72/Mcf. Also note that natural gas futures for delivery through the first half of 2025 are mainly below the full-year average – the calendar strip for January – June 2025 is $3.12/Mcfe. Simply put, based on the breakeven cost estimates I outlined earlier, CRK is on course for significant cash outspend – negative free cash flow – through at least the first half of next year. The company will need to fund that outspend by taking on additional debt or selling more stock. By the second half of 2025 and into 2026, CRK looks on course to be free cash flow breakeven or, at best, to produce some modest positive free cash flow at current gas strip pricing. And that brings me to this: Takeover or Take-Under A return to positive free cash flow would be a welcome development for CRK. However, it’s no panacea for the stock and the company still has a ton of catching up to do with the best-of-breed gas-focused E&Ps like EQT (EQT) and Expand Energy (EXE):   Comparison of CRK Free Cash Flow to Peers (Earnings Results from CRK, EXE and EQT)This chart reports free cash flow figures by quarter for EQT and Expand Energy from Q3 2023 through Q3 2024 inclusive. As I noted earlier, CRK’s free cash flow totals negative $473.40 million over this period; thanks to their lower cost structure and hedge realizations, EXE and EQT have produced positive free cash flow of $336.0 million and $343.9 million respectively over a similar holding period. The problem is that CRK has been forced to take on additional debt to fund its outspend over the past 5 quarters. So, when natural gas prices improve and CRK starts to produce free cash flow, it will likely need to deploy excess cash to pay down debt. While both EQT and EXE have also increased their net debt position over the past few quarters that’s been to fund the acquisition of valuable assets. In EQT’s case that’s the acquisition of Equitrans Midstream, a deal I covered in my Seeking Alpha piece on the stock back on May 8, 2024 “EQT: Cementing Position as Low-Cost Gas Producer.” For EXE, the increase in net debt is a result of the company’s purchase of Southwestern Energy I noted earlier, a deal which expands the company’s acreage position in both the Haynesville Shale of Louisiana and the Marcellus of Appalachia. In my view, the most logical outcome of all this is for majority shareholder Jerry Jones to take CRK private by purchasing the roughly 29% of the company he doesn’t already own. However, such a deal isn’t quite as straightforward as it might seem. At the current price near $15 per share, the roughly 77.8 million shares Jones does not own are worth $1.17 billion. However, Jones would also need to assume CRK’s net debt, which as I outlined earlier, amounted to over $3 billion as of the end of Q3 2024. Of course, as a private company, Jerry Jones would also need to fund any ongoing cash flow outspend for as long as natural gas prices remain low. A good cautionary tale is Harold Hamm’s deal to take oil-focused E&P Continental Resources private back in 2022. At the time Hamm announced the deal to take Continental private June of that year, he controlled about 83% of the outstanding shares and his initial offer was $70 share, about a 9% premium to Continental’s close the day before the deal was announced. Ultimately, Hamm sweetened the offer to close the deal, paying $74.28 per share for the stock in cash, representing a total cost of about $4.58 billion when the deal closed in November 2022. That’s about a 15% premium to the close for Continental on the day before Hamm’s initial offer in June. And Continental enjoyed several advantages that CRK does not. For one thing, at the time Hamm closed the deal, Continental had no net debt, so there was no need to assume debt obligations to close the transaction. Second, in mid-June 2022, West Texas Intermediate crude oil prices hovered over $100/bbl, near the highest level in 8 years. Since oil is Continental’s primary commodity, the company had generated over $1.23 billion in free cash flow in Q2 2022 alone and almost $2.4 billion through the first six months of 2022. Simply put, Harold Hamm was able to acquire a minority stake in a free cash flow gusher like Continental, with no net debt and oil prices over $100/bbl at a final premium of 15%. With natural gas prices weak, CRK sitting on over $3 billion in net debt and consistently outspending cash flow, it’s unlikely a savvy investor like Jerry Jones would be willing to pay a significant premium price to acquire a minority stake in the stock. That’s particularly true when you consider that, despite weak operational performance, CRK shares are already up 74% this year, partly based on speculation Jones might want to take the company private. After all, in the month before CRK announced its $100.5 million equity raise from Jones back in March, the stock was trading in a range of between $7.50 and $9.00 per share and Jones’ average purchase price for the stock is around $11.25 per share. Would he really be willing to pay a substantial premium to the current price over $15 just to gain outright control? That seems unlikely to me. Outlook and Risks The biggest risk to my bearish thesis on CRK is a short squeeze in the stock. Per Bloomberg, 32.74% of the outstanding float is already sold short and, as I mentioned earlier, the stock is up more than 70% year-to-date. That’s painful for the short sellers; a significant dip in the shares can provide an attractive opportunity for the bears to cover their shorts, driving the stock higher.  It’s also why I’ve not published a short thesis on CRK here on Seeking Alpha – that elevated short interest makes the stock a risky short play. In my view, however, there remain far better gas-focused E&P stocks for long-term investors to own including names like Expand Energy (EXE) and EQT (EQT), which have been generating meaningful free cash flow despite ultra-low commodity price realizations thanks to a superior cost structure. As I outlined earlier, CRK will struggle to produce free cash flow with gas prices under $3.25 to $3.50 while EQT and EXE can (and have) generated significant free cash at those levels.  CRK rates a sell.","kind":"highlight","is_publish_news":true,"is_publish_highlight":false,"is_publish_live":false,"is_publish_wemedia":null,"editions":null,"column":"","sentiment":"-2","news_tag":"analysis","news_rank":0,"symbols":[],"gpt_button":1},"commentList":[],"isCommentEnd":true,"newsSizeData":{"likeSize":1,"commentSize":0,"repostSize":0,"favoriteSize":0,"likeStatus":false,"favoriteStatus":false},"APP":{"userAgent":"Mozilla/5.0 AppleWebKit/537.36 (KHTML, like Gecko; compatible; ClaudeBot/1.0; +claudebot@anthropic.com)","isDev":false,"isTTM":true,"deviceId":"web-server-community-laohu8-v3","version":"4.29.3","shortVersion":"4.29.3","platform":"web","vendor":"web","appName":"ttm","isIOS":false,"isAndroid":false,"isTiger":false,"isTHS":false,"isWeiXin":false,"isWeiXinMini":false,"isWeiBo":false,"isQQ":false,"isBaiduSwan":false,"isBaiduBox":false,"isDingTalk":false,"isToutiao":false,"isOnePlus":false,"isHuaWei":false,"isXiaomi":false,"isXiaomiWebView":false,"isOppo":false,"isVivo":false,"isSamsung":false,"isMobile":false},"href":"/m/news/2485449922"}