Reviewing Natural Gas E&P Escalera Resources

Escalera has not borrowed money this year to run their operation–they operate on cash they generate.                                               The company does have a fair share of debt which they have just put in place with Societe General                                                         which replaces the prior line of credit.  Total debt is $45 million–which is plenty in our opinion–BUT                                                   unlike debt of MLP’s and some other small e&p’s the interest rate on this debt is rock bottom around                                       3% (Libor plus a margin of .75% to 2.75%)!!  This is key as debt service will kill some other                                                       oil and gas companies.

The company has 1.6 million shares of the 9.25% $25 preferred shares outstanding which cost the                                                 company $3.7 million annually in dividends.

Now looking at the hedges that Escalera has in place we find that the company has hedges for 75% of                                       production–both gas and oil. Natural gas hedges are around $3.60/mcf for 2015 and they have current                                           hedges for about 60% of gas volume for 2016 at just over $4. The crude oil production is almost                                                   meaningless in volume, but is mostly hedged at over $90/barrel.

Escalera has over 370,000 acres of land on which to explore with others for natural gas–most of their                                             holdings are undeveloped.  In total Escalera has interests in over 1,200 producing wells.  The vast                                               majority of the companies acreage is in Wyoming and covers coal bed natural gas areas which are prime                                         natural gas producing areas.  The wells in the coal beds are economical even during times of low gas prices.

During 2014 the company has had a number of issues with production that we hope are resolved soon                                                   (if not already).  These issues cut production in the quarter ending 9/30/2014 although not so dramatically                                             to cause the company to be cash flow negative.  They had a lightning strike which caused some wells to                                                 be shut-in.  Apparently coal bed production is highly sensitive to water flooding and the power outage                                               caused the wells to be flooded resulting in reduced production.  Additionally the company has experienced                                 reduced production because of infrastructure constraints (i.e. gathering system).  They do have significant                                       decline in production volumes in one of their production areas and natural decline will be an issue moving                                 forward.

Reviewing their reserves we see a severe drop from 2011 to 2012.  The way these reserves are calculated                                       causes reserve estimates to move significantly year to year.  When prices of natural gas are low–reserves                                       drop–when prices are high reserves are higher.  The reason for this is simply that more gas becomes                                             ‘economical’ to pursue when prices are high (over $4 or so).  When prices are lower (say $2.50) less gas is                                       ‘economical’ to pursue.  We will say that Escalera will need to have prices over $3 and preferably over $4                                             to be able to maintain their reserves.

We should also note 2 special items.  1) the company has a new leadership team with substantial experience                                       and 2) the company has been exploring a joint venture Gas to Liquids plant.  Given that Escalera would                                                 only be a 10% owner of any potential Gas to Liquids plant and the plant would not be completed for at least                                          5 years we think they should concentrate on expanding reserves and exploiting some of their large acreage                                         holdings and leave the Gas to Liquids plant in the exploration phase.  This plant would chew up a lot of capital                                   that the company likely won’t have readily available.

To summarize. Compared to the preferred stocks of all MLP’s and many of the smaller independent e&p’s we                                     would rather hold Escalera Resources 9.25% cumulative preferred.  Quite simply the odds are high that the                                   dividend will be paid each quarter for the next year–and likely, much, much longer.  The company has relatively                             stable revenue and positive cash flow, Unlike the MLP’s which are paying 8-12% on their debt Escalera hasVERY                                 low cost debt service costs (3%) and a new leadership team which is determined to get the share price of the                             common back up.

Do we think one should purchase these preferred shares?  We think they are some of the safest preferreds out                                       there of all MLP’s and small e&p’s and those looking for a decent risk to reward could consider these shares                                 (based on each investors needs and risk tolerance).  We have purchased shares fully knowing the risks and                                           believing that in the next 90 days we will experience a significant move higher in the preferred shares.