The Top 10 Reasons To Consider This Speculative Energy Preferred Stock

Even with the recent rally in oil, times remain tough in the energy sector. The bear market for natural gas and natural gas liquids has been even more brutal than the oil bear market. Producers such as REXX Energy Corporation (NASDAQ:REXX ^[1]) that are focused on natural gas continue to struggle. While many peers have been forced into bankruptcy, REXX has managed to buy more time for commodity prices to recover. Recent positive moves include a joint venture agreement, successful bond swaps and an export agreement for some NGL production. This article explores the speculative potential of the RXNRP cumulative preferred convertible issue.

Description of RXNRP

RXNRP is a par $100 cumulative preferred convertible issue with a 6% coupon. Cumulative dividends were deferred ^[2] on 1/21/2016. If dividends remain deferred for 6 quarters, then RXNRP holders will have the right to elect two additional Directors. This is an important covenant (see page S-36 of the prospectus ^[3]) to ensure that the interests of preferred holders are taken into consideration by the Board of Director s. Each share of RXNRP is optionally convertible into 5.5556 shares of REXX.

RXNRP dividends may be paid either in cash or shares of REXX common stock (see page S-34 of the prospectus). Paying the deferred dividends in common stock would be excessively dilutive and is not practical given the low market capitalization of REXX. However, this might eventually become a viable option if REXX survives the downturn and the stock price recovers significantly along with commodity prices.

Note that REXX is a corporation (not a partnership). In this article I also briefly discuss the preferred issues of Legacy Reserves LP (NASDAQ:LGCY ^[4]), Vanguard Natural Resource, LLC (NASDAQ:VNR ^[5]) and Gastar Exploration Inc. (NYSEMKT:GST ^[6]). LGCY and VNR are partnerships. Deferred distributions for LGCYO and VNRCP may be taxable even though no cash is actually being paid out. Fortunately the phantom dividend tax issue does not apply to RXNRP. This author is not a tax expert and individual tax circumstances may vary, so please consult with your tax advisor before trading.

What are the risks?

If REXX survives, the potential rewards of a preferred stock trading at only 7.5 cents on the dollar are extremely high if. The risk of failure is also very high. REXX appears to have some time for things to turn around, but they are still highly dependent on commodity prices. RXNRP trades OTC and is less liquid than REXX. Limit orders and patience are required to trade it. If you are looking for conservative investment ideas or can't afford to speculate, now might be a good time to stop reading and perhaps consider a low risk BDC debt issue ^[7] instead.

Volatile commodity prices are the biggest risk factor for REXX and are inherently unpredictable. My timing was not so good the last time ^[8] I wrote about speculative energy preferred stocks. Both oil and natural gas prices collapsed. No amount of cost cutting was enough to compensate for it. Anyone who wrote positively about virtually anything in the energy sector last year ended up looking bad. Perhaps the timing of this article will be more fortuitous. The fate of REXX may ultimately depend on unpredictable (at least by me) factors such as the weather (see item #10). Here are the top 10 reasons why speculators should consider RXNRP:

1. No bank borrowing base reduction is expected

Several energy companies have faced a liquidity crisis due to reductions in bank credit lines. Fortunately, REXX does not expect their bank borrowing base to be reduced. As CFO Thomas Rajan commented on the Q1 conference call ^[9](see page #6):

"...so, based on where we see the curve and how other banks have their price decks lined out, we would expect no change at this time, because I think we would have added production reserves, and we don't think the strip has really changed that dramatically. We have hedges in place. So, I think we would expect the same at this time."

The company's capital structure makes it less vulnerable to bank borrowing base problems than many energy sector peers. As of the Q1 2016 earnings report ^[10], REXX owed $143 million on the $190 million bank credit line. Total liquidity including $25 million in cash was $72 million. As of 4/25/2016 (when the completion of additional debt swaps was announced), there were $633 million of second lien notes and $13 million of unsecured notes outstanding. Banks have become increasingly restrictive during the energy downturn. Fortunately bank debt comprises a relatively small part of the company's capital structure.

2. The BSP joint venture has provided fresh liquidity

The 3/1/2016 announcement ^[11] of a $175 million joint venture with Benefit Street Partners provided an immediate boost to liquidity. REXX ended Q1 2016 with $25 million in cash as compared to a 12/31/2015 cash balance of just $1 million. As noted in the Q1 report:

"For the first quarter of 2016, operational capital investments were approximately $30.6 million, which were offset by $31.8 million in joint venture reimbursements."

Joint venture proceeds are also expected to offset a substantial portion of Q2 capital expenditures. This joint venture is a key vote of confidence for REXX. Benefit Street Partners is a large and sophisticated institutional investor that manages over $9 billion in assets ^[12]. They would not partner with REXX unless new wells were expected to produce high returns.

3. Bond swaps have slashed interest costs

REXX has given themselves time for commodity prices to rebound by slashing 2016 and 2017 interest costs. $633 million of unsecured notes were swapped for an equal amount of second lien notes. The new second lien notes ^[13] have a coupon of only 1% for the next 18 months. After that the coupon increases to 8%. REXX is literally betting the company that commodity prices will recover by 2018.

4. REXX is expected to be cash flow positive in 2016 and 2017

This 4/22/2016 article ^[14] by Elephant Analystics projected that REXX would be slightly cash flow positive in 2016 and 2017. This analysis was completed prior to the 4/25/2016 announcement ^[15] that an additional $29.1 million of unsecured bonds were swapped for shares of REXX. That swap will reduce interest costs by an additional $1.8 million in 2016 and $2.1 m illion in 2017.

5. RXNRP is cheaper than peers relative to bond prices

How do the prices of RXNRP, LGCYO, VNRCP and GST-PA compare to their respective bond prices? Bonds are senior to preferred stock issues and interest must be paid unless a company goes bankrupt. Therefore, speculators in these deferred cumulative preferred issues must insist on getting a large discount to bond pricing.

At a recent price of $5.89, the par $25 LGCYO is trading at 24 cents on the dollar as compared to the Legacy 2020 unsecured notes (CUSIP 52471TAB3) at 40 cents on the dollar. LGCYO offers a 40% discount as compared to the bond issue.

At a recent price of $2.74, the par $25 VNRCP is trading at just under 11 cents on the dollar as compared to the Vanguard 2020 unsecured notes (CUSIP 92205CAA1) at 24 cents on the dollar. VNRCP offers a 54% discount as compared to the bond issue.

At a recent price of $8.92, the par $25 GST-PA is trading at 36 cents on the dollar as compared to the GST second lien 2018 notes (CUSIP 36729WAA1 ) at 75 cents on the dollar. GST-PA offers a 52% discount as compared to the near term maturity second lien note issue.

At a recent price of $7.50 the par $100 RXNRP is trading at 7.5 cents on the dollar. The REXX 2020 unsecured notes (CUSIP 761565AB6 ) are now trading at 19 cents on the dollar. RXNRP is trading at a hefty 61% discount to the notes. RXNRP is a convertible issue (see item #9). If we assume that debt prices are an accurate representation of risk, then RXNRP appear to be the best relative value among this peer group of deeply discounted deferred energy preferred issues. Debt pricing also suggests that RXNRP is somewhat riskier than these peers. Note that the remaining REXX notes are a small and very thinly traded issue. This may limit their utility as a metric for estimating risk.

6. NGL exports are ramping up

The 4/11/2016 deal ^[16] with INEOS Europe provided REXX with a new and badly needed market for natural gas liquids. INEOS has invested $2 billion in the necessary infrastructure to bring US shale gas to Europe. The first ethane shipment to Europe was made in April 2016. Propane and butane shipments are expected to get underway in 2017. In Q1 2016, REXX realized just $12.20 (excluding hedging gains) per barrel for natural gas liquids. Access to export markets could not come at a more opportune time.

7. REXX holders should swap to RXNRP to avoid the threat of dilution

Assuming the company survives the downturn, the potential gains for REXX are still limited by the ongoing dilution of the common stock. 8.4 million shares of REXX were issued in the 3/31/2016 exchange of senior notes ^[17] for second lien notes. Another 7.1 million shares of REXX were issued in subsequent exchanges (See 4/25/2016 press release ^[18]). Further dilution of REXX is likely. This dilution limits the sp eculative recovery potential for REXX.

The new second lien notes are restricted and can only be traded by qualified institutional investors. The 8.875% unsecured senior notes due 2020 (CUSIP 761565AB6) and the 6.25% senior notes due 2022 (CUSIP 761565AD2 ) are also a good way for retail investors to speculate on a REXX recovery. However, the combined par value of the remaining unsecured note issues is now only $13 million. This makes the notes very illiquid and difficult to trade. RXNRP is more speculative than the unsecured note issues, but it is cheaper, convertible and easier to trade.

8. New midstream infrastructure will improve realized pricing

Inadequate midstream capacity has been a major challenge for REXX. This has contributed to very low realized pricing for their natural gas and natural gas liquid production. Fortunately several midstream projects are underway to improve this situation. These are detailed on pages 9 - 10 of the March Investor Presenation ^[19].

9. RXNRP is a convertible issue

Although I am not a fan of the REXX common stock due to the risk of dilution (see item #7), its possible that REXX may spike higher on good news or a potential short squeeze. Since RXNRP is a convertible issue, it would also trade higher. This was demonstrated when RXNRP spiked higher to $12.80 on 3/7/2016 due to a similar spike in REXX. RXNRP provides exposure to potential gains for REXX, while the fixed par $100 value makes RXNRP less vulnerable to dilution.

10. Summer is coming

Natural gas is an extremely volatile commodity. Prices are largely dependent on the weather. Summer heat waves increase prices as more natural gas is consumed by power plants to meet the high electrical demand for air conditioning. Cold winters also increase the demand for natural gas heating and electrical heating. This happened in the winter of 2014 when the polar vortex brought arctic air to the United States resulting in record demand ^[20] for natural gas.

Unfortunately for natural gas producers, the summer of 2015 was unusually cool. This was followed by an exceptionally mild winter. Even a reversion towards more average weather conditions would be a huge improvement for REXX. There is certainly no guarantee that we will get a nice prolonged heat wave this summer or be hit by another lingering polar vortex next winter, but RXNRP speculators could be very happy if that happens.

Conclusions

My Panick Value Research Report ^[21] is focused on high yield preferred stocks and exchange-traded debt issues. I provide members with continued coverage of all of the high yield issues I write about here. REXX management has made some good moves and appears to be betting on commodity prices to recover by 2018. RXNRP is an extremely risky issue, but offers good speculative potential at current prices. REXX investors should consider swapping to RXNRP or the unsecured notes to avoid potential dilution that could limit gains if commodity prices recover. VNRCP also appears to offer some speculative potential given the large discount to the bonds for that issue.

Disclosure: I am/we are long RXNRP,VNRCP,LGCYO,REXX BONDS,VNR BONDS,LGCY BONDS.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Editor's Note: This article covers one or more stocks trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks.