Houston Exploration Co. (THX) shares spiked more than $5 last Tuesday morning to a new 52-week high after its parent company KeySpan Corp. announced plans to transfer 10.8 million THX shares back to the exploration and production (E&P) affiliate in exchange for 100% of a wholly owned THX subsidiary, Seneca-Upshur Petroleum Inc., including 50.5 Bcf of Appalachian gas reserves.

THX shares gave back much of the ground gained a day following the announcement but still ended the week up about $1/share at $47.35 Friday at noon.

In exchange for share transfer by KeySpan, THX will give the Northeastern utility the proved reserves as well as a cash contribution from a share offering, for a total value expected to be about $449 million including debt.

“We welcome Seneca-Upshur into the KeySpan family and intend to grow this business through additional investments in energy-related assets that support our core businesses,” said KeySpan CEO Robert Catell. “This transaction allows the company to further concentrate on executing its strategy of growing its core energy businesses.”

KeySpan previously announced plans to sell or reduce its stake in THX, which it does not consider a strategic asset. It apparently has found a way to restructure its share of the company in a manner that is beneficial to both operations.

As part of the deal, 6.2 million of the THX shares KeySpan is transferring will be sold in a public offering and THX will retire the remaining shares it receives, reducing the number of THX outstanding shares from 31.9 million to 27.3 million. The transaction will cut KeySpan’s ownership in THX to 24% from the current 55% level.

Based on the Houston Exploration announced offering price of $48 per share, KeySpan’s Seneca-Upshur’s shares will be valued at the equivalent of $41.57/share. Houston Exploration has granted underwriters the option to purchase up to an additional 930,000 shares at the public offering price to cover any over-allotments. If the green shoe is exercised in full, KeySpan’s ownership of Houston Exploration will decline by 310,000 shares to 22.5% and the value of the exchange will increase to $463.3 million or $41.70 per share.

THX will contribute its Appalachian Basin assets, including the West Virginia proved reserves valued at $60 million, and an amount of cash to Seneca-Upshur Petroleum. At the time of the transaction, it is expected that Seneca-Upshur will have cash of $389 million. The new KeySpan subsidiary plans to use the cash to make additional investments in energy-related assets.

In addition, three of KeySpan’s five designated directors on the THX board will resign at the closing of the transaction, and KeySpan will retain the right to nominate two of the remaining seven directors on the THX board.

Other impacts of the transaction include the following:

Moody’s Investors Service affirmed the Ba3 senior implied rating and B2 note ratings for THX and left its outlook on the company stable, calling the deal “essentially a share buyback from KeySpan, funded with new equity, bank debt and the contribution of reserves.” Standard & Poor’s (S&P) also affirmed its BB corporate credit rating on THX, but it revised its outlook on the company to negative from stable, citing an increase in debt.

“The company’s proposed funding of the exchange transaction with KeySpan will increase Houston Exploration’s debt levels by about 40% and reduce its bank borrowing availability to about $165 million from $280 million as of March 31, which somewhat heightens Standard & Poor’s credit concerns for the current ratings,” S&P said.

“Furthermore, the company’s short reserve/production ratio of less than seven years makes Houston Exploration more susceptible to a rapid decline in commodity prices over the next 12 to 18 months, which would significantly affect its credit measures. A rapid commodity-price decline could also constrain the company’s liquidity, with the company’s need for additional bank borrowings to maintain current production levels in a low to mid-cycle pricing environment.”

Nonetheless, S&P said THX should continue to generate excess cash flow in the current high commodity price environment, providing the company with the ability to use excess cash flow to reduce some of its increased bank borrowings, which were used for the exchange transaction.

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