Quicksilver Resources (KWK)

Quicksilver Resources is an independent exploration and production company based in Fort Worth, Texas. Having more than 30 years of expertise in the E&P space, Quicksilver went public in 1999 and trades on the New York Stock Exchange under the ticker KWK. The company is primarily engaged in the development of long lived, unconventional natural gas reserves onshore the North American continent. Since its inception, the company's growth strategy has been organic, through the drillbit. Its business model revolves around assembling large acreage positions in early stage developing areas at the lowest cost. KWK has operating segments in the U.S. and Alberta, Canada. A small portion of its U.S. operations are located in Montana and Wyoming, but the majority of its operations and capital spending are devoted to the Barnett Shale play in the Fort Worth Basin of Texas. The Barnett Shale formation in Texas holds the most growth opportunities for the company. The company has over 250,000 net acres with over 60% of its net acreage position within its defined core fairway. At year end 2007, KWK increased its proved reserves in the Texas Barnett Shale play from 704 Bcfe to 1.2 Tcfe. The vast majority of the company's production and reserve base is comprised of natural gas and natural gas liquids, representing 99% of total proved reserves. At year end '07, 62% of the company's proved reserves were classified as proved developed.

In Q2 2007 Quicksilver Resources spun off its natural gas gathering and processing operations and infrastructure into a master limited partnership (MLP) called Quicksilver Gas Services (NYSEArca: KGS). Quicksilver Resources is the general partner and retained 73% ownership of the midstream MLP. In late 2007, Quicksilver Resources sold its legacy assets in Michigan and other Midwest states to BreitBurn Energy Partners (NYSE: BBEP), an MLP, for $750 MM and 21.3 MM common units, obtaining a 32% limited partner interest in BBEP. Quicksilver operates in Canada via its wholly owned subsidiary, Quicksilver Resources Canada. It began to focus on the coalbed methane potential in the Horseshoe Canyon of Alberta, Canada. Through the end of 2007 KWK had drilled more than 1700 wells and operated 16 compressor stations in its Horseshoe Canyon, with proved reserves of nearly 328 Bcfe. With 1,400 potential net wells to be drilled in Horseshoe Canyon, this low risk operation represents a reserve life of approximately 15 years. At year end '07, the company had 1.5 Tcfe of proved reserves.

INVESTMENT THESIS

Our positive sentiment towards Quicksilver Resources is based on:

Its industry leading low cost structure and low risk operating profile

The productive potential from the Texas Barnett Shale

The company's financial flexibility

Quicksilver's strategy of purchasing acreage cheaply while operating in lower risk areas allows it to boast some of the industry s lowest cost metrics. As of the company s 2008 analyst meeting, KWK has the second lowest overall finding and developing (F&D) cost and has the lowest proved developed F&D costs compared to a sampling a nearly 30 participants in the E&P space. This allows the company to generate larger cash flows and larger returns for its shareholders. Its lower risk operating profile allows the company to realize operating margins of approximately 45%, significantly higher than the industry average of 30%.

In the near term Quicksilver looks to ramp up its production mainly through its Barnett Shale project in the Fort Worth Basin and Lake Arlington, both located in northern Texas. In the core play of the company, Fort Worth Barnett Shale, 60% of the reserves are what is located in its defined fairway. The wells drilled in the company's North Texas area have an average estimated ultimate recovery (EUR) of 2.8 Bcfe. With just fewer than 20% of the planned 2000 wells drilled in the core fairway KWK looks to ramp up to full production mode by late 2008 increasing its reserves and doubling its production despite growing 200% year over year in 2007. There are 10 years of drilling inventory to provide long term production growth. We estimate that KWK will grow its Fort Worth production by double digits through 2012. It currently drills wells with 500' spacing and has begun to test the economics of downspace drilling at 250' between wells, effectively doubling its drillable locations in some regions of the 160,000 core fairway. The company also plans to drill between 18 and 20 wells in Lake Arlington, which is just east of the Fort Worth Basin and also targets the Barnett Shale. This should be an added benefit to production growth as these wells produce essentially double the IP rates of an average Fort Worth Barnett well. The EURs on these wells are around 5 Bcfe, nearly double a Fort Worth EUR. Although the Lake Arlington well costs are about 60% more expensive, the high IP rates and ultimate recoveries from these wells make this play extremely economic. We estimate that Texas production will increase just over 100% from '07 levels. With Lake Arlington in full development by 2009, Texas production will increase nearly 200% over 2007 levels.

In early Q3 the company acquired 13,000 net acres of additional Barnett Shale potential. KWK acquired 350 Bcf of proved reserves with 650 Bcf of additional reserve potential from, 340 possible drilling locations, bringing total reserve potential for the Barnett Shale to more than 5.5 Tcfe. We estimate that with addition of the recently acquired Barnett assets, Quicksilver could increase its yearly production nearly 3 fold from 2007 levels.

Acting as another near term growth catalyst, but to a lesser extent than the Barnett, is the Horseshoe Basin of Canada. This coalbed methane play has a current drilling inventory of three to four years and plans on increasing production by about 8% over 2007 levels. The company has also begun experimenting with downspace drilling from 160 acre to 80 acre spacing. If this is successful, this will extend current Canadian drilling inventory from four to seven years and roughly double its current Canadian proved reserve base.

After building infrastructure to handle and process the high Btu content gas produced from its Fort Worth Barnett Shale wells, Quicksilver decided to spin off those assets into a master limited partnership (MLP) called Quicksilver Gas Services (NYSEArca: KGS) hoping to unlock maximum value for KWK shareholders. The gas produced from the Barnett shale in this area is more valuable because it has natural gas liquids associated with it. As these liquids are stripped out and separated from the natural gas the company gets paid for both products. Because the price of these liquids is tied to crude oil prices, the increase in NGL prices have given the company the ability to sell its production at a 50% premium to benchmark natural gas prices. Being the general partner and owning a 73% limited partner interest in KGS, Quicksilver Resources is essentially paying itself every time its production is processed. Lastly, as the KGS facilities are located in an area of heavy exploration and drilling activities, this should bring in additional cash flows from third party producers.

Besides its productive assets, Quicksilver has two non-producing assets that it can utilize to provide liquidity, aid in acquisitions or to increase organic growth opportunities. With the Alliance acquisition in early July, the company added approximately $1 billion of debt to its balance sheet. However, besides having roughly $500 MM of additional liquidity from its credit facility, the company has equity interest in the MLP it spun off in '07 (Quicksilver Gas Services) and in BreitBurn Energy Partners. Quicksilver owns 17.2 MM limited partner units of Quicksilver Gas Services and 21.3 MM limited partner units of BreitBurn Energy Partners. Together these units are worth $651 MM based on current market values. This gives KWK added financial flexibility. The company will most likely sell some of its interest in these partnerships to pay down about 50% of the $1 billion of debt acquired from the Alliance transaction. In doing this Quicksilver will take its forecasted total debt-to-capitalization ratio from 60% in '08 to 50% in '09. Additionally, the added liquidity will allow the company to focus on its two exploratory stage growth prospects in the Delaware Basin in West Texas and the Horn River Basin in Canada.

Opportunities for future growth

Quicksilver has two exploratory projects in its pipeline of prospective growth opportunities in the Delaware Basin of west Texas and in the acreage recently acquired in the Horn River Basin of northeast British Columbia. In west Texas, as congruent with the company's business model, Quicksilver has been building up leasehold acreage for about two years and has around 375,000 net acres accumulated. The targeted formations are the Barnett and Woodford Shales. The Barnett formation thickness targeted is significantly larger than the Barnett of the Fort Worth Basin making vertical wells, which are less costly than horizontal wells, a viable possibility. The company has started to drill its first Woodford Shale horizontal test well and plans to ultimately commingle the vertical Barnett with the horizontal Woodford. Although this play is still very much exploratory at best, with potential reserves between 3 and 6 Tcf this project, if successful, could offer Quicksilver significant reserve adds and upside in its stock price. The company hopes to have a better understanding of the potential of the Delaware Basin by the end of the year after the Woodford shale tests are completed.

Early in the second quarter of this year the company acquired 127,000 net acres in the Horn River Basin of British Columbia. Targeting the Upper Devonian and Klua Shale formations, the 500' thick formations range from depths of 7,800 9,000 feet. This is an attractive area to drill due to the geological composition of the reservoir rock and the successful results from other producers in close proximity to Quicksilver's acreage. Nearby operators have reported production of up to 10 MMcfe per day per well. The company will drill four test wells towards the end of 2008. Although this play appears to have a great deal of potential, commercial production in the Horn River Basin wouldn't begin until 2011.

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