Description

Over 3 years ago, we posted a short idea on a company called BPZ Resources, an E&P company which had the right to explore acreage offshore Peru.   After numerous investor disappointments, the stock is down around 90% since then.  Hyperdynamics (“HDY” or “the Company”) reminds me a lot of BPZ and perhaps may present an even better short opportunity because we think there is an extremely high likelihood that the company may run out of cash in the next 12 months and we believe their concession could have little or no economic value.  

Hyperdynamics currently has no operations but holds a concession deep in the offshore waters in politically unstableGuinea,West Africa.  At the current share price of $3.77, HDY has a diluted market cap of $615 million.  At September 30, 2011, the company had $129 million of cash which we think will be entirely expended over the next 12 months.

DISCLAIMER:  We currently hold a short position in this security.  We may change our position at any time without posting an update.  The views expressed here are merely the opinion of the author.  Please do your own research.

Hyperdynamics can trace its origins to a heavily promoted penny stock that started off as a value-added reseller of computer hardware and software.  Originally led by Chairman and CEO Kent Watts from 1997 until he left the company in 2009, the company has never generated more than $2 million in annual revenues.  Having lost money every year of its existence, HDY has raised money to fund its cash burn through hype and grandiose press releases.  Furthermore, there have been accusations of questionable activities by the CEO’s brother, Michael Watts (more on that later). 

The company’s transition into oil and gas exploration in West Africa began in 2002 after it acquired SCS Corporation.  While SCS originally offered a range of oil & gas products/services, it became involved in exploration offshore Guinea through a company called USOil Corporation, which held the original concession under a 1995 Production & Sharing Agreement (PSA) with the government.  In December 2002, USOil renegotiated the PSA and farmed out its interest to SCS.

The concession area hasn’t been explored since the 1970s and, by HDY’s own admission in old SEC filings, “the area was not considered as attractive as other areas which more clearly evidenced hydrocarbon systems using contemporaneous technology and which were easier to explore and develop” (see page 5 of 2006 10-K:  http://www.sec.gov/Archives/edgar/data/937136/000114036106014476/form10-k.htm).  Even that description is too generous as the well drilled in 1977 by Buttes Resources was actually a dry hole (per HDY’s own commissioned resource report).

By 2004, the company had finished a 2D seismic study, but began to have issues with the concession in July 2005, when USOil sent notice to HDY that the 2002 PSA had been cancelled by the government in Guinea.  HDY filed suit against USOil and hired Famourou Kourouma as its new VP of Guinea Affairs (his father was the former Guinea ambassador to the US).  After multiple trips to Guinea by Kent Watts and other members of the management team, a revised oil and gas production sharing contract (the “2006 PSC”) was signed in September 2006.

In May 2009, HDY decided not to renew Kent Watts’ employment agreement and appointed Ray Leonard as CEO in July 2009.  Leonard’s background for the 10 years before joining HDY does not give us much more comfort in his ability to execute a massive new development effort halfway around the world.  Immediately prior to his hiring at HDY, Leonard was a mid-level executive at a private entity called Kuwait Energy Company (a small exploration company, not to be confused with the Kuwait National Petroleum Company).  Having begun his career with Amoco, Leonard left in 1998 to join First International Oil, a start-up in Kazakhstan.  After three years, he joined YUKOS, which after being accused of tax fraud by the Kremlin, was liquidated and its founder/CEO sentenced to prison (obviously the YUKOS affair can also be interpreted as Putin targeting a potential political rival).  Then, in 2005, he joined MOL (based in Hungary) as a mid-level executive and remained there for less than two years before joining KEC.

In September 2009, HDY entered into a Memorandum of Understanding (the “2009 MOU”) to settle “certain issues related to the 2006 PSC”.  Under the MOU, HDY would give up 64% of its original acreage, spud its first well by 2011 and receive a ROFR on any concessions offered by Guinea within the relinquished 64%.

Then, in October 2009, Hyperdynamics signed an LOI with Dana Petroleum (formerly listed on the LSE, but subsequently acquired by Korea National Oil Corporation) to sell a 23% interest in HDY’s concession in Guinea. The transaction closed in January 2010 with Dana paying $1.7 million for pro rata accrued expenses for a 2D seismic study and an additional $19.6 million in May 2010 upon approval by the government in Guinea.  Using this total consideration of $21.3 million as a guide, the total implied valuation for the concession at that point would be $92.6 million ($71.3 million for HDY’s current 77% interest), significantly below the company’s current EV. 

Further, the company also signed a non-binding LOI with Repsol in November 2009 to negotiate the sale of a 37% interest in the concession for total consideration of $31.5 million (total implied valuation of the concession of $85.1 million, or $65.6 million net to HDY).  Following extensions to the LOI period, no agreement was ever reached.

In March 2010 (after the Dana deal had closed), HDY announced an amendment to the 2009 MOU, which we think may be part of the reason no agreement with Repsol was ever reached, and may have caused Dana to regret the price they paid.  Under the amendment, HDY gave up 70% of the original contract area (not 64%) and agreed to give up another 25% of the remaining 30% by 2013.  In a second press release days later, HDY also disclosed that they no longer have a ROFR on the relinquished acreage.

While the original valuations of both the Dana and Repsol deals indicate a much lower value for the acreage than implied by HDY’s current share price, we would question whether those valuations are even still relevant given the lower overall acreage and loss of ROFR.  Why would any strategic buyer pay up for an interest in HDY’s concession when they can simply negotiate their own deal with the government and choose from large blocks within the relinquished acreage?

We take further comfort from the fact that HDY has shopped the concession consistently during the past year and been unable to come to agreement with any parties.  Management’s talk of data rooms, targeted processes and non-binding LOIs with “large independent oil and gas compan[ies]” that are never signed reinforces our view that the opportunity inGuineais of questionable value.

In November 2010, the Company was able to get a BlackRock fund to invest in a $30 million private placement at $2 per share.  The involvement of a well-known institutional investor drummed up significant retail interest in the stock and helped the company raise $144 million in a March 2011 secondary on the back of this “validation”.  These equity raises put them in a position to fund their two-well exploration drilling program and concurrent 3D seismic study.

In summary, by mid-2011, HDY had successfully brought in another promotional CEO, made a flurry of hires, hooked in a large institutional investor and generated excitement within its retail investor base.  The net result of all of this was an increase in the company’s market cap from ~$30 million when Leonard joined to ~$900 million. 

To further drum up investor excitement, the company often points to the Jubilee field in offshore Ghana, a producing asset owned by Anadarko and Tullow, among others.  We would point out that while Ghana and Guinea may appear somewhat close when looking at a map, they are roughly 1,000 miles apart – which is further than the distance from Houston to Miami (where the geologies obviously could not be more different). 

Current Strategy 

Fast forward to this fall, and as excitement around the much awaited drilling program grew, management held a conference call in September to discuss the program.  A total of two exploratory wells would be drilled, Sabu-1 and Baraka-1, for a total cost of $80 million ($62 million for their 77% share).  To manage the project, they had hired AGR Peak Well Management, who had contracted Jasper Drilling’s drill ship Jasper Explorer for the program.

On October 13, 2011, roughly nine years after HDY became involved in Guinea, the company finally commenced the drilling of Sabu-1, which has not gone according to plan.  On a November 9^th update call, management disclosed operational issues and cost overruns at Sabu-1, highlighting 1) infrastructure bottlenecks in Guinea, particularly port congestion, 2) operating issues with the Jasper Explorer and 3) $4 million in extra costs per well for more extensive logging programs on the well.  Further, they are now estimating that the two wells will cost $135 million ($104 million net to HDY), an increase of $55 million, or almost 70%, above their estimates from just two months prior.

Management also indicated that it is going to reevaluate whether they will continue with their prior plan to drill a second well following Sabu-1, “in light of the current operational well results of Sabu-1”.  In a move that we believe may be an admission by management that their operations in Guinea will never pan out, they announced a $10 million deposit had been paid on a potential acquisition that will “diversify” the business and “balance out our exploration portfolio in Guinea”.

Based on HDY’s July 2011 corporate presentation, a timeline indicated that Sabu-1 would be completed by mid-November and the second well completed by year-end.  Things have clearly gotten off track.  We believe these missteps show the lack of operational skill inherent in even the new management team at HDY.

Likely Need for Capital Raise in Coming Quarters 

We believe HDY will run out of cash.  Let’s start with HDY’s September 30^th balance sheet.  Including restricted cash held in relation to its current drilling contract, the company has $128.5 million in total cash.  HDY’s 77% share of the total two-well program will be $104 million, of which $21.3 million had been spent as of 9/30.  Further, they have committed to $22.3 million for their share of a 3D seismic program (commenced just last month).  Not counting minimum cash requirements for the business or corporate cash burn of around $1 million per month, HDY will be left with just $23.5 million in remaining cash, of which they have recently spent $10 million as deposit for the potential acquisition mentioned previously.  After overhead cash burn and the deposit, the cash balance will likely be depleted in less than 12 months.  If cost overruns continue, the cash could evaporate much sooner.

While Michael Watts (CEO’s brother) is no longer involved with management of HDY, we think a bit of background on him and his involvement with the company is useful in understanding the history of HDY and the individuals involved.

Michael Watts served as a consultant for HDY and was also a large shareholder.  As a broker at now defunct Texas Capital Securities, he was involved in arbitration for activities relating to HDY stock.  Specific allegations include: 1) he sold clients’ HDY stock “to pay his personal legal fees”, 2) he “controlled at least two offshore Cayman Island trusts which maintained brokerage accounts at Texas Capital and for which [he] held trading authorization” and transferred client shares into these accounts and 3) records relating to those accounts “had been removed from Texas Capital's file cabinet [to which he had access]”.  Further, Watts “openly represented to others that whatever assets he has are located offshore and could never be reached by his creditors” (for further details, see page 4:  http://www.supreme.courts.state.tx.us/ebriefs/10/10022902App.pdf).  While no longer involved with HDY, Mike Watts did resurface in 2010 with a letter to the board demanding a sale of the company.

In summary, after years of hype and hope, HDY has entered a new and dangerous frontier (much like BPZ in 2008), where they are forced to move beyond PowerPoint presentations and dreams of huge oil finds to executing on the expensive, complicated and risky task of being forced to prove that there is value in its Guinea concession. 

We believe concessions in politically unstable and geologically unproven and complex areas would have questionable value in the hands of the most experienced and well-capitalized operators in the world (as shown by the low private market value assigned to HDY’s concession through prior announced JV deals and the lack of recent interest in the field).  In the hands of Hyperdynamics, a company whose core competency has been stock promotion, not complex E&P projects, we think this project is doomed.  With every passing day, the company’s cash balance is dwindling and we suspect it won’t be long before Hyperdynamics returns to its roots as a penny stock.

Catalyst