Lucas Energy (NYSE MKT: LEI)

Oct 3, 2012 - $2.20

Lucas Energy is an oil-weighted E&P with no company debt and saleable assets I believe are worth twice the current market cap.  There is a potentially very large (~5-10x return) free call option if an apparently dysfunctional JV can be reversed.  This is a timely idea as there have been two investor groups separately filing 13D’s in the last week with one calling for a special shareholder meeting.  Though the value of their assets has been diluted from equity offerings over the last few years, it would appear there will be a new status quo in the relatively near future.

History

The company was founded in 2005 by Jim Cerna, Bill Sawyer (current CEO) and Peter Grunebaum to buy old wells in proven areas for very cheap prices and improve them.  It was focused on the Austin chalk.  The value of the properties was low but the prices they paid were even lower.  The land they acquired had deep rights which at the time leading up to 2009 didn’t mean very much because all the formations below the Austin chalk were not economic to extract oil.  Then the horizontal drilling revolution came to oil shale and has so far given us two massive new economic reservoirs with the Bakken and Eagle Ford shale.  At one point the company had nearly 20k acres of deep rights, held by production Eagle Ford acreage near the best area of the play - today this would be worth over $500mm had they sat on it.

The “JV” with Marathon

I put JV in quotes because it is a colloquialism in Texas to call these JV’s though they technically have a legal structure of a sale with a side contract as opposed to an actual partnership structure.

In early 2010 the company sold an 85% working interest in 12,300 gross Eagle Ford acres in Gonzales county for approximately $1k/acre to Hilcorp.  Within six months, Hilcorp had put that into a corporation funded by KKR at $8k/acre an then within another six months that corporation was sold as a package to Marathon at $25k/acre, in total over $3 billion.  I would not recommend shorting small cap E&P companies based on management quality with even moderate acreage positions as it is very much possible to have land values increase by a factor of 50 in a year or two.  The oil under their feet doesn’t know how smart or savvy the operators are. 

For context, Sanchez energy (SN) entered into a similar transaction on adjacent land several months before Lucas though they kept a 50% interest in 19,000 gross acres (they have 9,500 net today) which management at SN estimates accounts for 75% of their $650mm market cap (implying a valuation over $40k/acre).

The Assets

Lucas has several components to its valuation.

1)      Austin Chalk production and PV-10: $50mm

1. 10-K PV-10 reported at $73mm
2. About 22k net acres of oily Austin chalk acreage  
3. Current production is ~200 barrels per day
4. Have $22m non-recourse promissory note that we are conservatively netting out to zero here as if the properties have no value and they walk away.

2)      Eagle Ford Acreage: $88mm

1. Gonzales County: 2,400 net acres at $25k/acre ($60mm)
2. Karnes, Wilson, and Atascosa Counties: 3,500 net acres at $8,000/acre ($28mm)
3. A year ago management presentation claimed $25k/acre for Gonzales; $15k/acre for the rest and the areas have all improved.  Some Karnes acreage has traded for >$50k/acre for example.

3)      Eaglebine Acreage: $11mm

1. 3,700 net acres at $3,000/acre ($11mm)
2. Recent Halcon transactions nearby at $10k/acre

4)      Marathon JV rescission right: $250mm

1. 85% of 12,300 gross acres at $25k/acre minus $10mm original purchase price ($250mm)
2. Agreements are confidential so cannot be certain about this and likely will require significant legal action or negotiation.
3. Reason for rescission: Marathon supposedly has obligations to drill 2 or 3 wells per year and has not drilled for over 18 months, therefor defaulting on their side of the agreement
4. Zaza/Hess JV asset return several months ago was a somewhat similar situation and is an example of how this could work.

Undeveloped oil property valuations can be very volatile depending on recent well results and the local geology.  Lucas has about 5900 net acres in one of the best areas of the Eagle Ford shale oil window (“the trough”) in Gonzales, Wilson, Karnes, and Atascosa counties.  Similar public companies with pure play exposure to similar Eagle Ford shale are Sanchez Energy (SN) which has 9500 net acres in Gonzales county adjacent to Lucas with the same operating partner Marathon.  The CEO of Sanchez a couple months ago at Enercom publicly said that he believes that the Gonzales acreage that Sanchez has comprises at least 2/3rds of the value of their company and he wouldn’t sell their land for $25k/acre and he’d be forced to bring it to the board at $40k/acre. Aurora has about 18,000 acres in Karnes county and has an implied valuation of over $70k/acre net of production.

Debt

There is no company debt at the company though they do have trade payables.  There is a $22mm note payable to a limited partnership (Nordic LP) which is only recourse to the specific properties – which are in the Austin chalk and excluded from this valuation analysis.  This is a completely free call option – if the assets can be sold for more than the note, then they get the upside and if not then they can walk away free and clear from the note.  Why would the seller take this note in the first place?  Nordic LP was a partnership that had a finite life and was legally required by its docs to sell its assets, so Lucas bought them for a piece of paper that is non-recourse. 

Continued improving well results in the area

Marathon completing 3D seismic in Gonzales, drilling wells on the JV land and surrounding land

Recent 13D filings indicate active shareholder interest

Recently announced Chinese joint venture (presumably Chinese money is inexpensive though no details posted yet)