Description

Short Magnum Hunter Resources (MHR) Preferred Series C

For those that appreciate a brief pitch, at current prices MHR Preferred C represents all of the downside of a levered E&P with minimal upside. Shorting Magnum Hunter preferred stock presents an asymmetric investment with a good probability the company goes into significant distress. The issue is relatively illiquid making the trade viable for smaller funds and PAs only.

Bad News Bears Execution

Management’s style is to consistently overpromise and under-deliver while spinning all news to the positive. The best example of this is approximately a year ago when production was 10,049 boe/d and on the third quarter call on 11/8/13 the company reaffirmed its exit rate guidance for 2013 would be 24,000 boe/d. The actual exit rate one month later was 11,298 boe/d, an epic 53% miss and barley higher than their production at the time of guidance. One year later, 3Q 2104, the company has still failed to meet its prior year’s exit rate target with only 16,361 boe/d being produced (24.6 mboe/d if one count shut-ins, but investors shouldn’t--see below). Management is projecting a 35,000 boe/d exit for 2014, and like last year, they have a detailed bridge of wells in their presentation explaining the bridge to more than double production in a month. As they say, fool me once…

Other examples of poor execution include having their first (and long anticipated) Utica well blowout while drilling the lateral section in October of 2013 due to operator error. It turns out the well would have been irrelevant anyway since there was no existing pipe connection to move the gas, a situation that remains true today. However, the inability to make sales didn’t stop them from drilling and casing two more wells on the same pad. More recently on December 13, 2014 MHR experienced a blowout of their second Utica well while the Stalder 3UH was being brought back online from shut-in status. The result was an evacuation of local residents for 10 days and the inability to get the pad back online for another month or more. Other foibles include screwing up air permits that cost months of waiting to bring the Stewart-Winland pad online and a litany of behind schedule and below guidance non-core asset sales.

The Sky Already Fell

Despite the Bad News Bears level of execution, another production guidance miss is effectively irrelevant now. Our expectation is that MHR misses its 32.5 mboepd exit rate target, but what really matters now is their tight liquidity situation and lack of access to funding in the context of abysmally low commodity prices. MHR’s leverage situation was already precarious with oil in the $90s and nat gas in the $4s. At current levels, it can’t make money and it will be very tough to raise money. Realized commodity prices are even worse for MHR than the charts imply as a result of awful differentials in both their gas and oil. Henry Hub may be at $2.96, but MHR’s gas is coming from the oversupplied Appalachian region, where TETCO M2 spot pricing is in the $1.50 range (and had been in the sub $1 range for the prior month). MHR’s oil comes from an equally disadvantageous region with the Bakken at a $10-15 per barrel discount to WTI. Despite its transition towards a pure play Appalachian gas producer, MHR’s remaining Bakken operations along with wet Marcellus wells mean revenue is comprised 50% gas and 50% liquids.

Magnum Hunter will experience the full force of ugly pricing in 2015 since they have very minimal hedges in place. They have approximately 20% of their gas (30,000 mmbtu/d) and only 3% of their liquids hedged. The oil hedges are even lower since MHR, like so many (http://www.bloomberg.com/news/2014-12-19/oil-crash-exposes-shale-drillers-in-risky-three-way-bets.html), used three way collars with a $70 subfloor.

Last man standing

Shorting E&P preferreds has been wonderfully remunerative for the last quarter, leaving Magnum Hunter as one of the last holdouts. Comparable upstream producers with similar debt loads and acreage are already pricing in significantly more distress than MHR:

• Goodrich Petroluem’s debt is in high 40s and the preferreds range from $8-$9 with 2014 leverage of 6.9x

• Gastar Exploration’s debt is the high 80s and the preferreds range from $18.50-$21.75 despite a very large equity raise in September, just prior to capital markets closing. Leverage is 4.0x

• Miller Energy preferreds range from $8.50-$10.50 with leverage of 11.5x

• Sandridge Energy’s bonds trade in the high 50s with 2014 leverage of 2.5x

Analysts are bullish

Oddly, even very recent analyst reports and models do not incorporate real time commodity prices into their estimates. All but Imperial maintain a Buy rating on the equity.

In our model, using $48 oil and $2 nat gas ($2.46 realized w/ hedges) results in EBITDA of $12mm in Q1 for their upstream operations. Put that against $30mm in interest and preferred dividends and Capex of somewhere in the $40mm range (vs $130mm/Q for the last 2 years) and, Houston, we have a problem! As of November 4, revolver borrowing availability was only $47.7mm and the pending 2014 reserve report based on much lower commodity prices should not incite the banks to loosen the purse strings.

Cash Burn

Below is a simply cash burn projection for 2015. Clearly it’s very sensitive to commodity prices.

Why else are the MHR preferreds holding up?

Despite poor execution, Gary Evans is one of the smoothest pitchmen in the oil patch, which is quite a feat for a sector known for hyperbole that would make Elon Musk blush. The company spins everything to the positive from firing their auditors in 2013, missing every target, and slow divestiture executions. Perhaps more meaningful, Gary Evans is a Mad Money regular and receives Jim Cramer’s blessing at his 7 interviews on the show (see them here: http://www.magnumhunterresources.com/corporate_presentations.html). Cramer told the Mad Money faithful to purchase the Magnum Hunter Preferreds instead of the equity in his December 2014 appearance. This may help explain why preferreds trade richer than the Sr. Unsecured bonds.

The second reason MHR preferreds have held up better than most is a legitimate one. They have built an Appalachian midstream gas pipeline now 50% owned by Morgan Stanley. Eureka Hunter (EH) is on the path to an IPO in 2Q of this year with management pitching a $1bn valuation ($480mm for MHR’s 48% stake) based on 20-25x projected 2015 EBITDA of $50. However, MHR wants to maintain significant ownership in the EH and will not likely be a large selling shareholding in the IPO. If EH takes on additional leverage to expand, it’s unclear that moving assets out of MHR is a credit positive for the company. Further, Morgan Stanley is currently funding 100% of EH’s capex as part of its agreement with MHR. The repayment will either come in the form ceding more ownership to MS or additional cash MHR would have to come up with. If the IPO is delayed or pulled, their 48% stake doesn’t go far to plug the holes, even if they had had sole control over allocation of cash and the $50mm in EBITDA somehow resulted in cash flow. Put another way, the midstream assets have value, but they are not a panacea for the looming liquidity crunch.

How does this play out?

Any number of catalysts could make this position work.

• The 2014 reserve report should be released this month which should show a hit to PV-10.

• MHR could miss their exit production guidance.

• Q4 2014 cash position and liquidity in the earnings release should hammer home the liquidity concerns.

• Another E&P suspends its preferred dividends and owners of MHR preferreds wake up. It is surprising this has not happened en masse across the sector yet.

• If current commodity pricing holds, MHR will likely suspend its preferred dividends.

• Clearly we think Chapter 11 is a very real possibility.

Risks to the position

Maybe oil and nat gas prices bounce back and MHR squeaks by. Even with that outcome, there will be a significant period of uncertainty before that which the preferreds are not pricing in at $21.50. Anyone who takes a divergent view on the company would be better off buying a small position in the common instead. If the future somehow comes up rainbows for MHR, a par price for the preferreds mean a 15% loss. Other risks includes short recall buyins, expensive cost to borrow (approx. 16% annually), and illiquidity in the preferreds.

Catalyst

·         The 2014 reserve report should be released this month which should show a hit to PV-10. 

·         MHR could miss their exit production guidance. 

·         Q4 2014 cash position and liquidity in the earnings release should hammer home the liquidity concerns.

·         Another E&P suspends its preferred dividends and owners of MHR preferreds wake up. It is surprising this has not happened en masse across the sector yet.

·         If current commodity pricing holds, MHR will likely suspend its preferred dividends

• Restructuring/Chap 11