Description

While indeed a risky, leveraged E&P company, we think equity shares of Magnum Hunter Resources (MHR) offer substantial upside with notable catalysts.  MHR has 5 key resource plays – Eagle Ford (24,000 net acres), Bakken/Three Forks Sanish (125,000 net acres), Utica (61,000 net acres), and Marcellus (58,000 net acres), and Southern Appalachia (313,000 net acres) – and a growing midstream pipeline asset.  The company has 60mmboe of proved reserves (60% liquids), 26mmboe of PDPs (50% liquids), and 12,600 boepd (35% liquids) as of March 31, 2012.  Lead by an aggressive drilling program in high IRR acreage, management anticipates exiting 2012 with production of 18,000 boepd (~65% liquids) and ultimately reaching 30,000 boepd with ~80% liquids over the next few years.  Importantly, at $90 WTI oil, the company has substantial drilling inventory with relatively low-risk individual well IRRs in the range of 30% to 55%.  MHR drilled 203 successful gross wells in 2009 through 2011, vs 1 unsuccessful well (in 2009).  Additional value exists in the company’s midstream asset, with an implied equity valuation of $360mm based on a recent investment from an Energy-focused financial firm, ArcLight, of which MHR’s retained position is $300mm.

Based on our estimate of NAV, with equity shares at $4 the Enterprise trades at ~60% of Asset Value and we think a more reasonable discount of ~85% of NAV is appropriate, which would result in a $7/share price tag versus $4/share today.  Moreover, as the company continues to execute its drilling program on its high IRR, oily acreage, we anticipate value will begin to be better recognized by the market.  Finally, catalysts should support this convergence, notably the following:

• Possible announcement of results of a recently-completed EF well in Lavaca county that, according to Texas Railroad Commission records, shows 30-day IP of 1,236 boepd (90% oil) vs previous 10-well average IP of 780 boepd shown in their investor presentations – which in and of themselves were considered very economical and attractive.
• Recent results by Anadarko (4/19) indicate MHR’s Noble County Utica acreage, originally thought to be wet gas, may be much more oily than expected.  We anticipate positive results from MHR as they drill their adjacent acreage.
• Company is working to form Eureka midstream asset into an MLP and possibly roll it out, which will unlock that value to MHR shareholders.

Meanwhile, a superfecta of unfavorable factors has influenced a decline in the price of the company’s equity shares:

• Secular Nat Gas price decline.  While off the nadir, prices remain down substantially, with Henry Hub spot at $3/mcf versus the $4 to $5/mcf in most of 2011 through 2012.
• Recent decline in crude oil.  Over the past 2 months WTI crude has fallen from ~$100/bbl to ~$85/bbl.  Oil prices are impossible to predict, but despite the recent price volatility we think the macro picture for oil is quite different than for nat gas:
  • The difficulty of transporting natural gas makes it a regional commodity, while oil is a global commodity. 
  • Significant surplus of gas inventory in U.S., while no material surplus inventory of oil domestically or globally.
  • Increasing demand for both, however, in the U.S. it appears most of the coal to nat gas switching by power produces has taken place, implying incremental marginal demand will have to come from elsewhere (vehicles).
• Equity capital raise in May resulted in $60mm fewer proceeds to company as a result of share price decline during that period as part of capital raise for Baytex acquisition (originally anticipated 35mm shares offered at $6/share and executed same share count at $4.50/share, which some modeling implies company may need to raise fresh capital a year or two before FCF break-even at current annual capital investment program).
• Management announced yesterday that total production forecasts would be cut 10% (Appalachia region down 17%) as a result of destruction and disruption from the late June thunderstorms that rolled through the East Coast, resulting in shut-in wells and below-normal production volume in its WV processing plant.  Initially following the storm mgmt announced production would return to normal in the subsequent 5 days.

This is the 2^nd reincarnation of MHR, both time led by Gary Evans.  While the “Old Magnum Hunter” was sold to Cimarex for $2b in 2005, Evans was rumored to have been greedy in wanting on a higher price and rejecting previous offers for the same reason.  The current management team assumed leadership of MHR in May 2009 with a market cap of merely $10mm.  Through a variety of acquisitions, mostly in liquids rich areas just offset to “sweet spots” of the sexy resource plays, MHR now has exposure to a growing inventory of potential locations in the Williston Basin (Three Forks/ Sanish), Eagle Ford, Utica, and Marcellus.  By focusing capital on these mostly oily plays, the company is projected to exit 2012 with 65% oil and liquids mix driven by 92% of $325mm upstream capital budget being focused on oil and NGL projects.

It seems as if management is chasing liquids exposure like majority of their peers, but the seeds were planted years ago and at reasonable entry prices. In the case of the Eagle Ford, they broke into the play with a purchase of Sharon Resources for $2.35M (6,400 acres or $367/acre) in October 2009 and established the lion’s share of their position by late 2010. In the case of the Marcellus, they entered the play with a purchase of Triad Energy out of bankruptcy in February 2010 for $81M. Most recently, they were able to bolt-on an additional 12k net acres in the Utica for ~$2k/acre prior to this April’s positive liquids well results in Noble County by Anadarko.)

Admittedly, one must have conviction that in the future oil prices will remain above $80 and politics will continue to be generally kind to the idea of hydraulic fracturing, a necessity for making unconventional resource plays economical.

May 2012 $311mm acquisition of acreage from Baytex Energy

To fund the acquisition of an additional 37.5% WI, or 50,400 net acres, in the Bakken/Three Forks property in Divide County, ND that is operated by Samson, MHR raised $600M of capital ($450mm debt and $150mm equity) to simultaneously acquire Baytex acreage and pay down Term Loan and Revolver balances.  The net debt raise given the simultaneous refinance amounts to $150M versus the concurrent $150M common equity capital raise.  The balance capital approach is in line with recent historical and with “old magnum hunter” capital raise style.  This acquisition brings MHR’s WI to 47.5% within the Williston Basin.  The $311mm purchase price represents $3,700/acre for the undeveloped portion (approx. 85% of acreage is unproved)

We highlight the obvious concern: under the JOA, Samson has the right through the AMI provision to participate in the acquisition for a non-disclosed period of time.  If Samson were to do so, MHR would be left with substantial cash on the balance sheet which might result in an itchy trigger finger to execute another acquisition. Alternatively, Samson’s lack of interest to participate might indicate price is too high or acreage prospects are less robust than we or MHR mgmt anticipates. A phone call with KKR-owned Samson’s CFO, Phil Cook, suggested the company viewed the area favorably but might be hesitant given (1) they already have 400,000 net acres in the area and (2) they wanted to tend to their balance sheet by not outspending cash flow and creating/retaining flexibility to pay down the revolver over time, neither of which we view as a negative indication on the Baytex acreage.

Eagle Ford Acreage

MHR’s best asset is its Eagle Ford acreage.  The company’s entry into the play began in October 2009 with its purchase of Sharon Resources for $2.35mm (6,400 acres for $367/acre).  Today the company has about 24,000 net acres in the EF, with the bulk of it – almost 19,000 net acres – in the very favorable Gonzales and Lavaca counties.

As of March 31, 2012, the company had 21 gross (11 net) producing wells in the play. Since 2011, the company has participated in 19 gross wells in Gonzales & Lavaca County, 13 of which they drilled and operate. The 30-day IP rates of those first 10 operated wells averaged 776boepd (based on a pretty tight range of 596-908).  The company’s most recent new well data from Tex Railroad Commission (march 2012) showed 1,236 boepd 90% oil 30-day IP in northwest Lavaca county for MHR’s Hawg Hunter 1H well, drilled to roughly the same total depth of 10,000 feet as its other wells (these are horizontal wells).

 Data source: Texas Railroad Commision via drillinginfo.com

Hawg Hunter 1H location:

The remaining wells, Hunt operated, are performing much worse, with 30-day IP rates of 380boepd on avg and one as low as 213boepd. According to management, Hunt had been a poor operator and is just now moving up the learning curve (most recent well 24hr IP >1mboe).  Hunt was previously not geosteering the wells and going out of zone as a result, using too few frac stages, and ultimately replaced the engineering team.  

The company’s EF acreage is interwoven with EOG, Penn Virginia, Conoco and others. MHR’s acreage is mostly on strike with Penn Virgina’s, which has experienced 645 boepd (88% oil, 6% NGLs) across 47 wells with type curve EURs of 400 MBOE and higher.  Even at $80 WTI, we estimate $9mm horizontal wells on MHR acreage to yield 40% IRRs.  Break even we estimate at $40 oil.

Also in the Eagle Ford, MHR has a JOA with Hunt Oil and an undisclosed private company.  The JOA with Hunt Oil covers an AMI of 32,412 gross acres (15,050 net acres) in Gonzales and Lavaca Counties in which they each have a 50% WI. Both parties have agreed to work together within the AMI on an equal and joint basis through December 2014. Both parties have cross-assigned existing ownership interests in their respective lease acreage positions for both Lavaca and Gonzales Counties. Each company has also agreed to allow the other to be the designated operator for all wells on lease acres contributed to the AMI by the other.

The joint venture with the private independent company covers an AMI consisting of approximately 4,000 gross acres (2,000 net acres) of certain specific lease acreage positions currently owned by the Company and the other party in Gonzales and Lavaca Counties. Both parties have agreed to work together within the AMI on an equal and joint basis through October 2013. MHR is the operator under the joint venture, which is positive as they have proven to be effective operators in the Eagle Ford.

MHR has allocated $130M to drill 13 net wells in this area for 2012. Assuming 80 acre eventual downspacing, this equates to a remaining inventory of >150 net locations in the Gonzales and Lavaca Counties. After further risking the acreage using a 75% factor and assuming $2k per acre for the undeveloped acreage, this results in EF value of around $690mm on a PV-20 basis.

Williston Basin

The company’s Williston position is really focused on two core areas, both of which currently produce from the Three Forks / Sanish formations but are prospective for the Bakken. Since the Bakken is a bit shallower in the northern part of the basin (less thermally mature), we presume targeting the Three Forks /Sanish remains their lower-risk, higher IRR option.  Management is confident that both areas (the Baytex acreage & Tableland) are prospective for the Bakken, pointing to the drilling success that Husky and PetroBakken are having in the Bakken even further north in Canada. That being said, they will continue to develop the TF/Sanish which they have had success with thus far.

The 1^st core area is the 64,000 net acres in Divide County, ND that is currently operated by Samson. Divide County is located directly north of the most actively drilled areas of the Williston basin (Mountrail, McKenzie, Dunn and Williams Counties), but development in the area is ramping. Continental Resources is successfully developing acreage to the SE of MHR and NFX is located to the SW of MHR. Pro-Forma the Baytex acquisition, MHR will own a 47.5% WI in this acreage that is operated by Samson. While the company has drilled profitable Bakken wells on the acreage (Blue Jay Well / Oct ‘11 / 30-day IP 350boepd), the Three Forks / Sanish results are more encouraging, with the last 12 wells averaging 30-day IP rates of 515boepd. Even more encouraging, the 5 wells drilled in 2012 averaged 30-day IP rates of 728boepd, indicating Samson is getting a better understanding of the play and adjusting drilling and completion techniques. MHR has allocated $100M to drill 60 gross (14 net) wells in this area for 2012. We estimate PV-20 NAV of this acreage at around $300M after only giving the company credit for the Three Forks/Sanish potential despite stacked pay potential in some locations, $90/$3 pricing assumptions, $7M well cost, 320 acre spacing, and 75% risk factor.

The 2^nd core area in the Williston Basin is the Tableland Field, near Estevan, Saskatchewan, Canada. Unlike much of the domestic Williston Basin acreage, MHR operates this acreage. As of the MRQ, the company had 32k net acres and 19 net producing wells in the area targeting the Three Forks/Sanish formations. The company has experienced average 30-day IP rates of 273boepd for their last 5 wells. With well costs of only $3.5M (laterals are ½ the length), these wells have proved very economic. MHR has allocated $70M to drill 20 net wells in this area for 2012. For the remaining ~83k net acres in the Williston (which are spread throughout Divide, Burke, Renville, and Bottineau counties in ND and Saskatchewan in Alberta, Canada), we assume a value of $1k per acre. This results in a total Williston Basin value in the range of ~$480M (incl the previously mentioned $300mm value acreage), not taking into account any potential downspacing or Bakken prospectivity.

Marcellus Shale

MHR broke into the play with a purchase of Triad Energy out of bankruptcy in February 2010 for $81M.  Just over half of the 88,000 net acres are Marcellus Shale, and while the purchase price implies $900/acre, the assets also included over 5.1mmboe (about 2/3rds oil), more than 2,000 producing conventional wells, 3 rigs, 180 miles of gas pipeline and rights of way and 2 salt water disposal facilities.  Following multiple additional transactions, the company now controls an aggregate 72,500 gross (58,500 net acres) in the northern West Virginia area of the play. The Marcellus Shale acreage is located principally in Tyler, Doddridge, and Wetzel Counties, West Virginia.  The recent Antero presentation below shows MHR’s acreage in turquoise in the southwest region of the Rich Gas Window (adjacent to Antero’s southern acreage on its northwest border).

Once MarkWest Liberty’s Mobley gas processing complex is scheduled to become operational during Q4 2012.  Triad Hunter will be able to sell the liquids portion of its gas stream, which we anticipate will result in a pricing uplift attributable to these liquids of approximately $1.00 to $1.50 per mcfe.  Once the complex is online, MHR plans to complete the 4 wells behind pipe. As of the Q1 2012, the company operated 41 vertical and 10 horizontal wells in the area. Of the horizontal wells they’ve drilled, 30-day IP rates for the 8 available wells average 5,950mcfe/d. Assuming 25% NGLs, $90/$3 pricing environment, and $6.5M well cost; these wells generate a positive return today on a PV-10 basis but the return rates in the low teens are weak relative to the returns available in the Eagle Ford, Utica, and Williston.  As a result and given current gas prices, little new capital will be allocated to this acreage.  We assign no value today for this acreage in our consolidated NAV, however, we view this as an asset with nice option upside when/if gas prices recover, particularly given more than 60% of this acreage is HBP.

Utica Shale

Far from de-risked, the company’s 15,000 net acres in Noble County, adjacent to Anadarko acreage, might be more of an oil than a wet gas play.  Anadarko’s Brookfield A-3H well in Noble showed results of 575 boepd with 82% oil in its first 20 days.  MHR plans to drill 2 horizontal wells on this acreage in 2012. (APC press release: http://www.anadarko.com/Investor/Pages/NewsReleases/NewsReleases.aspx?release-id=1684886)

Type curves are still unknown at this point for Utica and applying EURs to IPs is undoubtedly guesswork, but using Eagle Ford decline curves as a proxy (geologist cite rock properties of the two as being similar), 320 acre spacing and 75% risk factor, we arrive an approx. value of $90mm.

Other Acreage

The company also holds ~310k net acres in the Southern Appalachian Basin (via the acquisition of NGAS in April ’11), which is primarily producing from the Devonian Shale and Mississippian Weir Sandstone. As of the MRQ, MHR had drilled 77 Devonian shale horizontal wells (16 in 2011), primarily in the Huron and Cleveland sections of the formation.

The Mississippi Weir sandstone, a wet gas play which MHR has 32,300 net acres, is yielding increasingly encouraging results from the 4 horizontal wells drilled in 2011. MHR plans to drill another 4 horizontal wells in the area in 2012. The area is 35% liquids (oil & condensate).  We estimate this Devonian and Mississippian acreage at $110mm using simply $500/acre assumption.

Eureka Hunter midstream assets

350+ mmcf/day capacity with expansion possibilities located in the Marcellus shale wet gas window in West Virginia, carrying MHR and 3^rd party volumes (100,000 mcf/d contracted via long-term agreements).  As of Q1 2012, midstream reported $1.2mm of revenues and EBITDA of 732mm, implying 3mm of annualized EBITDA, vs full year 2011 $2.5mm in revenues and EBITDA of $1.3mm.  Growth opportunities continue to materialize, with 60 miles of new pipeline are slated to come online by YE 2012 and 200 mcf/d of processing by year end through the new MarkWest Mobley Plant During March 2012, MHR sold 16.6% of its interest to ArcLight Capital for $60mm, implying a $300mm market valuation for Hunter’s retained position.

Catalyst

• Possible announcement of results of a recently-completed EF well in Lavaca county that, according to Texas Railroad Commission records, shows 30-day IP of 1,236 boepd (90% oil) vs previous 10-well average IP of 780 boepd shown in their investor presentations – which in and of themselves were considered very economical and attractive.
• Recent results by Anadarko (4/19) indicate MHR’s Noble County Utica acreage, originally thought to be wet gas, may be much more oily than expected.  We anticipate positive results from MHR as they drill their adjacent acreage.
• Company is working to form Eureka midstream asset into an MLP and possibly roll it out, which will unlock that value to MHR shareholders.
• less immediate, but ultimately management and Board have agenda of selling company.