MAGNUM HUNTER RESOURCES CORP MHR
January 21, 2014 - 12:24pm EST by
PantherHollow412
2014 2015
Price: 8.00 EPS $0.00 $0.00
Shares Out. (in M): 171 P/E 0.0x 0.0x
Market Cap (in $M): 1,360 P/FCF 0.0x 0.0x
Net Debt (in $M): 1,067 EBIT 0 0
TEV ($): 2,600 TEV/EBIT 0.0x 0.0x

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Description

MHR VIC Writeup – PantherHollow412

(Exhibits may not transfer to VIC platform, see Dropbox PDF link)

https://www.dropbox.com/s/uk2zsj22ff37m1f/MHR_VIC_1_21_14.pdf

 

Executive Summary

Magnum Hunter (MHR) is a mid-tier exploration and production company that operates in three exciting unconventional domestic O&G plays - the Utica, Marcellus, and Bakken.  MHR represents a unique value investment with short-to-medium term catalysts via the divestiture of non-core assets including the Eureka Hunter pipeline, a delineation of its Utica/Point Pleasant acreage, and strong year over year production growth.

Value Proposition:

  1. The company trades at a discount to company-stated Net Asset Value ($9-$14)
  2. The company has control of a valuable midstream asset that should be monetized in a tax-efficient manner in 2014
  3. Peers trade at a significant premium on an acreage basis (Antero, REXX, GPOR, PDCE, etc)
  4. A near term drilling program in the Utica will delineate its acreage holding and increase proved reserves

History

Formerly having done business as Petro Resources, Magnum Hunter was taken over by the current management team in May of 2009.  The new management team, led by CEO Gary Evans, who had built the prior iteration of Magnum Hunter (Inc.) and sold it to Cimarex in June 2005, began building a domestic asset base through opportunistic acquisitions. 

Among MHR’s first acquisitions after the new management team was put in place was the acquisition of Triad Hunter out of bankruptcy in late 2009 (deal closed in February 2010) for $81M.  That $81M bought 88,417 net mineral acres located in Ohio, West Virginia, and Kentucky. Approximately 75% of the acreage was held by production.  Of this, 47,000 acres overlapped the Marcellus Shale liquids-rich segment-that is Tyler County and Wetzel County, WV and Monroe County, OH (among others).

Triad had drilled the area vertically with little success and had not yet begun horizontal development.  There were other assets included in the Triad acquisition including drilling rigs, frac tanks, trucks, trailers, saltwater disposal wells and a 55-mile pipeline.  It is the acreage and assets from the Triad Hunter acquisition that are core to the MHR story today, especially the pipeline as is discussed later. 

I have included below an exhibit of the various acquisitions MHR closed since 2009.  Many of these transactions were funded with debt or equity as the company has been in asset-aggregation mode with little production until very recently.

 [Missing Exhibit]

 

Discount to NAV

 [Missing Exhibit] 

I have provided here a duplicate NAV calculation to the one presented in the company’s corporate presentation.  For those that cannot see the exhibit, the range is $9.33 - $14.42 per share.  With MHR’s shares trading at $8, the company trades at a 33% discount to the midpoint of company-provided NAV.

Note: As you can see, the largest influencers of value are the Utica acreage valuation assumptions (potentially $1B worth according to company assumptions) and the Eureka Hunter pipeline ($500M value net to MHR).  I focus my analysis primarily on these two assets and largely ignore the Bakken operations and rig fleet (Alpha Hunter Drilling).  It is my contention that the midstream segment is an overvalued asset and ought to be divested in the near term, the proceeds from which would be re-invested in the relatively undervalued Utica acreage.

 

Valuable Midstream Asset

So MHR acquired a 55-mile pipeline in 2010 in the Triad acquisition along with a bunch of other stuff.  What value was placed on the pipeline at the time of sale? My guess is not much.

In 2010, there was very little horizontal drilling in the liquids-rich Marcellus and Utica. To use the words of Gary Evans on the Q2 2013 call: "We didn't even know the Utica existed 3.5 years ago." In prior years dry gas in the Eastern Marcellus was more in focus. The prospects of the Utica and western Marcellus were largely overlooked in the NG boom years. Thus, a pipeline serving those areas was as well.

What happened in the meantime is, for lack of a better word, lucky. Natural gas prices have driven drillers out of the dry gas acreage of the eastern Marcellus and into the liquids-rich portions of the Marcellus and Utica where drillers can achieve sufficient rates of return.

Guernsey, Noble, Belmont, and Monroe Counties in Ohio are among the hottest oil and gas acreage in the country. Washington and Greene Counties in Pennsylvania are right behind them. Wetzel and Tyler Counties, West Virginia, are sandwiched right in between. As fate would have it, MHR finds itself sitting on one of the most important midstream assets in between two of the most important unconventional resource plays in the country – The liquids rich Marcellus and Utica.

Management commentary over the years reflects the rising importance of the Eureka Hunter midstream assets:

In 2010, Gary Evans talked of the pipeline being worth $10M to $25M as its own business segment.

In 2011, Gary Evans talked of the pipeline being worth $50M to $75M in a spinoff to shareholders.

In 2012, Gary Evans talked of the pipeline being worth $100M to $200M in a joint venture with a pipeline MLP, which would be executed in 2012. Never happened.

In 2012, MHR sold 40% of the pipeline for $200M to ArcLight Capital Partners ($500M total value). The stock didn't budge.

In 2013, Gary Evans envisioned a $750M gross asset ($400M-$500M net to MHR) sold outright to midstream MLPs looking for exposure to the emerging production of the liquids-rich Utica/Marcellus.

Finally in 2014, Gary envisions a $1-2B gross asset ($600M-$1.2B net to MHR) sold to midstream MLPs off 2015 forward adjusted EBITDA guidance in excess of $100M. The board of directors even rejected a Q4 offer that would have valued the pipeline at approximately $1B.

The Eureka Hunter midstream assets began 2013 with approximately 100 MMcfed throughput and management has guided for a 2014 exit rate of 300-350 MMcfed, which would indicate a full pipeline on its current design.

I expect discussions of the midstream divestiture should drive share performance over the next year or so. 

 

Utica Is An Exciting Play

 [Missing Exhibit]  

Over the last year or so, focus in the Utica has shifted from northeastern Ohio (where REXX’s Warrior North prospect lies in/around Carroll and Jefferson Counties) to south in the play (Guernsey, Noble, Belmont, and Monroe Counties).  Some of the most prolific wells have come from operators (mainly Antero) in Noble and Monroe Counties.  I have included an exhibit above (for those that can see it) with publicly disclosed well IPs in the southern Utica and the counties in which they were observed.  You will notice that Antero owns 8 of the top 9 24-hour IP rates in the play.  Interestingly, MHR has acreage directly adjacent to Antero in some spots of Noble and Monroe Counties.

Point Pleasant

In this area operators don’t actually drill the Utica shale because it tends to have a lot of clay.  Instead, the operators are drilling a formation known as the Point Pleasant. 

The Point Pleasant isn’t actually a shale, it’s a laminated-carbonate.  One of the good things about the formation is that it is contiguous over a large aerial stretch (150 miles north-south, 60 miles east-west).  It has good resistivity, porosity, permeability, depth,  thickness and pressure.  These attributes make it comparable to the Bakken, the Eagle Ford, and other more well-seasoned shale plays.

The most interesting aspect of MHR’s acreage holding is that the company has leased heavily along the southern portion of a natural fault line that runs from mid-Washington County up through Noble and into Guernsey County.  Along this fault line, there is really no need to fracture wells, since the rock is naturally fractured along the fauly and there is such high pressure. And so, wells that are drilled and perforated should in theory flow immediately.  This is very different from the Bakken or Eagle Ford where wells are fractured and then left to sit for 30-60 days before being tested and tied into sales.

I have included below exhibits that outline this natural fracture in the Point Pleasant and how it is positioned relative to MHR’s leased acreage.

 

 [2 Missing Exhibits]

 

Despite all of the excitement surrounding promising Utica well IPs and favorable geological formations, MHR still trades with the most leverage (Acres/EV) to the Utica of any operator active in the play (see exhibit below).  It follows that if you are looking for exposure to the Utica, MHR provides the most upside.

[Missing Exhibit] 

 

 

Valuation – Price Targets

[Missing Exhibit] 

My price target range is derived from a unique interpretation of NAV (See exhibit above).  I value the company based on what a potential acquirer might pay for the company on a sum of the parts basis.  That is to say, I account for the value of its assets and add to that the value of its current production on a per flowing barrels basis. 

The company has guided for 35,000 boepd of production in 2014.  In the low case, I value this production at $60k per flowing barrel; and in the high case, $80k per flowing barrel. 

The rest of the NAV table is substantially the same as that provided by the company in its corporate presentation.  The mid-point of my NAV range is my price target for the shares - $19.75.

The Bear Thesis/Risks

My bull thesis suggests that MHR is a good investment because of the quality of its asset base and its looming ability to begin producing substantially more oil and gas from its acreage in a relatively short amount of time. 

That said, I don’t think it is fair to mention MHR without talking about the bear thesis, which has merits of its own and reflect real risks associated with the company.  After all, MHR is one of the most shorted stocks on the NYSE

The bear thesis is fairly nuanced, so I will try to hit the major points:

  • Management
    • CEO Gary Evans is viewed by investors as overly promotional, an over-promise, under-deliver type of manager
    • He is known to capriciously spend hundreds of millions in capex and acreage acquisitions
    • He runs a very aggressive balance sheet and is not afraid to issue equity
    • Gary fired and replaced the auditor in early 2013 after a string of quick acquisitions in 2012 – Company was financially dark for 9 months
    • MHR’s Acreage May Be Non-Core
      • This is the biggest X-factor in both the bull/bear theses – Is the Utica core further south than where Antero has seen 30 MMcfed wells?
      • Bears think MHR’s Washington County acreage will be very gassy and hence less valuable – There is no doubt MHR is getting gassier, but it likely has the same stacked pay potential seen by Antero
      • Overextended Growth Plans
        • Gary is trying to jump up the production growth curve while maintaining a vertically integrated enterprise
        • MHR maintains its E&P operations, its midstream segment, and a rig fleet
          • The short side is betting against these multi-directional growth plans

I acknowledge the bear thesis is not unreasonable.  However, the introduction of a strong shareholder could promote a simplification or streamlining of the business (sell midstream, focus on high-IRR drilling).  And so, I think MHR would make an intriguing activist target.

 

Catalysts/Event Path

  • 2014 Utica Well Results
    • Delineate MHR’s acreage holding in the southern part of the play, thus removing uncertainty about the acreage
    • Test for stacked pay potential in Utica, Upper Devonian, Marcellus,
    • Non-core Asset Sales
      • Non-core asset sales necessary to close the 2014 funding gap
      • $400M capex guidance vs. $250-325M of planned non-core divestitures => Approximate $300M funding gap
      • Midstream Sale
        • Simplify the growth story => Focus on E&P business in high-IRR acreage with fewer headaches from continual midstream hiccups
        • Simplify the balance sheet => Call the $400M worth of preferreds and refinance the senior notes to a lower rate (currently 9.75%)

 

Investment Options

Common Shares: As outlined above the common shares represent a compelling value opportunity with substantial based upon an analysis of MHR's asset/acreage base.

Series E Preferred Shares: The Series E shares carry not only an 8% dividend on their $25 liquidation preference, but they have a convertible feature meant as a sweetener in the Viking International acquisition in 2012. Each E share is convertible into shares of MHR at $8.50.  This conversion feature offers the longer-term holder a decent amount of leverage and a positive carry. The convertible feature is why I prefer the E shares to the C preferred shares, which have no similar type of embedded option.

 

I do not hold a position of employment, directorship, or consultancy with the issuer.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

Catalysts/Event Path

  • 2014 Utica Well Results
    • Delineate MHR’s acreage holding in the southern part of the play, thus removing uncertainty about the acreage
    • Test for stacked pay potential in Utica, Upper Devonian, Marcellus,
    • Non-core Asset Sales
      • Non-core asset sales necessary to close the 2014 funding gap
      • $400M capex guidance vs. $250-325M of planned non-core divestitures => Approximate $300M funding gap
      • Midstream Sale
        • Simplify the growth story => Focus on E&P business in high-IRR acreage with fewer headaches from continual midstream hiccups
        • Simplify the balance sheet => Call the $400M worth of preferreds and refinance the senior notes to a lower rate (currently 9.75%)
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