Shorting Magnum's Been a Horrible Trade

 | Feb 21, 2014 | 6:00 PM EST
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One of the key factors I used in selecting Mad Money names was a contrarian angle. The most tangible evidence of this is a company with a high short position against its shares. I broke my own rule (small-caps only) to put Magnum Hunter Resources (MHR) in Mad Money because of the large short position against it. I've extolled the virtues of MHR's Marcellus/Utica shale strategy in prior columns, but the fact that almost 20% of Magnum's float was held short made it irresistible.

Anyone betting against the Utica was ignoring strong results from other players in the area such as Eclipse and Antero (AR). And further ignoring the large jump in valuation of acreage in the Utica, as shown by the recent American Energy Partners-Hess transaction. At Portfolio Guru, when we see willful blindness we take the other side immediately.

But what about Magnum Hunter's company-specific issues? The company's auditing follies with PwC seem like a distant memory (as does the sub-$3/share stock price that prevailed during Magnum's "crisis" in April) now that BDO is on scene and reports are being filed in a timely manner. Magnum will report full-year 2013 earnings on February 28.

The last two weeks have seen a flood of what must be "bad facts" for those short Magnum.

  • Last Friday Magnum announced an initial production rate of 32.5MMBCF of gas from the company's Stalder Pad in southeast Ohio. So after so much success from competitors in the region, Magnum finally had its own "30 million a day" well. This one data point confirmed Magnum CEO Gary Evans' Utica shale thesis, and Magnum's strong share price performance Friday and into this week was indicative of a short squeeze.
  • Natural gas prices have gone bananas in that same 6-day trading period. As of this writing the front-month natural gas contract sits at $6.09, near a five-year high and a full 50% higher than the corresponding contract's price in early January.

Obviously that doesn't drop to Magnum's bottom line immediately due to hedging contracts, and I am not in the business of predicting short-term natural gas futures prices. But Magnum publishes IRR figures based on a range of commodity prices, and a well that produces an 37% return for Magnum at $4 would by their estimates produce an more than 60% return at $6 gas. That difference in return is impossible to ignore...Take that, mister short-seller!

Want more "bad facts" for the shorts?

At this week's EnerCom conference in San Francisco (I was unable to attend but able to listen thanks to the great job of webcasting done by Greg Barnett and the EnerCom team), Evans gave the keynote lunch address and made the following points:

  • The Eureka Hunter pipeline is going to see HUGE increases in throughput as new customers come on-line. At this point EHP is doing about 190mmBTU/day in volume, and is well on its way to hitting MHR's rated capacity of 300-350mmBTU. In his presentation Evans showed a graph showing EHP's potential. In Magnum's projection EHP throughput hits 1 billion BTU/day by 2018 thanks to the addition of three new customers.
  • Evans mentioned in passing that Magnum will consider selling its Bakken assets. Magnum's assets in the Williston Basin of North Dakota represent a viable business now with a daily production rate of greater than 5,000 boe. It's big enough to sell, but I believe Evans would only consider that if he were convinced that accelerating development of Magnum's remaining undeveloped acreage in the Utica would produce a higher return for shareholders.

In short... shorting Magnum has been a horrible trade. As the shorts scurry to cover their losing position, I believe Magnum shares will continue to rise to (and through) my $12.25 price target. And, yes, to answer the question I have received so many times this week, I would still buy Magnum shares at their current level above $9 a share. 

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