Shorts Hit Dry Hole in This Drill

 | Jul 26, 2013 | 1:30 PM EDT
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Yes, it's Miller Time. Terrible puns aside, Miller Energy Resources (MILL) shares have been on fire of late, rising 20.6% in the last five trading days.

I wrote positively about MILL on May 22 and noted the company's rapidly-improving fundamentals were at odds with the large short position against MILL. Clearly, short sellers didn't read my column, as the short position actually increased in the last reported period. As of July 15th, a full 35% of Miller's shares outstanding were sold short.

That's a classic buying opportunity, and the company's upbeat conference call on July 16 has brought the "short squeeze" into play.  Extreme volume combined with strong price jump indicates the squeeze is on, and Thursday's trading volume for Miller was more than 5x the recent average.

Why were the shorts in that position in the first place? Miller is in the early stages of producing oil from wells in the Cook Inlet of Alaska that were first exploited in the 1960s. The company is in even earlier stages of drilling horizontal lateral wells in the Mississippian Lime formation in Tennessee.

Typically, an early stage company will have minimal cash flow and high debt levels until the hydrocarbons start to flow. That is certainly the case for Miller as they produced negative earnings before interest, taxes, depreciation and amortization of $5.2 million for the fiscal year ended April 30, 2013. They actually showed decreased year-on-year revenues and production for the fiscal year.

Yes, that's risky, but it's also history. Shorts always forget that stocks are discounting mechanisms and present performance is more important than past, and the outlook for the future trumps both.

Miller has indeed struck black gold in the Cook Inlet and the performance of Miller's well RU-2A has been stellar and well ahead of my expectations. RU-2A is currently producing 1,314 barrels per day, an amazing ramp-up from a well (technically a rework of an existing well) that came on-stream in mid-June.  Management predicted that RU-2A will provide $10 million in incremental revenue per quarter, a huge amount considering Miller's total corporate revenues were $34.8 million fiscal 2013.

So, one well can produce more than the entire company produced last year. It's not shocking; it is oil exploration. Remember that drilling is a learning process and Miller has five other oil wells in the Cook Inlet that will benefit from lessons learned from RU-2A. If the shorts were betting on dry holes, they were dead wrong.

The silver bullet: Management mentioned the possibility of joint ventures on its conference call. For evidence that "de-risking" a play is viewed favorably by the market, check out the chart of Gastar Exploration (GST), a Portfolio Guru, LLC favorite, and a company I have mentioned in previous columns. So, if Miller were to announce a partner -- and a related cash infusion -- worries about MILL's high debt levels would dissipate further.

At Portfolio Guru, LLC we seek income-producing alternatives to undervalued common, and we own Miller's Series C preferreds -- currently yielding 12.5% -- for our clients. Miller will continue to use the Series C as a funding mechanism, and have been offering the shares at a discount to face value ($25 par; 10.75% coupon) to facilitate those transactions. That could restrain the market price of the Series C preferreds, although the yield gets safer with every barrel produced.

The common stock obviously faces no such hurdles. With the shorts clearly panicking, this may be an instance where the capital gain from a completely misunderstood/misvalued common can actually offset the foregone income from the preferreds. It's a "tastes great/less filling" argument, but we'll keep riding with this management team (and filleting the shorts) in every way we can.



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