Drilling Down on a Fracking Small-Cap

 | Aug 01, 2013 | 6:00 PM EDT  | Comments
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GreenHunter Resources (GRH) operates in an attractive subsector of the hydrofracking industry. The company handles the water produced from the hydraulic fracturing process in a number of different ways. GreenHunter can store it above ground, recycle it for reuse (removing the briny contaminants in the process) or, most simply, send the water back underground in salt water disposal wells. 

It's a great business, but GreenHunter is still in the process of becoming a great company. After a few years of dabbling in other green energy areas, it's strictly in water disposal now, but the growing pains remain. In the first quarter, because of a variety of operational issues, GreenHunter posted negative EBITDA, giving rise to liquidity concerns in the market. I believe those concerns are alleviated by GRH's recent decision to sell two SWD wells in Texas, raising a combined $12.7 million in proceeds.

Also, GreenHunter founder (and Magnum Hunter (MHR) CEO) Gary Evans has a personal (undrawn at last report) $2 million line of credit available for GreenHunter, and since he owns 48% of the shares outstanding, he has a vested interest in GreenHunter's prosperity Much like Magnum Hunter, GreenHunter is using Evans' strategy to de-emphasize Texas gas production and go "all in" on the Marcellus/Utica shale region in Pennsylvania, West Virginia and Ohio.

GreenHunter is in the most attractive shale play. There is a misconception about the strength of the Marcellus shale, a misconception based on rig counts. While it's true that the 78 rigs currently operating in the Marcellus represent a year-over-year decline of 23%, anecdotal evidence shows that production is growing strongly there. Note also that the rig count in the adjacent and overlapping Utica shale formation (which lies directly on top of the Marcellus, geologically speaking) has risen 50% year over year to 36 rigs, and anecdotal evidence is that early production returns (it's a "newer" play than the Marcellus) are phenomenal.

GreenHunter shares fell this week as competitor Nuverra Environmental Solutions (NES) (formerly Heckmann) pre-announced a disappointing second quarter. Nuverra's management blamed most of the shortfall on a slowdown in the Bakken shale, which was hit hard by unusually cold and wet weather in the Dakotas. In fact, Nuverra management described its business in the Marcellus and Utica shale as "stronger than expected" and noted Nuverra is "actively expanding our operations there."

Looking at the drillers and their second-quarter earnings and production releases,

Range Resources (RRC) said it had "continued success ... in the Marcellus shale. Second-quarter production ... exceeded the high-end of company guidance." Cabot Oil and Gas (COG) said, "Our current Marcellus ... production rate represents a 15% sequential increase from our 1Q2013 exit rate ... we have made the decision to bring a sixth Marcellus rig into the field." Seneca, a division of National Fuel Gas (NFG), said, "As a result of better than projected performance of Marcellus shale assets, the company is increasing its 2013 production guidance."

Since GreenHunter has a strong concentration in the Marcellus/Utica shale, it is positioned to serve the most attractive part of the U.S. natural gas market. I believe that attractive positioning will show up in greatly improved financial results for GreenHunter in the third and fourth quarters of this year.

If GreenHunter can surmount its early stage hurdles, I believe the shares could trade above $3 per share, more than double the current price. CEO Jonathan Hoopes has referred to "the $30 million question," i.e., the company's ability to raise funding, likely in the form of an equity injection. Such an investment would "de-risk" GreenHunter's balance sheet and allow the company to consolidate the fragmented frack-water disposal industry.

At Portfolio Guru, we are buying GreenHunter's Series C preferred stock for clients at the current price of $0.73 on the dollar. The preferreds are yielding 13.8% currently, but a meaningful equity injection would, in my opinion, eliminate the large discount to par, another way to realize a capital gain.

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