A Pair of Petroleum Previews

 | Sep 25, 2013 | 7:00 PM EDT  | Comments
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mhr

,

epm

As I mentioned in Tuesday's column, I'll be attending the Independent Petroleum Association of America's OGIS Conference in San Francisco presented next week. Today, I will preview two more companies I'll be seeing there.

Magnum Hunter Resources (MHR) has been quiet of late. Since I saw the company's managers at EnerCom in Denver on Aug. 12, there has been no corporate news. Yet the shares have risen 33% in that time period. Why? It's all about the pipeline.

Magnum CEO Gary Evans mentioned that MHR would begin marketing the Eureka Hunter pipeline in September, and the stock seems to be responding to the buzz surrounding that potential sale. Magnum owns 60% of the pipeline, and Evans has pegged the valuation at $750 million to $1 billion ($420 million-$570 million for Magnum's share.) MHR's goal is to have daily throughput for the pipeline of 200,000 mmBTU by year-end, and any update on that progress will add visibility to the pipeline's value.

In regard to Miller Energy Resources (MILL), I do not place much weight in management's self-valuations. MHR's self-ascribed net asset value is $8.32-$13.43 per share. So what? MHR has actually put some real value on that by issuing warrants at a strike price of $8.50 (at a 1/10 ratio) for all common shareholders of record as of Sept. 16. The warrants are exercisable in September 2014 and expire in April 2016. Additionally, Magnum's Series E preferreds are convertible into common stock -- also at $8.50 per share beginning in November 2015.

Evans clearly believes MHR will be trading above $8.50 by 2016. The key to unlocking that greater-than-55% of upside won't be the pipeline, however, because I believe that will be gone by early 2014. The real key will be the activity on the company's Farley, Stalder and Ormet pads in Ohio and West Virginia.

These pads give Magnum Hunter the ability to drill into the Marcellus and Utica shale formations. Geologically, the Utica is several thousand feet below the Marcellus. The Utica formation is much larger geographically than the Marcellus, and it's a newer, less-crowded play. Some observers believe the Utica will far surpass the Marcellus in terms of production IRRs -- Evans clearly does. If this is the case, MHR's early-mover advantage will prove very lucrative. That will determine if those warrants are valuable and if an $8.50 price for MHR common is realistic.

Evolution Petroleum (EPM) is a mess right now. The company's main asset is a royalty interest in the Holt Bryant Unit in the Delhi Field in Los Angeles. The operator, Denbury Resources, had a major accident in that field in June, and the CO2 injection that was being used to force out the hydrocarbons had to be temporarily halted.

Issues regarding EPM's indemnification for remediation costs occupied most of the company's recent earnings call, but the bottom line is this: EPM's royalty interest will revert to a working interest when the field reaches a pre-determined level of aggregate profitability. If it weren't for Denbury's unfortunate accident, that threshold would be within reach. However, management noted on their call that they now believe a Jan. 1, 2014 date is feasible for the interest reversion.

So, it's just a hiccup, and as we move into calendar 2014, Evolution will at some point assume a greater capital burden. But it will also share in much more of the cash flow from the field. Management has been very clear that this reversion will be a net positive for Evolution's corporate cash flows.

Yet Evolution was not created to be an operator -- the company has 11 employees. CEO Bob Herlin and CFO Sterling McDonald were brought in to help shepherd the value of the Delhi play -- as well as other assets/technologies in Oklahoma and Texas -- for the original private equity sponsors. That job is almost complete, so now it's time to think exit strategies, and Herlin and McDonald were very clear on their call that those discussions are being undertaken with the board.

The issue is that Evolution has a minuscule tax basis on its Delhi interest. A "sell to the highest bidder" strategy may not be tax-efficient. Other options, such as joining with a Master Limited Partnership are clearly being considered, and this uncertainty has probably put a lid on EPM's common share price near its current level of $11.32 per share.

I am not predicting an imminent resolution, but my firm owns Evolution's preferreds (EPM-A) so we are content to sit back and collect monthly dividends while EPM's ultimate fate is determined.

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