In my opinion the domestic oil and gas production story has been one of the few positive economic highlights through our "recovery." The benefits of increased domestic production to our country as a whole are numerous, both from an economic and political stand point. Selfishly, I have also observed the tremendous returns that can be generated when you are early to an emerging production growth story and sequential bopd increases can translate into increased profitability and higher equity prices. As a result, I have remained interested in earlier stage E&P growth stories where I see scalable potential and management teams that are solely focused on value creation for equity holders.
Having done very well investing in Arena Resources years ago and watching management there balance production increases, leverage and strategic positioning for an exit strategy; I have seen how much money can be made investing in small cap E&P. On the flip side, having more recently been burned in American Standard Energy (OTCPK:ASEN) I am leery of land grabs, leverage and management compensation in these early stage companies. While I realize that the sale of Arena to SandRidge (SD) for $1.6B took place in headier times, I continue to believe that a successful production development growth story (where management's interests are aligned with shareholders) can generate outsized returns for shareholders.
More recently I have watched two companies, whose stocks had followed divergent paths, have begun to rise together, largely because of the success they had found within the same region, the Hunton Formation in central Oklahoma. Then as I began to educate myself more on this formation and the players that had direct leverage to its increased production, I was able to watch another player enter the scene as a Hunton-specific IPO, launched earlier this year, listing with a fairly high valuation relative to trailing production. While the Hunton has a production history of nearly 100 years, there are few public players in this NGL rich formation; which is something I think is likely to change given the initial results I have observed from each of the players I will discuss. You will have to forgive my pragmatic approach in reviewing the options in the formation, and while I do love the opportunity to write with conviction, I am also cautious with capital allocation and recent price appreciation in many of the names I will discuss has kept me on the sidelines. I will briefly talk through several of the stories I have gotten up to speed on as Hunton plays and I welcome input from contributors to help in my vetting process.
Equal Energy (EQU)
My interest in the Hunton formation started nearly a year ago, as I learned from reading the work of other seekingalpha.com authors, about an interesting battle that had begun between shareholders and the management of Equal Energy. You can read more about it here, here and here. While EQU was a Calgary domiciled, dual-listed company, shareholders seemed intent on shifting management's focus and capital allocation to developing the presence it had been building in the Hunton Formation. Some shareholder activism coupled with sharp-elbowed moves from management and lots of public bickering later, the stock has doubled off of its lows. The company was recently approached by a potential acquirer and has retained advisors and begun to form a special committee to review strategic alternatives…which unfortunately leads me to believe that there will be an eventual sale, likely leaving the bulk of the value creation from here forward to occur privately, rather than to the benefit of long frustrated shareholders. What was most interesting to me from this process was that while management and activists could not agree on much, they did see eye to eye on the potential value in the development of the Hunton and management's decision to sell assets to provide liquidity to increase its focus on this play has confirmed their shared view. While EQU may prove to be a good upside trade from here, the premium is likely to come at the cost of losing the public entity, so I have decided against investing here and instead wanted to use the interest in the formation to find alternative means to play the same concept, but hopefully where I can identify larger and longer term upside.
In moving on from Equal I had begun to read a number of articles published recently in regards to a company I had been previously unfamiliar with, Gastar and its entrance into the Hunton play. You can read more about it here, here and here. While the stock has started to get away from me more quickly than I would have liked (tripling from $1.00 to $3.00 over the past three months) I did take the opportunity to attend their recent IPAA presentation in New York and to participate on the subsequent earnings call to listen for their focus and enthusiasm towards early results in the formation. Here management has decided to divest troubled East Texas assets to increase its focus on both the Marcellus and Hunton locations. Management has described the Hunton as "a highly prolific new oil play" with 430k boe average gross recoverable reserves. They also stated that "our current plan is to drill approximately 12 gross (6 net) wells in 2013, of which eight are within the existing area of mutual interest (AMI) previously established in our Mid-Continent joint venture," with a yet undisclosed operating partner. Having been particularly pleased with initial results in which their second well has produced 1,169 boepd on average for the past 30 days ending April 30th; the company recently raised $200mm in an oversubscribed debt offering, in part to term out revolver debt but with the balance to complete a large Hunton-based acerage acquisition from Chesapeake (CHK) and provide additional drilling capital. Even after shares have tripled, and additional debt has been raised, the enterprise value of the company is only ~$500mm and shares remain to trade very strongly, indicating to me that we are seeing this story graduate from a largely retail shareholder base, moving into institutional hands. I am increasingly confident that the initial production results are indicative of a much larger opportunity in the play as a whole. My concern here is two-fold though: first, that shares have already tripled and I hate to chase a stock and second, that even with the additional capital from the debt raise, management is going to have to balance its CAPEX desires against cash flow and an already extremely accommodating credit market, if they are to avoid the urge to tap the equity markets to fill a funding gap. While a secondary would likely allow them to "buy" some sell-side support, outside of the fees paid on the debt financing, and create further institutional sponsorship, it would likely derail the upward momentum in the stock; so my current take away is that I feel I need to take a wait and see attitude until there is better clarity on the capital liquidity vs. CAPEX side.
New Source Energy Partners (NSLP)
This brings me to the recent IPO of New Source Energy Partners . New Source is an MLP that is a pure play on Hunton production. According to management "the New Source Group has drilled over 246 gross wells in the Golden Lane field of the Hunton formation since 1999. Our technical team has over 28 years of experience, with a 98% success rate of all wells drilled in the Hunton." Here are the links to the company's Q1 2013 results, Q4 2012 results and another Seeking Alpha article discussing the company. So now I am able to see that a newly public player with a considerable amount of experience in this formation has also had extremely high success rates, which continues to support my thesis of the potential returns that can be generated in the Hunton. My concern with NSLP resides in the transaction; the offering was completed in February of this year in which the company raised gross proceeds of $85mm, selling 4.25mm shares at $20.00, with only 250k shares of the 600k available of the overallotment being exercised. Looking at this transaction something sticks out to me, there are seven banks on the cover of the deal; which is a lot for a small IPO, especially when taking banker greed into account. This tells me that either management was incredibly astute in realizing they were about to write a big check to the street, and in return for fees they wanted to buy as much aftermarket support as possible, or the distribution of this MLP was difficult and required multiple participants; the latter of which is somewhat supported by the partial exercise of the overallotment. In the three and a half months since the offering, shares are essentially flat and the current dividend, if extrapolated, equates to a ~11% yield. I am not an MLP investor, but I can see that the yield is attractive and given management's bullish outlook on production and the ability to increase its acerage in the region, it looks like the current yield is sustainable and that there is a possibility of some increase in share price either as dividends increase or as investors chase yield. Based on trailing revenues, the company currently trades on an enterprise value to revenue multiple of 7x, which seems like a pricey entrance point to me given the growth horizon. NSLP gives me a good comparable from an operational standpoint, but because I'm looking for a lower initial valuation to match higher rates of longer term growth, to hopefully reward me with greater equity appreciation, I'm not sure that NSLP offers me equity enough upside from an investment perspective.
Speculative Hunton Play: Torchlight Energy (TRCH)
Given the limited public company presence in the Hunton, the companies I've discussed so far are what I would consider small-caps, but while I was working on this post I received a press release regarding a micro-cap E&P company, Torchlight Energy Resources (TRCH); whom I had also met with at the recent IPAA conference after the GST presentation. The announcement stated that they had just signed a contract with a private operator called Husky Ventures, which gives them a 15% working interest in an AMI covering 3200 acres in the Hunton that would allow them to drill 20+ wells. You can read more about this in the company's recent press releases here, here and here. From our recent meeting at IPAA and a quick look through their public documents I know that Torchlight is an early stage company with two operating wells (the production from which has essentially gotten them to break even from a cash flow perspective) within what looks to be an attractive Eagle Ford parcel of ~1100 acres where there is meaningful production essentially on all four sides, as well as a Kansas opportunity that is supposed to be in development, with no additional capital needed, by summer. Reviewing the presentation with management I asked them about the "seeking drilling capital" item and they discussed a CAPEX plan to develop several wells, which they felt would take them from a current production rate of 100bpd to 800-1000bpd by year end and that the company was in the midst of a small Sr. Secured offering, which the K and Q indicates they have raised a couple of million from. My takeaway at the time of the initial meeting had been that it looked like an interesting story that could have some nice growth legs, if they were able to get the funding, which has been a big if given the current aversion towards small caps. Over the past two weeks the company has had a number of announcements that lead me to believe that things have begun to pick up steam there: they announced an AFE for a horizontal Buda well on their Texas property, then the AMI in the Hunton which should result in fairly aggressive drilling schedule and in the Q1 filing there is a brief mention of the acquisition of two properties, one in Kansas and the other in Oklahoma, both to be further developed, with the final cost contingent upon production targets that would essentially quadruple current production rates, as well as a recently completed salt water disposal well. While it took the announcement of their Hunton contract to catch my attention; I find this volume of activity to be extremely interesting relative to what had I had viewed as a sleepy story over the past 2.5 years. This leads me to believe that the raise we had discussed has gotten much better traction than the Q indicated and tells me that I need to sharpen my pencil on TRCH. While bulletin board listed companies tend to tie my stomach up in knots, I am starting to think that I may be coming to this at the right inflection point; and the stock, which has held $2 well over the past five or six months (despite the public pronouncement that they were raising drilling capital) indicates to me that this has been under accumulation for some time. A successful horizontal Buda well on the Texas property, in and of itself, could generate several million dollars per year of cash flow, if Husky Ventures previous drilling history is indicative of the wells they are to drill with TRCH it could also result in an additional several million dollars of cash flow per year out of the Hunton, significantly more if they are as successful as GST and its partner has been; add to that whatever production they receive from the Kansas wells that are supposed to be starting and this Torchlight looks a lot more like the early start that Arena Resources had versus the sleepy story I looked at a couple of months ago. Given the scale of these projects relative to the current market cap of $30mm, the fact that there is a clean capital structure and heavy insider ownership at ~40%, I see the potential for this stock to show significant near term upside to current share prices as progress reports begin to let us know how production is ramping. I have dipped my toes in the water around current levels while I do more work and attempt to speak again with management. I will follow up with an additional posting on what I find and I also welcome the input of my fellow authors as their work was how I came upon these developments in the Hunton in the first place.