Will Lucas Energy's Gonzales County Acreage Be Developed?

Jul.25.13 | About: Lucas Energy, (LEI)

There have been quite a few articles written on Lucas Energy (NYSEMKT:LEI) lately. I have written one of these articles and Josh Young has written the others. You can search LEI on Seeking Alpha to read these articles. For reference: Young is a former director of the company and a shareholder of LEI with a significant position. I have no position, long or short, in the company. I write to gain knowledge for myself and others and to provoke intelligent discussion regarding LEI.

It has been previously stated in the comments section on one of the other articles on LEI that most of the value lies with the acreage in Gonzales County. From this news article, it appears the company has 10,500 gross acres in Gonzales County. I don't believe I have seen the company break out the numbers for only Gonzales County. If I have overlooked this number, please let me know in the comments! As you can see from the above news article, Lucas entered into a JV with Hilcorp [now Marathon (NYSE:MRO)]. Lucas received cash up front along with a drilling carry on two wells. Hilcorp received an 85% working interest, leaving Lucas with 1,575 net acres.

A Lucas presentation from 2011 goes into more detail on this transaction. The news article states Lucas received ~$8.9MM upfront in the deal. The presentation states that Hilcorp would spend a total $15MM on the two wells. This makes the 15% carry worth $2.25MM. In the end, Lucas received roughly $11.15MM in exchange for 8,925 acres. That comes out to $1250 an acre. Slide 9 of Lucas' presentation shows recent deal activity in the Eagle Ford Shale. The lowest price per acre listed is (ironically?) KKR's (KFN) investment in Hilcorp's acreage for $6,000/acre. Clearly Lucas got the short end of the stick for such "premium" acreage. Whether or not this discrepancy was a red flag is hard to say, but it is certainly worth noting.

Hilcorp ended up drilling two wells on the lease. The wells are Hagen EF 1H and 2H. The Texas Railroad Commission (RRC) lease number for the Hagen EF lease is 15296 in District 01. The production data for the lease is shown below:

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Peak production was in April 2011 when the lease produced 14,674 barrels of oil. Factoring in 30 days in the month and 2 wells on the lease gives an average 30 day peak rate of 245 BOPD/well. The wells are currently producing an average of only 44 BOPD/well. That's definitely not what you want to see out of $6-7MM+ wells. These wells are marginal at best. These results are likely the main reason Marathon has not elected to continue to drill this acreage. Average well production chart is below:

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Proponents of the acreage state that completion techniques have improved. They believe this is the reason the wells were poor and future wells will be great. The quality of the rock is the most important feature of a good oil well and it is obviously not controllable by anyone. This being said, the importance of the rock certainly does not diminish the importance of the completion technique. I find it hard to believe that the completion technique is the main culprit of poor results, given the fact that operators were making great EFS wells in 2011. Slide 10 of the previously mentioned Lucas presentation illustrates this well. "Local well characteristics are listed with IP rates of up to 1,220 BOPD." Newer wells have certainly been better than this, but the Hagen wells aren't even in the ballpark.

Recent well performance by EOG (NYSE:EOG) is cited as another reason Lucas' acreage should be superior. This well is some six miles from the edge of Lucas' acreage. While there are many games that can be played to inflate initial production data, there's no getting around the fact that EOG has put out a very significant IP. The problem is that six miles is an eternity in oil and gas production. Production can and will vary widely over a distance that large. I believe that well performance on lease and Marathon's inaction has much more relevance than EOG's well six miles away.

$98MM NPV10 per 640 acres, per an EOG presentation, is often thrown around as an indicator of the value of Lucas' acreage. My rebuttal to this is that if the Lucas acreage is really worth this, why hasn't someone purchased Lucas or at least made an attempt? The most likely buyers would be Marathon or the insiders of Lucas. If you apply the $98MM NPV10/section to the 1,575 net acres in Gonzales County, a value of $241MM could be placed on just the acreage in Gonzales County. Current market cap is $40MM with the share price around $1.50. A 100% share premium is only $80MM. It sure seems like shareholders would approve a $3/share deal seeing that the stock has only briefly been at that level in the past five years and that was mainly due to the Hagen well hype back in 2011.

$80MM to get assets worth $241MM plus 200 BOPD of production and Lucas' other properties? Seems like a no brainer to me. Why hasn't this happened? Surely it would be a slam dunk for Marathon to scoop up the other 15% of the lease on the cheap. Insiders would have an even easier time getting the deal done being that they already own ~25% of the stock. Insiders seem well connected and appear to have access to money as well.

Another red flag on the company level is the recent insider purchase by the entity associated with the chairman of the board. On July 17, 2013, Meson LP purchased 185,185 shares of LEI directly from the company for 0.01 above market price. The total monetary value of the transaction was $250,000. One of the curious things with this transaction is that it was only disclosed in a footnote at the very bottom of an ownership filing. No press release or any other mention of the transaction.

Why did Meson not purchase the shares on the open market? They have purchased on the open market before. Why go straight to the company now and dilute other shareholders? LEI trades roughly 220,000 shares a day. There is plenty of liquidity in the stock to open a position in a single day and certainly enough to do it over two or three days like Meson has done in the past. Why would the company want to issue additional equity for a measly $250,000? You can't do a whole heck of a lot in the way of workovers/recompletions with $250,000 and this amount is roughly equivalent to two weeks production for LEI. What was so pressing that it couldn't wait? Is this a working capital issue? Need to pay some invoices? Is Lucas so desperate for cash that they have to issue stock for $250,000? I don't know, but the company should come out and make a disclosure that they are issuing stock and why they are issuing it.

It seems to me that the new management would gain much more respect with shareholders if they were more open with their dealings and the plan for moving the company forward. Non disclosure and other suspect deals seem like characteristics of the old management. Certainly the new management want to distance themselves from that.

Questions that should be answered: What are the plans to raise capital for increasing production? Do they even have short-intermediate term plans to drill? Are they planning on more (larger) stock dilution? Are they going to borrow against the existing production? Where are they going to get the cash to cover the working capital deficit and repay the rather large 14% note that is due soon? How do they plan on developing the supposed crown jewel asset in Gonzales County without having Marathon on board? Have they had any recent talks with Marathon? What have they said? A large portion of their most recent presentation is dedicated to a geology lesson of South Texas. These things are well known already and just serve as a filler of the presentation. How about some detailed plans on where the company is heading and management's plans for it?

The Marathon question is certainly one of the most important ones being that the control of the best asset is in the hands of Marathon. I think investors are due answers to all of these questions. I know I certainly would want them answered before making an investment in Lucas. Good luck in your investing and as always, do your own research and make your own decisions!

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. I have no position, short or long, in LEI.