Dear Mr. Evans,
I would like to begin this letter by thanking you for your years of service to the shareholders of Magnum Hunter Resources (MHR). You have been a tremendous steward of the company over last half decade. Your service should not go unrecognized.
It is thanks to your vision that the company sits atop some of the most coveted natural resource acreage in the country. It is thanks to your vision that the company has developed arguably the most strategically important midstream assets in the country. Finally, it is thanks to your vision that the company is poised to grow its production rapidly in the short to medium term and produce returns for shareholders.
Let's take a moment to review some of your successes as CEO of Magnum Hunter. During your tenure with the company, you have overseen 27 individual transactions (according to the Capital IQ database). Notable among these were the purchase of Eagle Ford shale assets in September 2009 for $2.4 million in stock, which were subsequently divested to Penn Virginia Corporation in April 2013 for $401 million. Even after accounting for an estimated $200 million of capital expenditures in the Eagle Ford, the return on investment is outstanding.
Similarly notable was the October 2009 acquisition of Triad Hunter out of bankruptcy for $81 million. This acquisition included 88,000 net mineral acres, 53% of which now comprises the company's core acreage holding in the Marcellus and Utica overlay. Lest I forget, this transaction included a 55 mile natural gas pipeline that came at little to no incremental cost. This same asset -- the Eureka Hunter pipeline -- has become a significant non-core asset for the company with a potential gross value that could exceed $1 billion in an imminent transaction.
It is the assets from the Triad acquisition that represent the runway of growth for Magnum Hunter and will define the future of the company. Given the superb well economics of the Marcellus and Utica, I anticipate the future of Magnum Hunter to be very bright. Allow me to once again to commend you for your prescient decision making that has led the company to this pivotal moment.
You have spent the last four years building an enviable set of assets that have remarkable potential to produce value for shareholders. Magnum Hunter is quickly approaching a new stage of development in its young life. It is transforming from a speculative cluster of largely unrelated assets into a concentrated, self-sustaining producer. I stress that this is no small achievement and deserves praise.
While the asset base you have built at Magnum Hunter is magnificent, the company remains constrained. There is simply not enough capital available to fund your aggressive multidirectional growth plans. As evidence of this constraint, one merely needs to cite the ongoing orderly liquidation of non-core assets, the proceeds from which are expected to fund near-term capital expenditures in both the upstream and midstream segments.
You appear determined to fully develop both the Utica/Marcellus acreage and the Eureka Hunter pipeline simultaneously. I acknowledge the strategic importance of the pipeline in the vastly underserved Utica acreage. Furthermore, I acknowledge that control of this asset will allow Magnum Hunter to bring wells into sales much sooner than competitors. Lastly, I acknowledge that Magnum Hunter has a virtual monopoly on takeaway capacity in the southern Utica for the time being.
However, the divestiture of the Eureka Hunter pipeline is a critical and necessary next step for the company in its growth trajectory. I was deeply saddened to learn the board of directors elected to turn down an offer for part of the midstream business that would have valued Eureka Hunter at over $1 billion per the Q3 conference call. The capital provided by a partial or complete divestiture of the pipeline would be of paramount importance in terms of funding the company in its 18- to 24-month forward upstream capital plan.
Magnum Hunter is an exploration and production company, not a master limited partnership and/or midstream operator. Therefore, I urge you to divest the Eureka Hunter pipeline as soon as it is operationally feasible to do so. Here are my thoughts as to why a near term divestiture of Eureka Hunter is in the best interest of the shareholders:
Drilling Is a Higher Return Investment
I posit the cheapest and easiest way to reverse the company's capital constraints is through a monetization of the midstream assets and a continued focus on drilling and reserve growth. The return on investment in the midstream business is unclear whereas the returns associated with drilling are widely understood and accepted. Not to mention, they are exceedingly high.
According to the company's November corporate presentation, the internal rate of return (IRR) on investment in the Marcellus is expected to exceed 80% at current pricing. Given the results of neighboring operators in the Utica (including Antero, Consol, Anadarko, Rex, PDC, and Gulfport), one can safely assume the returns there to be comparable if not stronger.
This raises the question: Will the IRR of investing in the midstream assets exceed that of investing in either the Utica or Marcellus? Unfortunately the answer is unattainable given publicly available information. At the Canaccord conference in October you intimated the Eureka Hunter pipeline would produce $125 million EBITDA in 2015. However, you fail to cite a level of capital expenditure that would be necessary to produce $125 million in EBITDA in two years' time. I remind you that the midstream business is currently on pace to produce just $60 million in revenue in 2013.
I reiterate that it is unclear to the investing public what the potential return of this project will be due to the untold millions that will undoubtedly be put into the project. Therefore, I urge you to provide a detailed evaluation and investment guidance to your shareholders supporting your decision to leave capital invested in the Eureka Hunter pipeline.
Lofty Valuation of Midstream Assets/Interest Rate Risk
As is very well known in the marketplace, there is a substantial premium afforded to midstream assets at the present moment. This premium -- largely a function of low interest rates -- is fleeting and should be taken advantage of sooner rather than later. Should interest rates and borrowing costs for potential MLP acquirers rise, the value of Eureka Hunter will undoubtedly fall for obvious reasons. Alas, the value of Eureka Hunter is inextricably linked to interest rates. I speak for all shareholders by suggesting management should reduce or eliminate this significant interest rate risk via a partial or complete sale of Eureka Hunter in the near term.
If management remains unwilling to divest the midstream assets forthwith, I urge you to produce a reliable timeline detailing the divestiture. How many more months will shareholders be required to underwrite the risks of the midstream business? Six months? Twelve months? Longer?
Return Value to Shareholders
Once the midstream asset is divested, I urge management to consider returning a portion of the after-tax proceeds to shareholders who have been exceptionally patient during the tumultuous early years of the company.
Mr. Evans, you have been an outstanding leader for this company since you took the helm four years ago. Your contributions to date cannot be understated. I praise you for your leadership, your vision, and your considerable efforts. That said, I hope you take seriously the thoughts and concerns presented in this letter and address them in due course. Primary among those concerns are the company's immediate need for capital and its bifurcated growth plans.
To reiterate, I contend the most effective means of curing these issues is through an immediate sale of Eureka Hunter and a simplification of the company's growth story. If this contention is incorrect in your view, please heighten your level of public disclosure surrounding Eureka Hunter so that the shareholders can independently verify the merits of the project.
I would welcome the opportunity to discuss my thoughts with you directly. I intend to reach out to you privately to discuss these matters, and plan to furnish an electronic copy of this letter to you.
Disclosure: I am long MHR. 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.