Troubling Developments For These 2 Companies In The Energy Business

Dec.16.13 | About: Synergy Resources (SYRG)

(Editors' Note: This article covers a micro-cap stock. Please be aware of the risks associated with these stocks.)

I am generally long biased, both because I am inherently an optimist who believes the world progresses over time, and because there is generally more upside from going long an undervalued security than going short an overvalued security. However, there are currently two stocks that I am short; I am short them because I believe they are poorly positioned and because they trade at what seems to me to be unsustainably high valuations compared to their peers and their underlying assets / businesses. My investment on the short side in both of these cases is supported by a flow of information and events that to me illustrate challenges to their businesses and to their unsustainably high valuations.

One of these companies is Synergy Resources (NYSEMKT:SYRG). Synergy has been a wildly successful growth E&P story, with the stock up 4x in the past 15 months. The stock has traded up as the company proved its ability to develop its Wattenberg Niobrara and other formations. However, there are aspects of the bullish thesis which drove the stock up which are unsupported by facts and have seen recent developments (or lack thereof) which could imply a much lower stock price and valuation might be coming and might be more appropriate. For example, much was said about Synergy's acreage in Nebraska, after rumors of a nearby massive well (a newspaper published a report of a 1,000+ barrel of oil per day well). Subsequently, there has been silence, and there has been virtually no drilling activity in the area, indicating that perhaps not much value should be attributed to that asset.

Recently, Synergy released news that sounded positive but is in fact substantially negative and implies that a radically lower public market valuation might be appropriate. The company announced that their borrowing base has been raised to $90 million and that their proved reserves had risen to $236 million. This might have been great news if it were a $150 million market cap company, as it might imply a fair value for the stock might be ~$200-250 million based on proved reserves, and that the liquidation value for the collateral for the borrowing base might be ~$150 million (banks typically lend against 60% of their conservative view of value of proved reserves, so dividing $90 million by 0.6 yields $150 million). Unfortunately for current owners of Synergy stock, the current market cap is $680 million, substantially higher than both the proved reserve value and the value implied by the bank credit facility. Obviously there are other ways of calculating value, and fair value for SYRG could be higher than $250 million, but the difference between that $250 million number and the current $680 million value is striking.

Another company that has seen a wave of unfavorable developments is Green Hunter Resources (NYSEMKT:GRH). Green Hunter has been challenged on a number of fronts, but most recently there have been two developments that could have a significant negative impact on the market valuation of the company that have not drawn much attention yet. First, there is a move towards regulating moving frack water and disposal water by barge. GRH stock spiked earlier this year on news that barging operations had commenced, indicating that this business is material to Green Hunter. Banning this business or further regulating it could negatively impact Green Hunter's revenue and margins.

This would be problematic for Green Hunter because, even without this negative development, it was unclear how the company would be able to finance paying interest on its debt and preferred and fund its capital budget without raising significant, dilutive capital. And speaking of raising very expensive money, another development which was not press released but was in a filing with the SEC, Green Hunter's Chairman Gary Evans, who is also Chairman and CEO of Magnum Hunter (MHR), lent Green Hunter $1.5 million. The loan was at 13% interest, comes due in ~2.6 months, and was accompanied by 107,142 5 year warrants with a 1 cent strike price (the stock was at $1.33 that day).

The cost to Green Hunter for $1.5 million for 6 months is $42,250 in interest and $141,427 in value for the warrants (based on the difference between the strike price and trading price on the day of issuance). So the total cost is ~$183,677 for $1.5 million for ~2.6 months, or approximately a 57% annualized interest rate. Obviously a 57% interest rate is unsustainable.

There are a few implications from this. 1) it seems unlikely this deal was "shopped" because the going rate for senior capital for a business of Green Hunter's size is much lower than that interest rate. Even debtor in possession financing is substantially cheaper than this. This raises a huge corporate governance red flag because the loan is from the Chairman of the company, and could attract attention from regulators and from shareholders of both Green Hunter and Magnum Hunter, where the lender is the Chairman and CEO.

2) This deal seems to imply that Green Hunter preferred, which is junior to this loan, may be substantially mispriced. It currently yields ~13%, which is far lower than the effective rate Green Hunter is paying on this new, more senior money.

3) this high cost loan was accepted despite recent issuance of preferred and recent other financing. This implies Green Hunter may be in a tight liquidity situation. This is negative for the business if it is unable to raise additional capital, and implies that prospective lenders may have bargaining power to lend money at a higher cost to Green Hunter than might have been expected.

And 4) This implies that the company may not think GRH is "actually worth" $1.33 per share. A more "appropriate" interest rate more in line with other bridge financings in the market at the moment might be closer to ~20%, which would imply a share price of ~$0.21 cents.

Obviously these observations about Synergy and Green Hunter are just that, my observations. There may be other interpretations of the developments I described above, and it is possible I may have missed other developments that may have been positive or may have misunderstood aspects of these developments. However, I am short these stocks despite a general long bias. And I have done very well with long investments I've publicly written about this year; a company I have written about at length, Gastar Exploration (NYSEMKT:GST) is up more than 5x this year. It is nearly impossible to earn 5x on a short position, but it seems that these recent developments at Synergy and Green Hunter have not yet been priced in, and the discrepancies seem large enough that they have attracted my capital on the short side. These are small stocks which incur additional risks; as always, caveat emptor.

Disclosure: I am long GST. 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 am also short SYRG and GRH. I may buy or sell these or any securities mentioned without further notice.