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Summary

  • The drilling results from the Tuscaloosa Marine shale are not impressive, given the fact that the cost per well is approximately $13 million or higher.
  • Halcon made an expensive deal with Apollo to fund the development of its acreage at the Tuscaloosa Marine shale.
  • Halcon's valuation is very high although its balance sheet remains highly leveraged.
  • There are much cheaper E&P companies out there with low debt ratios and a stellar balance sheet.

Introduction

As a financial writer who covers a wide swath of names, it is always heartening to revisit a call that has worked out as planned. One of these successful calls is my bearish call for Halcon Resources (NYSE:HK) that was made in early 2013, when all the analysts and the reports were overly bullish about this company.

To me, Halcon was following a risky strategy to grow at all costs that was weakening its balance sheet, and I had to warn the investors about this. As such, when the stock was at approximately $8 in early 2013, I explained why Halcon was an excellent short candidate at those levels. My article is here.

The stock started its downtrend after that article, and when it was at approximately $5.4 in August 2013, I presented the reasons why Halcon was still overvalued at those levels. Additionally, I did not bite the company's first cheery result from the Kibler 1H well at the Utica shale. One swallow doesn't make a summer and several other Utica wells (i.e. Phillips 1H) proved to have poor and gassy results. My article is here.

A few months later, Halcon left Utica and started to look for another core area. The stock also dropped down to $3.3 in early January 2014, as shown below:

(click to enlarge)

I still recall that I had plenty of naysayers back then, and my articles had more than 100 comments each, excluding those that were deleted because many folks used derogatory language.

In late March 2014, when the stock was at approximately $4.4, I wondered whether the Tuscaloosa Marine Shale (NYSE:TMS) would be the final nail in the coffin for the company. It was when Halcon made a decision to concentrate on making the Tuscaloosa Marine shale a new core play in lieu of Utica. I said this because TMS was an uncharted land, and if TMS was a dud like Utica, Halcon's weak balance sheet would become even weaker. My article is here.

The Speculative Rise And Apollo's Financing Was A Sour Pill

Since then, two things have happened:

1) In mid-April 2014, Goodrich Petroleum (NYSE:GDP) announced that its well in the TMS achieved a peak 24-hour average production rate of 1,270 boepd. Goodrich's stock rose 31% on the day.

2) Halcon's stock has been the beneficiary of Goodrich's result in the TMS and has risen approximately 25% over the last weeks.

Despite this highly speculative rise, I will not bite the TMS bait. Based on the drilling results to date, I am still not convinced that TMS can help Halcon improve its balance sheet substantially.

And the recent deal with Apollo does not help me change my mind. Let's take a look at the details of that deal: "Apollo will invest up to $400 million in the company's wholly owned subsidiary, HK TMS. Apollo will contribute $150 million in cash consideration for 150,000 of HK TMS preferred shares, and under certain circumstances, may acquire up to an additional 250,000 preferred shares of HK TMS.

Holders of the HK TMS preferred shares will receive quarterly cash dividends of 8% per annum. In conjunction with the issuance of the preferred shares, HK TMS agreed to assign a 4.0% overriding royalty interest (ORRI), subject to reduction to 2.0% under certain circumstances, in 75 net wells to be drilled and completed on its TMS acreage. The number of wells subject to the ORRI will increase to the extent that Apollo subscribes for additional preferred shares, with a maximum of 200 net wells subject to such ORRI if Apollo subscribes for the full additional 250,000 preferred shares."

Firstly, I expected Halcon to announce a farm out agreement in order to de-risk its TMS acreage while reducing its CapEx for that area.

Furthermore, the terms of this deal are bad. It is not only the ORRI but also Apollo's interest rate of 8% compares to an average yield of 7.48% in the "Oil & Gas Exploration & Production" preferred stock category, according to Preferred Stock Channel.

The following facts are also indicative of the high interest rate from the deal with Apollo:

1) In late 2012, when Sanchez Energy (NYSE:SN) was a junior producer with less than 3,000 boepd, it priced a private offering to eligible purchasers of 2.5 million shares of a newly created series of convertible preferred stock, to be designated as 4.875% Cumulative Perpetual Convertible Preferred Stock, Series A.

2) In March 2013, when Sanchez Energy was producing less than 4,000 boepd, it priced another private offering to eligible purchasers of a newly created series of convertible preferred stock, to be designated as 6.50% Cumulative Perpetual Convertible Preferred Stock, Series B.

3) Even Halcon's existing Series A perpetual convertible preferred stock has an interest rate of 5.75%.

And why couldn't Halcon find another E&P company to share the costs and de-risk its TMS properties? Why was the deal with Apollo expensive? To me, there are two reasons behind this:

1) The TMS has not convinced many yet that it can be drilled economically, let alone be comparable to the prolific crude oil window of the Eagle Ford shale, where Sanchez Energy and several other E&P companies have their properties.

2) Halcon has a very weak balance sheet to demand better terms from Apollo.

TMS And The Definition Of A World-Class Oil Play

In the latest NR, Halcon's CEO also said: "We are off to a solid start in the TMS, and the capital from our partnership with Apollo will help us to accelerate activity. The TMS is quickly evolving into a world-class oil play."

I will disagree with Halcon's CEO. To me, the use of this term (world-class oil play) is premature because the TMS play is still at its infancy. Basically, it is untouched and Halcon has completed only one well (Horseshoe Hill 11-22H-1) there thus far. Since one swallow doesn't make a summer, it seems to me that Halcon has not learned its lesson from the Utica fiasco.

Just 10 wells were drilled in the TMS in 2013, and the companies have reported significant operational issues since then, struggling to find a cost-efficient way to tap the pool of oil trapped in deep underground rock. The issues that have plagued the TMS to date might be resolved over the next years, but this remains to be seen.

The cost per well currently is often higher than $13 million, and Encana (ECA) said in late 2013, that the company's three, latest Tuscaloosa wells cost about $16 million each to drill, complete and bring into production. Devon spent $17 million per well to drill, complete and bring into production.

This high cost is partially a result of the fact that the TMS play is deeper than most other shale plays. Also, the operators are concerned about the clay content, which is higher than in other shale plays, as illustrated below:

(click to enlarge)

Additionally, the west TMS acreage where Halcon owns ~73,000 net acres has shown several disappointing results (i.e. Lambright, Broadway H1 wells) thus far. The disappointing results are not also missing from the Eastern TMS acreage, where Halcon owns ~241,000 net acres. Six of Devon Energy's (NYSE:DVN) wells had a total production around 600 bbls/d, and the company sold its TMS assets in 2013.

Let's take a look at EOG Resources (NYSE:EOG) to see what a world-class oil play means. EOG Resources owns 632,000 net acres at the Eagle Ford shale and most of this acreage (564,000 net acres) is located at the crude oil window of the shale, as shown below:

(click to enlarge)

The average cost per well at the crude oil window of the Eagle Ford shale is often less than half the average cost per well in the TMS. EOG's cost per well is $5.5 million with a lateral of 4,000 feet.

Additionally, here are some indicative results from EOG's acreage at the crude oil window that extends from LaSalle and Atascosa to Wilson, Karnes and Gonzales counties:

Well

County

IP-24 (boepd)

Burrow Unit #5H

Gonzales

(South)

~8,660

(87% light oil)

Wilde Trust Unit #1H

Gonzales

(South)

~6,640

(83% light oil)

Wilde Trust Unit #2H

Gonzales

(South)

~7,470

(87%% light oil)

Wilde Trust Unit #3H

Gonzales

(South)

~6,560

(84% light oil)

and below:

Well

County

IP-24 (bopd)

(excludes the wet gas portion)

Neets Unit #1H

Gonzales

(South)

4,940

Magoulas Unit 1H

Gonzales

(South)

4,195

Presley Unit 1H

Karnes

(North)

4,970

Korth Unit 3H, 4H, 5H

Karnes

(North)

3,015 - 3,400

Lynch Unit 1H

Karnes

(North)

4,260

EOG Resources has also many wells at the oil window of the Eagle Ford shale with IP-24 rates much higher than 2,000 bopd (excluding the NGLs and nat gas portion), as illustrated above.

To me, this is the definition of the world-class oil play. And I have not seen the combination of high IP-24 rates with a low cost per well at the TMS thus far.

Sanchez Energy is one of the companies that have also benefited a lot from the high productivity of the acreage at the oil window (Gonzales, Fayette, Frio and Zavalla counties) of the Eagle Ford shale, as shown below:

Quarter

Production (boepd)

Q2 2012

859

(~85% light oil/liquids)

Q1 2013

3900

(~85% light oil/liquids)

Q3 2013

11,773

(86% light oil/liquids)

Q1 2014

18,784

(87% light oil/liquids)

After all, and given the small number of drilling results (to date) from the operators of the area (i.e. Encana, Goodrich, Halcon) along with the extremely high cost of the wells, TMS has still a long way to go to be considered a world-class oil asset. And this is my opinion.

The Valuation After Apollo

Assessing an oil and gas producer is about the company's finances too. The key metrics matter here, and only those who are in denial will not look at a company's key metrics and fundamentals to see what possible risks lie beneath. And those investors are doomed to lose.

That being said, let's dig deeper into Halcon to see where it stands from a valuation standpoint. All the following companies own significant producing properties in the Eagle Ford shale, which is one of Halcon's core area:

1) Halcon Resources has its core producing assets in the Williston Basin, Eagle Ford (El Halcon) and the TMS, as shown below:

(click to enlarge)

and below:

(click to enlarge)

and below:

(click to enlarge)

El Halcon is the extension of the South Texas Eagle Ford play northeast of the San Marcos Arch, and Halcon's acreage is in the "sweet spot" of the play, as illustrated above. The drilling activity in Burleson and Brazos counties has revealed strong results, as shown below:

Well

IP-24 (boepd)

Stasny-Honza

1,262

Falcon

1,218

Reveille

1,416

Pivonka

1,266

Stifflemire

1,066

These results in conjunction with the decent cost per well make El Halcon a premier liquids-rich area that hosts a capital-efficient shale play.

2) Lonestar Resources (OTCQX:LNREF) is a strong growth oil-weighted producer, whose production is coming from the crude oil window of the Eagle Ford shale.

Lonestar's assets at the Eastern part of the Eagle Ford shale (5,022 net acres) are located at Halcon's sweet spot acreage, as shown below:

(click to enlarge)

and below:

(click to enlarge)

Lonestar has also ~11,000 net acres at the central crude oil window, and ~7,000 net acres at the western region, as illustrated below:

(click to enlarge)

and below:

(click to enlarge)

Lonestar's acreage at the Western and central region of the crude oil window is very close to the acreage of other proven EF producers like EOG Resources, Anadarko (NYSE:APC), Chesapeake (NYSE:CHK), Apache (NYSE:APA), EP Energy (NYSE:EPE), Forest Oil (NYSE:FST) and Hunt Oil, as shown below:

(click to enlarge)

and below:

(click to enlarge)

Lonestar's Eagle Ford acreage pro forma the recent acquisitions is illustrated below:

(click to enlarge)

Lonestar has also been producing conventional assets in Texas and properties in the Williston Basin in North Dakota, as shown below:

(click to enlarge)

and below:

(click to enlarge)

3) Goodrich Petroleum is a small intermediate producer in the US. Core properties are in South Texas which includes the Eagle Ford Shale, in Northwest Louisiana and East Texas which includes the Haynesville Shale and Cotton Valley Taylor Sand, in Southwest Mississippi and Southeast Louisiana which includes the Tuscaloosa Marine Shale, as shown below:

(click to enlarge)

"Source: Goodrich Petroleum website"

4) Clayton Williams (NYSE:CWEI) has operations primarily in Texas (Eagle Ford) and New Mexico (Delaware Basin), as illustrated below:

"Source: Clayton Williams website"

5) Carrizo Oil and Gas (NASDAQ:CRZO) is another mid-cap operator whose most production is coming from the wet gas window of the Eagle Ford shale, as illustrated below:

(click to enlarge)

Carrizo has also acreage in Colorado (Niobrara), in Pennsylvania (Marcellus), and in Ohio (Utica).

Given that I took into account the working capital (surplus or deficiency) to calculate the Enterprise Value accurately, let's take a look at the following key metrics:

1) Per EV/Production: This is the table with the first key metric:

Company

EV

($ million)

Current

Production (*)

(boepd)

EV

---------

Current

Production (*)

($/boepd)

Goodrich

Petroleum

2,030 (****)

~11,770

(37% light oil)

172,472

Halcon

Resources

6,400 (**)

40,000 (***)

(90% light oil/liquids)

160,000

Clayton

Williams

2,130

16,000

(83% light oil/liquids)

133,125

Carrizo Oil

and Gas

3,930

~29,630

(~71% light oil/liquids)

132,636

Lonestar

Resources

470

~4,700

(~85% light oil/liquids)

100,000

(*): Estimate, based on the latest corporate news.

(**): Pro forma Apollo financing ($150 million).

(***): Pro forma the sale of the East Texas assets.

(****): Including the preferred stock.

2) Per EV/1P Reserves: Here is the table with the second key metric:

Company

EV

($ million)

Proved Reserves

(MMboe)

EV/1P

($/boe)

Halcon

Resources

6,400 (**)

119.6 (***)

(91% light oil/liquids)

53.51

Carrizo Oil

and Gas

3,930

101.5

(69% light oil/liquids)

38.72

Clayton

Williams

2,130

68.5

(82% light oil/liquids)

31.09

Goodrich

Petroleum

2,030 (****)

75.4

(27% light oil/liquids)

26.92

Lonestar

Resources

470

25.6 (*)

(82% light oil/liquids)

18.35

(*): Pro forma the acquisition in LaSalle, Frio, Wilson, Brazos and Robertson Counties.

(**): Pro forma Apollo financing ($150 million).

(***): Pro forma the sale of the East Texas assets.

(****): Including the preferred stock.

3) Per EV/EBITDA: Let's check out the table below with the third key metric:

Company

EV

($ million)

2014 EBITDA (*)

($ million)

EV

---------

2014 EBITDA (*)

Goodrich

Petroleum

2,030 (****)

140

14.5

Halcon

Resources

6,400 (***)

690

9.28

Carrizo Oil

and Gas

3,930

480

8.19

Clayton

Williams

2,130

310

6.87

Lonestar

Resources

470

115 (**)

4.08

(*): Estimate, based on the company's production guidance.

(**): Pro forma the acquisition in LaSalle, Frio, Wilson, Brazos and Robertson Counties, according to the company's official guidance.

(***): Pro forma Apollo financing ($150 million).

(****): Including the preferred stock.

4) Per Net Debt To EBITDA Ratio: The higher this ratio is, the weaker the balance sheet is. To find the net debt of the companies mentioned, I took into account the working capital surplus or deficiency (if any) and the latest offerings.

From this perspective, Halcon Resources has the weakest balance sheet and Lonestar Resources has the strongest balance sheet, as shown below:

Company

Net Debt

($ million)

2014 EBITDA (*)

($ million)

Net Debt

---------

2014 EBITDA (*)

Halcon

Resources

3,450

690

5

Goodrich

Petroleum

500

140

3.57

Carrizo Oil

and Gas

1,070

480

2.23

Clayton

Williams

650

310

2.1

Lonestar

Resources

193

115 (**)

1.67

(*): Estimate, based on the company's production guidance.

(**): Pro forma the acquisition in LaSalle, Frio, Wilson, Brazos and Robertson Counties, according to the company's official guidance.

My Takeaway

An investor is free to bury his head deep in the sand and ignore the fundamentals. He is free to live his myth and enjoy the hype instead, as long as it lasts. That being said, it will be a complete waste of time, if this type of investor reads this article. However, this type of investor has to be aware of the fact that his portfolio will most likely under-perform and he will most likely end up receiving peanuts as part of his initial investment in a grossly overvalued and highly leveraged company.

In fact, this article has another target group. It is for the prudent, knowledgeable and experienced investor who pays attention to the fundamentals before dipping his buying toes into a company. And my proven track record over the last 17 months I have been writing for SA has been accomplished exclusively by buying growth companies with healthy balance sheets and low key metrics, while shorting the hyped and the speculative plays. This is how my picks have outperformed the market, and many of them have hit triple digit returns over the last months.

Regarding Halcon, nothing has changed with its strategy and its balance sheet since 2013. The company continues following a risky strategy to grow at all costs, and it remains a highly leveraged producer with a very weak balance sheet. And it has not convinced me that it will improve substantially its balance sheet anytime soon. Halcon has a large funding gap and is spending far more than it is taking in. And my estimate is that Halcon's funding gap will not close by 2016 (to say the earliest). I know I am spoiled from Lonestar that has designed its 2015 capital spending target to be funded out of internally generated cash flow. But this is me.

After all, I will state the obvious: Halcon Resources trades with very high key metrics ($/boepd, $/boe, EV/EBITDA) at the current price of $6.7, although it has the weakest balance sheet (Net Debt/EBITDA) among all the EF producers above. No, Halcon is not the only girl in town and I steer clear of it.

Goodrich Petroleum is another grossly overvalued natural gas weighted company with a weak balance sheet, and I will not touch it with a ten foot pole at the current levels of $28.8.

Clayton Williams and Carrizo Oil are fairly valued at the current price of $127 and $63, respectively.

Last but not least, Lonestar Resources has the strongest balance sheet but trades with the lowest key metrics at the current price of $0.37 (US listing), as also shown in my previous article.

Since all fingers are not the same, some other investors are free to ignore the numbers. The markets though do not ignore the numbers for long.

Disclaimer: This article covers a stock trading at less than $1 per share. Please be aware of the risks associated with these stocks.

The opinions expressed here are solely my opinion and should not be construed in any way, shape, or form as a formal investment recommendation. Investors are reminded that before making any securities and/or derivatives transaction, you should perform your own due diligence. Investors should also consider consulting with their broker and/or a financial adviser before making any investment decisions.

Source: Halcon Resources: The High Debt And The High Key Multiples Continue Going Hand In Hand

Additional disclosure: I may initiate a short position in HK and GDP over the next 72 hours.