A Look At Halcon Resources' Warrants

| About: Halcon Resources (HK)

Summary

Halcon should benefit considerably from any OPEC agreement to reduce output as its hedges become much weaker in 2017.

It needs around $55 to $56 oil to maintain production levels without hedges, so a faster rebalancing will reduce Halcon's cash burn or production declines.

Halcon's warrants are a decent way to play an oil rebound as their implied volatility appears a little low.

I estimate that the warrants should be worth closer to $3 if the implied volatility increases and Halcon's share price reaches the midpoint of my previous estimates.

There is some risk from Halcon adding equity (for acquisitions or its capital expenditure budget) at prices lower than the warrant strike price.

Halcon Resources (NYSE:HK) is a company that should benefit well from OPEC's plans to reduce output if those plans actually get implemented and enforced. Halcon's hedges become much weaker in 2017 and it has an unhedged breakeven point around $55 to $56 oil, so continued oversupply and mid-$40s oil would either result in Halcon reducing production some more or incurring additional debt. OPEC's output agreement should significantly move up the timeline to reach a supply and demand balance, though.

Output Reduction

OPEC's reported agreement to cut output by up to 0.7 million barrels per day will help speed up the supply/demand rebalancing by up to seven months based on demand growth of approximately 1.15 million barrels per day during 2017. This benefits Halcon a fair amount since it has strong hedges remaining for 2016, but much weaker hedges in 2017. Halcon's unhedged breakeven point is estimated at approximately $55 to $56 WTI oil, so a prolonged period without a supply/demand rebalancing would cause it to burn cash and/or accept production declines to mitigate cash burn.

Halcon's Warrants

Halcon's unsecured noteholders and convertible noteholders received warrants that expire on September 9, 2020, with a strike price of $14.04. It appears that there is a total of 4.5 million warrants, of which 3.6 million went to the unsecured noteholders and 0.9 million went to the convertible noteholders.

I've previously mentioned that the warrants would potentially add one to two cents on the dollar to the value of the notes. At the most recent warrant price of $2.00, the warrants add around 1.1% recovery to the unsecured notes, which is just within my estimated range. However, I do think that the implied volatility for the warrants might be a little low and that there could be some value there.

Running the numbers (at an $8.77 share price and a $2.00 warrant price) through a Black-Scholes calculator indicates that the implied annualized volatility is approximately 46% to 47% currently, which seems a little low. Excluding the first couple days of trading, the post-restructuring Halcon shares have been somewhat less volatile than Whiting Petroleum (NYSE:WLL), which has an implied volatility of around 70% to 75% on its 2018 LEAPS. Whiting's debt makes up a higher percentage of its enterprise value, which contributes to its higher volatility.

Allowing for a lower volatility for Halcon's longer-dated warrants due to the length of term and also adjusting for Halcon's slightly lower day-to-day volatility may result in a 50% to 55% implied volatility being a more accurate estimate. This would result in a value of approximately $2.23 to $2.58 for Halcon's warrants, based on its current share price. This is around 12% to 29% above Halcon's current price. If you combine a 50% to 55% implied volatility with the $9.63 midpoint of my estimated valuation range for Halcon, the warrants should be worth around $2.70 to $3.07.

Acquisition Financing

Halcon mentioned in its presentation that it intended to finance acquisitions more through equity this time around, which makes sense given that accumulating too much debt ended up forcing Halcon into restructuring before. Adding acquisitions through equity may reduce Halcon's ability to go above the warrant strike price of $14.04, though. Much depends on whether the acquisitions end up being worth more than what Halcon pays for it. But generally speaking, financing acquisitions with equity worth $9 per share would cause Halcon's stock to become more anchored towards a $9 price. Equity would increase as a percentage of Halcon's enterprise value, reducing the stock volatility somewhat.

Thus it will be important to monitor what price Halcon does equity offerings or finances acquisitions with equity at. Halcon's employee options appear to be priced at $9.24 per share though, so there is incentive to make sure that any new equity is added at prices above that mark.

Conclusion

The OPEC agreement (if carried out) should improve Halcon's chances of maintaining production in 2017 without incurring significant additional debt, although it does still need prices to move a bit higher to reach the unhedged breakeven level. Halcon's warrants appear to be a reasonably favorably priced method of playing stable to improving oil prices, given the relatively low implied volatility. There is some risk of equity dilution reducing volatility (and thus affecting the value of the warrants), but overall I believe the warrants are underpriced.

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Disclosure: I am/we are long HK.

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.

Additional disclosure: Also long HK warrants.