We presented our investment thesis for Miller Energy Resources (MILL) in an article ("Miller Energy Resources Looks Massively Undervalued") back in January 2012. We would encourage readers to review that article carefully for an overview of the company.
Miller shares have doubled from their 2011 lows. In the nine months since our article came out, MILL shares have risen 70%, rewarding those who had the fortitude to hold the stock amid tremendous volatility. The logical question now: is there much upside left? We believe the answer is an emphatic "Yes!" Indeed, our conviction in the MILL investment thesis is even stronger than when we wrote the original article. Let us summarize recent developments:
- Operational Progress: As envisaged, Rig 35 on Miller's offshore Osprey platform is now fully operational. In October 2012, the company achieved a momentous milestone, the successful restart of the RU-1 well to restore production using its modern new drilling rig. Remember, these are existing once-producing wells that Miller is bringing back online. Miller is now poised to convert these already proved oil reserves into a gusher of cash flow, which alone would unlock more than $8 of value per share.
- Financial Progress: In late June 2012, Miller announced a $100 million credit facility with Apollo Investment Corp, a well-regarded institution, at improved interest rates, better repayment terms, while avoiding dilutive common stock issuance. This is in line with its record as smart capital allocators and owner-operators (inside ownership at Miller is a stellar 34% of outstanding shares). Just as significantly, in September 2012, the company demonstrated its ability to access more liquid capital markets at even more attractive rates through the issuance of Series C preferred shares. Miller's drilling plans are now well-funded.
- Strategic Midstream Assets: We visited Miller's properties in Alaska's Cook Inlet region in late July 2012 as participants in an "Investor Day" conducted by the company. We were very impressed by Miller's dedicated and resourceful personnel, and the company's modern infrastructure, which stood in stark contrast to the decrepit, near-obsolescent facilities of neighboring operators. Most importantly, the visit provided us with insight into Miller's mid-stream assets, which our previous article had not evaluated in detail. Apollo, Miller's new creditors, independently appraised the value of its midstream assets at $190 million or $4 per share. As oil and gas exploration and production activity in the Cook Inlet region revs up (more on this below), these hard-to-replicate assets will have tremendous strategic value.
Based on these recent developments, we have raised our estimate of Miller's net asset value to $12 per share. In other words, MILL shares deserve to more than double from today's levels. For further details see the valuation update section below.
Investor Day - Our Impression of Miller's Assets
In late July 2012, we participated in a site visit to Miller's Alaska properties, located in the Cook Inlet region near Anchorage, Alaska's largest city. It was very valuable for us to get to see the three primary facilities up close: the West McArthur River Unit, the Kustatan Production Facility, and the Osprey offshore oil platform.
The West McArthur River Unit (WMRU) currently produces about 750 BOE/day from its onsite wells. This represents the lion's share of Miller's production today (though it will soon be eclipsed as 4,000+ BOE per day from the Osprey platform comes online in coming quarters). More importantly, WMRU represents a 'home base' of sorts, providing a state-of-the-art control room from which Miller personnel monitor and control all its facilities through a graphical user interface. Additionally, WMRU provides living accommodations, kitchen, cafeteria, and a helicopter pad. A key takeaway for us was that these mundane aspects of the WMRU have become an important part of the fabric of the local oil and gas industry. While we were there, the WMRU cafeteria was buzzing with personnel from other industry players such as NordAq. As other industry players ramp up their Cook Inlet presence, Miller will reap benefits by providing services such as hosting/accommodations, and serving as a general contractor for road construction.
The Kustatan Production Facility (KPF) was perhaps the most eye-opening part of our visit. Built in 2002, KPF appealed to us as well-designed, modern asset. Much of the oil produced in the Cook Inlet is laden with water and sediment which need to be separated. The so-called "water cut" can exceed 90% water (though Miller's aren't that high). The output oil needs to be at purity levels to meet pipeline specifications. The separated water can be re-used for injection into oil wells in the extraction process. Also, oil concentrations in any water effluent must be reduced to microscopic levels to meet strict environmental criteria. This requires heavy-duty equipment to pump, heat, and separate fluids. KPF is equipped to process as much as 50,000 BOE per day! Even once Miller's offshore and offshore wells are producing at peak levels, there will be plenty of capacity left to serve other oil and gas producers in the area. KPF also has significant power generation capacity. In addition to providing electric power to the Osprey offshore platform and WMRU, it has plenty of surplus capability to sell to others. KPF also has storage tanks with capacity of more than 50,000 barrels.
On a separate note, Kustatan also happens to be the first location where Miller deployed its new onshore rig ("Rig 34"). While this well achieved some success, it is likely that it will be utilized as a "disposal well" for waste products. Miller has other such "grind and inject" disposal wells that are becoming lucrative midstream assets for the company. For example, the company charges other operators $250 per barrel for disposing of drilling waste products and recently signed a cuttings disposal contract with Nabors that is already yielding profitable revenues. Miller is the lowest-cost option for many local operators. Overall, visiting KPF convinced us that we needed to raise our estimate of Miller's net asset value to give due credit to its midstream assets.
We arrived at the Osprey via a short helicopter ride. The Osprey offshore platform, located 3.5 miles southeast of KPF (and connected to it by pipeline) is Miller's best-known asset. Originally deployed a decade ago, the Osprey is still the newest offshore platform in the region. It became clear to us that the platform's sophisticated, adaptable design enabled it to handle a large number of wells. Before the credit crisis forced the overleveraged previous owner, Pacific Energy, into bankruptcy, the Osprey platform was producing nearly 5,000 BOE per day! It was designed for up to 21 wells and 25,000 BOE per day, so there is plenty of capacity. Indeed, the most compelling part of the Miller investment thesis is that we are not hoping on a geological lottery ticket - the oil is down there, and was being produced just a few years ago! (Actually, one of the wells on Osprey, RU-7, has been in production for months). But other production needs to be restored by reworking the wells.
To maximize operational flexibility, Miller opted to build a new rig (known as Rig 35) for use on the Osprey platform. At a cost of more than $20 million, Rig 35 has been the key driver for Miller's capex budget recently. However, due to severe weather and contractor time overruns, the deployment of Rig 35 was delayed by several months. This was a serious disappointment for investors, who perceived that Miller's management had "overpromised and underdelivered", and undoubtedly weighted on Miller's share price. But finally, construction of Rig 35 was completed in July. (A few weeks after our visit, Rig 35 received final approvals from the state of Alaska and began its drilling program). Miller management now has the opportunity to rebuild its credibility by executing effectively on its drilling schedule, as indicated in its latest operational update call discussing the successful restart of the RU-1 well on Osprey.
Since our previous article, Miller's third-party reserve consultants have increased the value of their reserve estimates. The primary driver of the increase was the change in benchmark oil prices. In March 2012, the company announced that it had executed a new contract that obtained Alaska North Slope (ANS) pricing for its Alaska oil, replacing West Texas Intermediate (WTI). Since ANS prices currently substantially exceed WTI, the reserve values have increased sharply.
Let's take a closer look at Miller's oil and gas reserves. The value of these assets is represented by the so-called "PV-10" of its proven, probable and possible resources. The PV-10 is the present value of the net cash flows (discounted at 10% per annum) expected to be generated by the company's resources. Miller's Alaska reserve estimates were compiled by Ralph E. Davis Associates, a highly reputed reservoir engineering firm that has been in business since 1924.
Proved Reserves (P1):
9.0 million BOE
PV-10: $447 million
Probable Resources (P2):
8.4 million BOE
PV-10: $387 million
Possible Resources (P3):
35.5 million BOE
PV-10: $710 million
(It is noteworthy that much of Miller's exploratory activity in Olsen Creek and Otter, have already revealed resources that are not even accounted for in the P3 number above. And of course, we are altogether ignoring the company's assets in Tennessee, where it owns and operates 600 wells, and has commenced exploratory horizontal drilling in the promising Mississippian shale.)
To be ultra-conservative, let's focus only on Miller's P1 reserves, but as discussed above, let's give the company some credit for the value of the midstream/infrastructure assets. Apollo, Miller's lenders, conducted an independent appraisal of Miller's infrastructure assets, and arrived at a fair value of $190M. It is important to note that replicating a facility with the capacity of KPF today in Cook Inlet would entail more than two years of environmental studies and a cost in the ballpark of $400M. But we will use the $190M number for all of Miller's midstream assets to be very conservative.
Oil & Gas Reserves $447 million Based on P1 from 3rd Party Reserve Engineers
Midstream/Infrastructure $190 million Based on Lenders' Independent Appraisal
Net Debt and Preferreds ($38) million Based on Balance Sheet (July 31 2012)
Net Asset Value $600 million
Using Miller's share count gives us a NAV per share of approximately $12. We could argue, with considerable merit, that Miller's vast P2/P3 (and beyond) resources and the company's impressive capital allocation record mean it deserves a premium to this NAV. Also, upcoming initiatives such as the proposed trans-Foreland pipeline could slash Miller's transportation costs and thus boost its reserve values.
On the other hand, it is noteworthy that while the PV-10 calculation factors in capex, direct costs and transportation, it omits corporate overhead costs. Therefore, Miller's G&A costs represent an incremental drag. However, these will be less relevant to a well-financed strategic buyer (such as Apache or Hilcorp) that could achieve synergies with Miller's G&A structure.
On balance, $12 is a good value estimate for now. With good capital allocation and execution, the number could rise. The other aspects of the Miller investment thesis articulated in our previous article remain very much intact, and value investors should wait patiently for the expected rewards.
Catalysts - Cook Inlet Interest Heats Up
Miller's strategic mid-stream assets, and its vast acreage in Alaska become even more intriguing in light of recent developments. In mid-2011, the U.S. Geological Survey released a report indicating that thanks to improved data, and better technology, the inlet held vastly greater oil reserves than previously estimated, and as much as nine times the previously estimated gas reserves. As we detailed in our previous article, Alaska's fiscal strength, business-friendly climate, and production incentives (including 65% reimbursement of E&P expenses) make it very attractive for oil and gas producers. The Cook Inlet region is also home to the only LNG export facility in the U.S. (again, near Miller's properties). Longer-term, Miller may well be able to export its vast natural gas holdings to lucrative Asian markets, where natural gas fetches $10-$15/mcf, much higher than in North America.
Ironically, a local natural gas shortage for heating and electric power generation looms over the Cook Inlet, leading to high prices (in stark contrast to the lower 48) and producer-friendly government policies, provides a very positive backdrop for Miller. Indeed, Miller has sequenced its gas well RU-3 on the Osprey platform ahead of its subsequent oil wells to ensure it will have the natural gas it needs for its own power and heating requirements. But more importantly, the sense of urgency of the Alaska government on natural gas might accelerate the development of Miller's vast acreage in the Susitna basin. (While we are not counting on it, this could unlock value in the company's P2/P3 resources and take the stock well beyond the $12 value per share outlined above.)
Hilcorp, one of America's largest privately held oil companies, purchased Cook Inlet assets from Chevron (CVX) and Marathon (MRO) (in proximity to Miller's midstream facilities) and announced its intent to double its production in Alaska. Intriguingly, Hilcorp's recently sold off its assets in the Gulf of Mexico for $550M, giving it plenty of financial firepower for strategic actions in Alaska, including a Miller buyout. Apache (APA), whose vast Cook Inlet acreage is adjacent to Miller's own lease holdings, could well be another suitor. Apache commenced a large scale 3D seismic shoot across its properties, and expects to spud its first wells within the next couple months.
Response to Disparaging Article
A disparaging article ("This Time Isn't Different: Miller Energy Is A Short") was posted on Seeking Alpha in late September 2012. As many of the comments posted on that article effectively demonstrated, that article was a hatchet job. Still, we wanted to set the record straight on its most spurious claims.
The article begins with a scare tactic of tarnishing Miller with the bankruptcies of companies (Forcenergy in 1999, and Pacific Energy in 2009) that previously owned some of its Cook Inlet assets. The writer conveniently fails to mention that both Forcenergy and Pacific were highly indebted companies. Forcenergy had piled on $690M in debt from an acquisition spree. When oil prices hovered below $20 per barrel (!) in the late 1990s, Forcenergy just could not make the payments on its debt. There was nothing fundamentally wrong with the assets! Indeed, Forcenergy in Chapter 11 was sold to Forest Oil for $547M, and Forest Oil went on to make substantial investments in its Alaska operations, including the construction of the state of the art Osprey offshore platform. The story of Pacific Energy was similar. Pacific Energy racked up hundreds of millions in debt when it bought Cook Inlet assets from Forest Oil for $464M. When oil prices cratered and the world fell into a financial crisis in 2008-2009, Pacific Energy could not service its debt load.
The difference between these two predecessor companies and Miller today is night and day. Miller bought these assets out of bankruptcy debt-free. While the company has since taken on some modest debt (to the tune of $40M at the end of the last quarter), the proceeds are being used for a well-defined, high ROI project - bringing its proved reserves back online and into production. Also, when Miller bought Pacific's assets out of bankruptcy, it was able to cherry-pick the assets and excise away unprofitable assets, including five non-operating platforms.
This focus on increased production is especially impactful since Miller's operations have relatively high fixed costs but low variable costs. If you think about it, that's what one would expect from its extensive, highly automated yet underutilized infrastructure (see above). In several forums, Miller management has mentioned that the variable operating cost per barrel from platform is as low as $2 per barrel, which means that incremental production dramatically improve profits and cash flows.
But we don't need to take this on faith - it can be gleaned from the actual results. As an example of this dynamic of fixed vs. variable operating costs, let's look at what happened in August 2011. David Hall noted that production volume rose 44% to 46,882 barrels that month compared to the monthly average of the preceding quarter. Meanwhile, lift cost per barrel declined 29% to $23.46 per barrel. Doing the math, we can calculate that the marginal lift cost per barrel works out to be $1.72. Hall concluded, "We expect continued declines in our lift costs as we leverage the fixed costs associated with our Osprey platform."
The article also attempts to disparage the use of the PV-10 metric (which uses a 10% discount rate) as a measure of Miller's proved reserve values, arguing that Miller's borrowing costs are 18%. But you can't invest by looking in the rear view mirror. The fact is that Miller's cost of capital is coming way down (as the writer later acknowledges in the commentary about the 10.75% preferred shares). As production and cash flows grow in coming quarters, Miller's cost of capital will improve even further. It is worth mentioning that Miller's wells brought online have outperformed its PV-10 production assumptions. Also, our expectation is that Miller will eventually be bought out by a strategic buyer. So what really matters is the cost of capital of potential buyers. Based on its long-dated bond yields, Apache's borrowing rate is barely 3%. Buying Miller at $12 or even higher would be highly accretive for the likes of Apache or Hilcorp.
Ridiculously, the article tries to portray Miller - one of the best bargains we have seen - as overvalued relative to other players in the industry! The key to the writer's sleight of hand here is his use of a metric of "Enterprise Value per Barrel of Oil Equivalent" or EV/BOE. At first glance, it may seem like a reasonable measure of how much an investor is paying per unit of resource.
But it is also very wrong! All BOEs are not created equal. Oil and liquids command vastly higher prices ($100 per BOE) than dry gas ($18 per BOE). Gas in Alaska ($36/BOE) is not the same as gas in the lower 48. While Miller's proved reserves are 95% oil, the "comparison" companies the writer chooses are much more gas-centric. Chesapeake's (CHK) and Devon's (DVN) proved reserves are only 40% oil! Comparing these companies with Miller using a blunt metric like EV/BOE is like comparing apples and watermelons. In the case of Buccaneer Energy, while the proved reserve mix are more comparable, the writer blunders by missing the value of Miller's midstream assets - which equates almost to its entire market capitalization today.
While the shares have more than doubled over the last year, investors (both long-term value investors and short-term traders) may have been frustrated over the last few months by Miller's operational delays. But the company has made tangible progress, and the successful restart of the drilling program on the Osprey platform represents a breakthrough. With its net asset value of over $12 per share, Miller shares deserve to double from current levels.
KMF Investments may hold positions in the securities mentioned in this article.