HKN: A Low Risk, High Reward Oil Play

Includes: HKNI, OIH, USO
by: Jay Springate

HKN Inc. (HKN) is an oil and gas exploration and production company with operations primarily in Texas and Louisiana that I began following during the oil price decline last fall. The primary difficulty for the investor with a bullish outlook on oil is dealing with the accompanying volatility and managing risk accordingly. The strength of HKN's balance sheet makes it an ideal holding for the investor who wants exposure to rising oil prices with limited downside potential. HKN has no debt and trades at a significant discount to the value of the cash, oil and gas properties, and other investments on its balance sheet, while still providing exposure to rising oil prices.

HKN has three main assets:

  1. Cash (my favorite asset - easy to value)
  2. Oil and gas properties
  3. An equity investment in a publicly traded company

As of the 10-Q filed on August 7, HKN reported cash holdings of $12.4 million, more than half of the company's market cap of $23.86 million as of the August 7 market close.

HKN also reported evaluated oil and gas properties of $35.2 million. But here is the kicker: these properties have not been re-evaluated since the annual report was released back in January. Thus, the valuation assigned to these properties is based on oil prices of $44.60/barrel. Suffice it to say the oil resources (the bulk of the company's properties) are worth substantially more now, with oil over $70/barrel, and will be worth even more should oil climb higher, as many expect.

HKN's other key asset is an equity investment in Global Energy Development (GED), an oil exploration and production company traded on the London Stock Exchange, with operations primarily located in South America. As of the June 30 close, this investment was worth $12.2 million, but the GED stock has appreciated further since then, and as of the August 7 close in London, HKN's investment in GED is worth approximately $13.4 million. It should be noted that this equity investment is also an asset that provides exposure to rising oil prices, as GED has a similar oil exploration and production business to that of HKN (in fact the management teams of the two companies overlap somewhat). I believe a careful analysis of GED's financial statements will reveal that the GED stock itself is undervalued based on the company's own assets, but even with the GED investment valued at its market price, HKN is still clearly undervalued.

HKN does have some other minor assets (receivables, patent technology, etc.), but I will ignore them for the purpose of this analysis - they are just the icing on the cake.

With cash holdings of $12.4 million, oil and gas properties valued at $35.2 million (that are now likely worth substantially more), and a stock investment currently worth $13.4 million, HKN has real, tangible assets worth at least $61 million, and total liabilities of only $10.1 million, yielding a rough tangible book value of $50.9 million (over $5/share). And yet, as of the August 7 close, HKN had a market capitalization of only $23.9 million - less than the value of the company's cash and security holdings alone. The oil properties, which are substantial and likely undervalued on the balance sheet, come free to the investor.

Even with oil prices well below current prices, HKN generated positive cash flow from operations in the first and second fiscal quarters of 2009, indicating the company is likely to benefit from an increasing cash pile going forward. Rising oil prices would continue to increase HKN's intrinsic value, while the strength of HKN's assets should allow the company to hold up well even in the event of a decline. HKN shares have significantly outperformed both the OIH and USO ETFs since oil prices began rising early in May.

In conclusion, based on my analysis of the company, HKN shares provide a favorable risk/reward dynamic to the investor with a bullish outlook on oil. I would plan to sell shares as the company approaches the true value of its assets, near $5/share - roughly double the current market price.

Disclosure: Author owns shares of HKN.