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Given the controversy over the pollution risks from the improper handling of wastewater produced from fracking operations, I looked into GreenHunter Resources (NYSEMKT:GRH) hoping that I might find an appealing small cap energy services play. I have to say that I came away disappointed and unimpressed.
I do believe that GreenHunter is addressing a large potential market opportunity. Although wells in the Marcellus and Utica shales do not typically require as much water as those in the Bakken, the lack of disposal capacity (including haulage) has led to strong pricing.
My problem is with GreenHunter's apparent operating plan and financing woes - although I understand it takes money to make money, I don't see enough upside in the shares right now to compensate me for the risk. Speculative investors who believe that GreenHunter can grow out of its funding problems may be proven right (and have sizable profits to show for it), but I'm willing to take the risk of missing out until I see more signs of capital stability in the business.
Fluid Disposal An Important, If Underappreciated, Part Of the Process
Most readers are probably aware that a large percentage of the wells being drilled in the U.S. today require hydraulic fracturing to produce enough oil and/or gas to be economically worthwhile. Performing that fracturing requires large volumes of water, some of which flows back almost immediately (flowback) and some which flows back over time with production (produced water).
In the past, a large percentage of this wastewater has been collected and re-injected into oil and gas reservoirs to increase reservoir pressure and improve well production. When that is not an option, wellsite operators call on companies like GreenHunter to haul away and dispose of the water through Class II injection wells.
GreenHunter has 13 such wells (also called saltwater disposal wells, or SWD wells) in operation in the country, with eight in Ohio and West Virginia addressing the Marcellus and Utica shales. These are the most valuable assets for the company right now, as the tipping fees (the fee operators like GreenHunter can charge to send the wastewater down the well) in Appalachia are running about $3/bbl to $3.50/bbl, or almost six times the rate in the Eagle Ford in Texas and more than four times the rate in the Bakken in North Dakota.
GreenHunter isn't just about the SWD wells, though. The company owns a large facility in New Matamoras, Ohio, with 70K barrels of storage capacity and barge loading facilities. GreenHunter is also looking to develop a facility in Wheeling, WV that can not only store fluids and offload to barges, but also recycle wastewater. The company is also working to build up a business in modular above-ground storage (the MAG tank) as an alternative to the lined pits that are frequently used to contain drilling fluids and water at well sites.
Numerous Flies In The Ointment
Although I do believe that wastewater disposal is an important part of the well drilling and production process, I'm not sold on it as a lucrative opportunity in energy services, or at least not for GreenHunter.
First, this is not a tremendously knowhow-driven operation. It does take capital to acquire disposal wells and trucks, but I don't see how a company like GreenHunter will be able to create economic or competitive moats. Energy service companies like Basic Energy Services (NYSE:BAS), Key Energy (NYSE:KEG), and Nabors (NYSE:NBR) already have sizable fluid trucking fleets that bring fluids to wellsites, and Basic has already started expanding into the wastewater management side of the business. Neither Basic nor Key are particularly focused on Appalachia at present, but I am not sure there is any real impediment to competition in this space other than access to capital, and all of these service companies can beat GreenHunter there.
Speaking of capital, getting enough of it has been a real issue for GreenHunter. Seeking Alpha writer Josh Young has written extensively on GreenHunter's adventures in capital-raising and I don't want to restate his work. Suffice it to say, the company exited the third quarter with an acid test ratio of 0.47 and despite management's claim on November 12 that it expected to finalize $35 million in second lien debt "within 30 days", it's almost the end of January and that financing has not been finalized.
I also question whether the company can keep up with the times. Transporting wellsite wastewater has become a real issue with environmentalists, many of whom are up in arms about the Coast Guard's intention to allow wastewater to be transported by barge - something that would be a significant plus for GreenHunter from both a cost reduction standpoint (barge versus truck) and maximizing the value and throughput of its SWD wells. Longer-term, the move toward more onsite recycling could be an issue as well - General Electric (NYSE:GE) and Halliburton (NYSE:HAL) have both made significant strides with wellsite recycling systems that could ultimately lead to meaningful reductions in the volumes of wastewater to be handled and disposed.
Can GreenHunter Get There?
I will note that GreenHunter has logged a couple of 100%-plus revenue growth quarters, with revenue in the third quarter growing 20% from the second quarter. I will also note that operating cash flow turned positive in the third quarter. Even so, though, the company is still some distance from being able to cover its internal capex needs and the difficulty the company is having raising capital leads me to question whether the returns on the growth capex will be economical in the long run.
The Bottom Line
The last straw for me was the resignation earlier this week of interim CEO Jon Hoopes. With Chairman Gary Evans taking over in the interim, that brings even more potential conflicts of interest into the picture (Evans is also Chairman and CEO of Magnum Hunter (MHR)) at a time when GreenHunter really needs an experienced hand in energy services to reassure investors and creditors that the company has a workable and profitable plan.
The company's cash flow picture has me doubting that the company can raise enough capital on affordable terms to get past these growing pains and establish a profitable footprint in wastewater disposal. Likewise, looking at the current expectations for EBITDA in 2014 and giving GreenHunter the benefit of the doubt (a higher-than-peer multiple of 7x) suggests a fair value around $1 - not nearly enough reward to interest me given the current risks.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.