Oil Crash Just Getting Started - Levered Under-Hedged Juniors Like Magnum Hunter In Jeopardy

Scott Brown profile picture
Scott Brown
432 Followers

Summary

  • Existing hedges and ramped-up production are keeping many juniors alive for now.
  • Too few bankruptcies and oil storage near capacity indicates we are not near a bottom yet.
  • Magnum Hunter is facing increasing costs in the midst of lower commodity prices and access to capital. Watch out.
  • If management's partnership and asset monetization strategies are not successful right away, look for Magnum Hunter to suspend preferred dividends.
  • Write downs of assets are coming which could jeopardize loan covenants, NAV, and all subordinate stakeholders.

Several months ago I wrote an article encouraging people to consider the yield and capital appreciation opportunity of Magnum Hunter (MHR) Preferred stocks. At the time, the price of oil was declining but not yet in a free-fall and most energy-related stocks were under significant pressure. The bullish thesis pointed out, among other things, that Magnum Hunter had largely transitioned away from oil and into their higher margin natural gas business. I pointed out that Magnum had historically done a good job of proving and expanding resources, raising capital, and disposing of assets in a prescient manner. The company got a nice bump from an interview with Jim Cramer who mentioned the attractiveness of both the common and preferred shares. What he didn't mention was that management isn't eating their own cooking. Management is not just net sellers of stock, they simply aren't buying…at all.

Upon examination of their latest annual filing and in light of some of management's recent decisions, I feel the need to update my original position while the preferred stocks still display significant market value. In short, I believe that the oil crash is not at all near resolution yet. Magnum did a poor job in hedging themselves for this downturn and while they have successfully negotiated a waiver in their credit agreements, they may have merely bought themselves a few months of wiggle room. In light of the lower commodity prices that the company is contending with (including the widening differential on Appalachian gas that they are receiving below NYMEX spot prices) I believe that they will soon be making the decision to suspend preferred stock dividends. In addition to the loss of income owners will suffer, they will also likely see a collapse in the share price of the preferreds.

Oil shock and awe hasn't even begun.

Oil shale has been a game changer globally, with the US nearly doubling oil production in the last six years. It used to be that the Saudis were responsible for adding to or removing the marginal production to balance global oil supply, but since the US is now the largest oil producer in the world (producing more than 10% of global daily oil production) the Saudi pricing power was being marginalized. OPEC does not like to be marginalized. While they have enjoyed the rise in prices that has accompanied global economic growth, they do not want to see their market share and pricing power vaporize due to new supply coming online. Since many of their fields are plentiful, well-known, and established, and their production costs cheap, they are the world's low-cost producers of oil. For many years they have been able to control prices by being the world's core and marginal producers. In other words, when the world's energy requirements increased, the Saudis were able to increase production to meet those requirements. When energy requirements slightly decreased, the Saudis brought that excess production offline and prices could remain relatively stable.

Saudi firing squad on shale oil

As the US began to rapidly ramp up shale oil production, the marginal pricing power increasingly shifted to the United States. The Saudis have repeatedly denied that they were targeting the US producers when they decided to maintain production in the face of a declining oil price late last year. Their decision to maintain production while simultaneously undercutting existing spot prices to certain global regions ensured that the price of oil would not recover and that the new marginal producers (i.e. US shale) would be unprofitable. Inordinate amounts of energy-related junk bond debt have been issued over the past several years to ramp up exploration and production among US junior producers and the capital raises were obviously very successful in proving up new fields. However, to date most of the producers have been able to stay afloat due to swaps and hedges and cost cutting. The risks are rising, though, and if the price of energy stays low there will be significant defaults. Rig counts are already dropping precipitously which does not bode well for expansion of production. Despite the drop in rig counts, energy production seems to be counterintuitively rising as evidenced by the chart below:

This is mainly due to the fact that oil and gas production incurs most of its cost upfront. When commodity prices go down and fixed expenses do not, marginal producers that have the ability to do so may opt to ramp up production to maintain cash flow. I can recall the chief of Chesapeake (CHK) being interviewed in the middle of the last natural gas bust. Many players in the industry viewed Chesapeake as the OPEC of US natural gas and were calling on them to reduce supply in order to cause prices to stabilize. The problem was that Chesapeake had incurred a lot of debt during their expansion and for them to reduce supply would have cut into their cash flow - putting their debt service in jeopardy. When asked if they were prepared to reduce supply to support prices they made a statement to the effect of "don't expect us to fall on our swords for the industry's health." They, instead, vowed to maintain or even increase production to stay solvent. They were selling below their development cost because they viewed the low commodity price as unsustainable. They just wanted to outlive everyone else. In their case, the strategy worked. Today's move by the Saudis is very similar to this example only we have not seen the carnage of the junior producers yet. Everyone is trying to be the last man standing and it is likely that we will see the price of crude (USO) continue to drop as we approach capacity of oil storage facilities. I do not think we will truly see oil prices bottom until the hedges that the juniors put on begin to fall off. A lot of companies will hedge a significant amount of production year to 18 months out. When those hedges expire, the end of the energy bear will be near. Watch for companies like Gastar (GST), Miller (MILL), Penn Virginia (PVA) and Goodrich Petroleum (GDP) to start looking for partners, waivers, significant asset sales, or mergers.

Strip pricing has collapsed

Since most energy producers have a mix of both oil and gas, when oil production became unprofitable to drill, gas production got ramped up. This was the strategy that Magnum Hunter employed. Unfortunately for these producers, beginning in early January the natural gas (UNG) strip pricing began to collapse as well. In this environment, companies will try to outlast each other until they simply cannot do so any longer. The low prices are unlikely to improve until significant defaults occur and consolidation happens en mass in the energy patch. Near the end of the crash I would be unsurprised to see mid-east sovereign wealth funds or state-owned oil companies enter the space as white knight saviors to many troubled companies. This would give OPEC a bargain-priced foothold in North American gas reserves where cartels are technically illegal, while simultaneously replenishing the reserves of sovereign-operated companies that have been criticized by many as being overstated.

But none of that has happened yet. Meanwhile, the world's economies continue to struggle to find growth and that puts further pressure on demand and pricing. In my opinion, we're not even close to being done with the oil correction yet.

Magnum Hunter's main strategy has been to find unproven fields, prove them through development and production, then sell them while growing BOE production. They've added value a number of ways including owning/operating their own drilling company and building a network of pipelines in the Midwest. As long as the general trend in the energy markets was stable to higher, they were able to use cash from operations, frequent capital raises, and asset monetization to grow their production profile and the strategy worked well. The problem that they face now is that they obtained much of their growth through costly leverage instead of equity. As commodity prices have fallen, they must now service this debt and attempt to grow their production profile largely with internal cash from operations. In addition, not all BOEs are created equal. Natural gas BOEs bring in significantly lower cash flow than do liquid BOEs, and gas is where Magnum Hunter has seen their BOE production grow the most. Even with recent new prolific wells having been brought online I just don't think they have the cash or the staying power to service their debt burdens.

The company has repeatedly stated that their goal is to hedge forward production at 50% and opportunistically more when available. When I wrote my previous article, I was confident that they had done so. In fact, even as late as January they had the opportunity to sell a $4+ 2015 strip. Today that pricing is near $2.75 and threatening to decline further. The company, as it turns out, was - and is - only 20% hedged on natural gas production for 2015. Their oil production is nearly completely unhedged. Foolish, in my opinion, especially since they have bragged about their production costs being near $2 in Appalachia. A $4 hedge would have been very prudent. I'm sure management feels the same in hindsight.

Average Realized Prices (U.S. Dollars)

Year Ended

Three Months Ended

Year Ended

December 31, 2013

March 31, 2014

June 30, 2014

September 30, 2014

December 31, 2014

December 31, 2014

Oil (per Bbl)

90.04

83.14

97.13

90.55

58.79

83.53

Natural gas (per Mcf)

4.07

5.56

5.13

3.43

2.87

4.19

NGLs (per BOE)

43.61

57.19

55.71

41.29

38.05

48.04

According to their 2014 annual report, Magnum Hunter realized an average sales price of $83.53 per barrel of oil and $4.19 per natural gas Mcf last year. With those prices, they generated approximately $175 million in EBITDA. Current spot prices show crude around $42 and gas around $2.70 (less differentials). Giving the company the benefit of their projections of 32,500 BOE/day and assuming that the bulk of those BOEs are natural gas a quick back-of-the-envelope estimate would suggest 2015 revenues of about $175 million plus subsidiary contributions. Unfortunately, the company's interest on their debt burden has grown exponentially.

Contractual Obligations

Total

2015

2016-2017

2018-2019

After 2019

Long-term debt (1)

$

961,388

$

10,770

$

18,077

$

329,716

$

602,825

Interest on long-term debt (2)

456,898

87,448

174,386

168,144

26,920

Gas transportation and compression contracts (3)

120,514

11,567

23,158

23,134

62,655

Asset retirement obligations (4)

26,524

295

9,536

2,769

13,924

Operating lease obligations

1,039

502

360

177

-

Drilling rig installments

5,200

5,200

-

-

-

Contribution to Eureka Hunter Holdings

13,300

13,300

-

-

-

Total

$

1,584,863

$

129,082

$

225,517

$

523,940

$

706,324

According to their annual report, they have $129 million of interest, debt repayments, and contractual obligations coming due in 2015. This figure does not include the dividends on the C, D, and E preferred stock which amounts to roughly $36 million. When added together, the company has approximately $165 million of fixed expenses next year without taking into account cap-ex, general admin and expense, or any other overhead cost. In the past they have covered their shortfalls through asset sales and capital raises. Though the company is hoping to close on some non-core asset sales, it is questionable what value those sales would bring in this depressed commodity environment even if they were to be successfully closed (likely fire sale prices). It is even less likely that a capital raise would be successful at any reasonable interest rate or non-dilutive price. Even if they wanted to try a capital raise, the credit facility might not allow it to occur:

The New Credit Agreement contains negative covenants that, among other things, restrict the ability of the company and its restricted subsidiaries to, with certain exceptions, (i) incur indebtedness, (ii) grant liens, (iii) make certain payments, (iv) change the nature of its business, (v) dispose of all or substantially all of its assets or enter into mergers, consolidations or similar transactions, (vi) make investments, loans or advances, (vii) pay cash dividends, unless certain conditions are met, and with respect to the payment of dividends on preferred stock…

The company has pledged nearly all of their assets to their new fully-drawn credit line, which further restricts the company's financial flexibility and adds risk to all existing stakeholders. Per the annual report:

The second lien credit agreement provides for a $340 million term loan facility secured by, subject to certain exceptions, a second lien on substantially all of the assets (excluding undeveloped leasehold acreage) of the company and our restricted subsidiaries. The entire $340 million second lien term loan was drawn on October 22, 2014. We used the proceeds of the second lien term loan to repay amounts outstanding under our revolving credit facility, to pay transaction expenses related to the new credit facilities, to fund operations in the Marcellus and Utica Shale plays in West Virginia and Ohio and for working capital and general corporate purposes. Amounts borrowed under the second lien term loan that are repaid or prepaid may not be re-borrowed.

The company was not in compliance with the covenants in the senior secured revolving credit facility as of the end of the year and needed to obtain a waiver to stay in compliance with financial ratios. In order to stay complaint it is likely that the company will need to finalize some asset sales prior to the end of June. While this may happen, the annual report admitted that "while the company is currently evaluating the monetization of certain of our assets, market factors, including further declines in the prices of oil and natural gas, may result in postponement of such asset sales. "

Additionally, the company will need to satisfy certain reserve ratios with both the senior secured and the second lien facilities that may be in jeopardy when the assets are written down at the end of 2015 (baring a sharp recovery in commodity prices, this will happen). Per the annual report:

With respect to the 2014 PV-10 value… the estimated future production is priced based on the 12-month un-weighted arithmetic average of the first-day-of-the-month price for the period January through December 2014, using $94.99 per barrel of oil and $4.31 per MMBtu and adjusted by lease for transportation fees and regional price differentials.

…A sustained decline in oil or natural gas prices might result in substantial downward estimates of our proved reserves. Our revolving credit facility and second lien term loan agreement contain financial covenants based on our levels of proved reserves and proved developed and producing reserves. In addition, the borrowing base of our revolving credit facility is based, in part, on our proved reserves. Reductions in our estimated proved reserves could result in our failure to satisfy these reserve coverage ratios, which could result in an event of default under the revolving credit facility and second lien term loan agreement, and could result in a reduction of our borrowing base under our revolving credit facility.

We review our oil and gas properties for impairment annually or whenever events and circumstances indicate a decline in the recoverability of their carrying value. Once incurred, a write-down of oil and gas properties is not reversible at a later date even if oil or gas prices subsequently increase.

The write downs, of course, are not unique to Magnum Hunter. They will be affecting nearly every oil and gas company in North America. Just one more thing to watch out for when investing in the juniors today.

I've admired Magnum Hunter's management for a long time, and I believe that they have executed their growth strategy well for a stable to rising commodity price environment. But their strategy is being severely tested in a falling commodity environment. Management has a few cards up their sleeves but if those cards do not play out as they hope or expect them to, Magnum Hunter will be in a very difficult situation. Whether their strategy is effective or not is largely contingent upon where commodity prices are headed over the next six to 12 months. It is my opinion that they will stay low or are even headed lower, and this will make Magnum Hunter's growth strategy nearly impossible to execute. The company is over-levered, under-hedged, and highly dependent upon asset sales and access to the capital markets in a very depressed environment for their continued success. I believe they made a crucial error in not hedging their gas exposure when prices were favorable to do so and now their leverage is haunting them. An investment in Magnum Hunter today is merely speculation. In my opinion, now is not the time to have any exposure to Magnum Hunter. Not their debt nor their common nor their preferred equity. If the company is able to successfully monetize their pipeline assets to pay down debt or if commodity prices significantly rise from these levels, I would suggest that my thesis may be wrong and the company could then potentially make a reasonable speculation. Otherwise, there is exceptional risk in Magnum Hunter (and many levered juniors) at these levels. Most people would be wise to follow the lead of Magnum Hunter's management and avoid the investments for now.

Editor's Note: This article covers one or more microcap stocks. Please be aware of the risks associated with these stocks.

This article was written by

Scott Brown profile picture
432 Followers
Scott has been involved in the financial services profession for more than 18 years. He has enjoyed studying market gurus as well as non-traditional newsletter writers and bloggers while benefiting from extensive and varied reading. He has worked both as a retail broker and as a representative of investment advisers and also has an extensive background in insurance products and annuities. His primary focus is on high-yielding income strategies.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Clients of author's firm may own positions in any or all of the securities mentioned above and may increase or decrease positions at any time. This article should not be construed to provide individual investment advice.

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