Halcon Resources: Considering Fir Tree's Proposal

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About: Halcon Resources Corporation (HK)
by: Elephant Analytics
Summary

Fir Tree is pushing Halcon to explore a sale of the whole company and reduce G&A costs.

Halcon's fixed costs (G&A and interest) are high for its level of production.

Halcon's two-rig drilling program may result in 24,000 BOEPD in average 2019 production, while its fixed costs are more appropriate for 36,500+ BOEPD in production.

Halcon also has 53 years of base case drilling inventory (with upside to 79 years) with a two-rig drilling program.

If Halcon isn't interested in selling itself, it probably needs to outline a plan to cost-effectively ramp up production to 36,500+ BOEPD.

Fir Tree Partners is pushing Halcon Resources (HK) to explore a sale of the company and reduce its G&A expenses. I largely agree with Fir Tree's points as Halcon is not receiving credit from the market for the value of its acreage and has a high level of fixed costs for its current and projected near-term production levels. It also has a very high amount of drilling inventory given its decision to go down to two operated rigs after oil prices declined in late 2018.

While Halcon has plenty of liquidity after its water infrastructure sale, it will slowly bleed cash due to its fixed costs (interest and G&A) unless it can boost production to appropriate levels for those fixed costs. Therefore, if Halcon isn't interested in exploring a sale, it needs to outline how it can get production up to the 35,000+ BOEPD range quickly and cost-efficiently and/or reduce its fixed costs while going with slower production growth.

High Level Of G&A Per BOE

I agree with Fir Tree that Halcon's current level of G&A is too high for the company given its level of production. Halcon is planning on operating two rigs during most of 2019, which helps with its cash burn (compared to previous plans for running three to three and a half rigs in 2019) but also means that its fixed costs will remain elevated on a per BOE basis.

If Halcon can average 24,000 BOEPD during 2019 with a two-rig program, then $40 million in cash G&A will translate into around $4.57 per BOE. The slower rate of production growth also means that it will take longer for Halcon's production to reach the level it needs to get cash G&A down to a more reasonable amount per BOE. I'd consider under $3.00 per BOE to be reasonable for cash G&A, and Halcon would need production to reach around 36,500 BOEPD to reduce cash G&A to $3.00 per BOE at $40 million per year. Alternatively, with 24,000 BOEPD in average production, cash G&A would need to be reduced to $26 million to achieve that $3.00 per BOE benchmark.

Interest Costs

Interest costs per BOE are also an issue with Halcon with its reduced production growth rate. Halcon's liquidity situation has been significantly improved by its water asset divestiture, so that isn't a concern at the moment. However, at $42 million per year, Halcon's cash interest costs would be around $4.80 per BOE at 24,000 BOEPD in production.

This means that Halcon's fixed costs (cash G&A and interest) are probably over 25% of its revenues at strip prices and 24,000 BOEPD in production.

A Huge Amount Of Inventory

With a two-rig drilling program, Halcon is left with a huge amount of inventory. It previously noted that it had 53 years of inventory while running three operated rigs. This increases to 79 years with two operated rigs.

Source: Halcon Resources

This does include upside locations from the Avalon Shale and 1st and 2nd Bone Spring that haven't been derisked yet. However, even if only the derisked 3rd Bone Spring and Wolfcamp locations are included, Halcon would have around 52 years' worth of inventory with a two-rig drilling program.

Acreage Value

The challenge right now for Halcon is that the market is giving minimal value for its acreage, so holding on to all that inventory isn't doing it much good at the moment.

Source: Fir Tree

If Halcon isn't interested in exploring a sale of the whole company, then it probably would be best served by attempting to sell some of its acreage and then using the funds from that sale (and its available liquidity) to rapidly grow production to a point where its fixed costs aren't such a burden per BOE. At 36,500 BOEPD in average production, its fixed costs would be reduced to around 17% of revenues (from 26% at 24,000 BOEPD) assuming that its interest costs don't increase.

A sale of Hackberry Draw in its entirety may not work since that would also reduce its production significantly, leaving it further away from the level it needs to support its fixed costs properly. However, if it can sell some acreage with minimal production that would be more ideal.

Conclusion

Fir Tree highlights some important issues with Halcon, such as its high G&A costs relative to its level of production. Halcon also has significant interest costs, so relatively slow production growth will lead to it bleeding a lot of money towards fixed costs.

Fir Tree is pushing Halcon to explore a sale of the whole company. If Halcon is not interested in that, it needs to outline how to cost-efficiently grow production to a level that is more appropriate for its fixed costs. This may involve selling some acreage with minimal production, as Halcon has more drilling inventory than it can effectively use at the moment. With improved oil takeaway options and gas treatment costs in the second half of 2019, that would be a good time for a significant production ramp up if Halcon goes that route.

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.