Even in a business whose lifeblood is borrowing, Magnum Hunter Resources Corp. (MHR) stands out.
The Houston-based shale driller owes $891 million -- about 70 times more than its earnings before interest, taxes, depreciation and amortization, or Ebitda, in the past year, according to data compiled by Bloomberg. The industry average is 4.3.
The U.S. Securities and Exchange Commission opened an inquiry last year into Magnum Hunter’s accounting that began after the company’s auditor found “material weaknesses” and Magnum Hunter dismissed the firm. Chairman and Chief Executive Officer Gary Evans also rents his plane to the company, and he’s chairman and interim CEO of another firm, GreenHunter Resources Inc., hired to handle Magnum Hunter’s wastewater.
Investors have driven the shares up 127 percent in the past year. Twenty of 21 analysts tracked by Bloomberg recommend owning the stock. Out of five wells Magnum Hunter drilled in an undeveloped corner of the Utica shale formation in Ohio and West Virginia, three can’t produce because they don’t have pipeline hookups and one was a gusher. The company and its investors are betting on more of the gushers.
“We’re guessing,” said Gabriele Sorbara, an analyst at Topeka Capital Markets Inc. in New York. “We don’t know until they drill it.”
Lenders, investors and analysts backing a driller that’s spending borrowed money faster than it comes in, with questions about its future production and potential governance issues: Welcome to the U.S. shale boom. Innovations in horizontal drilling and fracking have pushed the country to the closest it’s been to energy independence since 1987.
At the vanguard of the shale revolution are small producers such as Magnum Hunter, with a $1.6 billion market capitalization. North American drillers owe about $230 billion, up 47 percent since 2010, even as revenue fell 17 percent to $301.7 billion, according to an analysis of the 76 companies in the Bloomberg Industries North American Independent Exploration & Production Index.
“This is not a growth industry, but the only way companies differentiate themselves is by growth, and growth comes with more risk,” said Fadel Gheit, an oil and gas analyst at Oppenheimer & Co. in New York. “Everybody is popping out champagne bottles until everybody gets drunk and gets sick, but so far the party goes on.”
It’s not unusual that smaller drillers such as Magnum Hunter spend more than they make and fund the difference with bank debt, bonds, equity and asset sales, said Leo Mariani, an analyst at RBC Capital Markets LLC in Austin, Texas.
“Theoretically it can continue forever,” Mariani said. “It’s generally not seen as a major issue by investors.”
Some energy companies use Ebitdax instead of Ebitda to measure profitability. Ebitdax also excludes exploration expenses. By that metric, Magnum Hunter owes 6.8 times what it earned in the past year. The company’s amended agreement with lenders requires its debt to be no more than 4.75 times Ebitdax in the three months ending June 30, 2014, according to a company regulatory filing.
Magnum Hunter’s revenue has increased more than 17-fold since fiscal year 2008 while its net loss has widened 32-fold. The company has raised $200 million from selling land this year and will increase cash flow from new wells, Evans said in an interview. It also helped that in May the company raised $150 million in a private placement of equity from hedge fund Relational Investors LLC, which received a 15 percent stake, Evans said.
Evans, 57, once turned $1,000 into $2.2 billion. After starting his career in banking, he decided in 1985 at age 27 to start his own drilling company. He had that initial four-digit funding and hired his mother as the first employee, he said.
As the company, called Magnum Hunter Resources Inc., grew in Texas and the Gulf of Mexico, “it got to where it wasn’t any fun,” Evans said. He sold it to Denver-based Cimarex Energy Co. (XEC) for $2.2 billion in 2005.
As part of the deal, Evans couldn’t work in the industry for two years. So he helped start an investment bank called Global Hunter Securities LLC, and later cashed out. He also pursued investments in wind power and biofuels through GreenHunter.
Evans said renewable energy was too dependent on government subsidies. He shifted GreenHunter to managing wastewater from fracking, which involves blasting rocks deep underground with water, sand and chemicals to unlock oil and gas. He also took over a small driller and renamed it Magnum Hunter -- he’d kept the rights to the name in the Cimarex sale. He leased land in Texas’s Eagle Ford, North Dakota’s Bakken and the Utica shale.
The last patch excites him most, he said. In a slide show for investors decorated with a photo of a stalking leopard, Magnum Hunter calls the Utica potentially the best shale play in the U.S. The company has leased 118,000 acres there, according to a June regulatory filing.
“We’ll either drill it ourselves or we’ll be a prime takeover target for somebody,” Evans said in the interview.
Magnum Hunter said in February that one of its Utica wells pumped 32.5 million cubic feet of natural gas a day. That’s one of the biggest ever, according to Neal Dingmann, an analyst at SunTrust Robinson Humphrey Inc. in Houston.
“If they can replicate that it would be a game changer,” said Chad Mabry, an analyst at MLV & Co. in Houston.
The company is spending about $2.72 on capital projects for every dollar of operating cash flow this year, Goldman Sachs Group Inc. estimated. Losses per share will widen to 38 cents in 2016 from 25 cents this year, Joseph Stewart, a New York-based Goldman Sachs analyst, said in a May 12 report.
Moody’s Investors Service changed Magnum Hunter’s credit outlook to stable from negative and upgraded its rating on June 25, citing improved liquidity and “production visibility.”
To handle its wastewater, Magnum Hunter hired Grapevine, Texas-based GreenHunter (GRH), of which Evans owns 47 percent. GreenHunter charged $282,000 to rent storage tanks and $3 million for disposal services last year, according to regulatory filings. GreenHunter’s total revenue was $25.7 million, meaning Magnum Hunter accounted for 13 percent of its business in 2013. Magnum Hunter also paid $22,000 to rent office space and $122,000 to rent equipment from GreenHunter last quarter, the filings show.
GreenHunter shares have risen 137 percent in the past year, to $1.92.
Magnum Hunter also paid $166,000 in 2013 to rent an airplane from Pilatus Hunter LLC, a company wholly owned by Evans, according to Magnum Hunter’s annual report. In the first quarter of 2014, the payment was $70,000, a 49 percent increase from a year earlier, a regulatory filing shows. The rental price is market rate and was approved by independent directors, Evans said.
“Are you serious?” Evans said. “We’re talking about $150,000 a year on a company generating $400 million in revenues and you’re asking me about a private plane?”
Magnum Hunter reported revenue for 2013 of $280.4 million. Its 2014 revenue will be about $444 million, according to the average of 17 analyst estimates compiled by Bloomberg.
Magnum Hunter isn’t the only company with a private plane rented from an executive. Starbucks Corp., valued at $58.7 billion with stores in more than 60 countries, pays $269,297 a month to rent a plane from its chairman and CEO, Howard Schultz. Schultz repays the company for his personal use and hangar space, according to a regulatory filing.
The deals for Evans’s plane and with the wastewater management company he leads are fair, Evans said in the interview. Magnum Hunter said the costs are competitive with or better than prices available from unaffiliated suppliers, according to a regulatory filing. The relationship isn’t a conflict of interest because it’s reviewed by independent directors at both companies, and it’s common for oil and gas companies to buy services from affiliates, Evans said.
An external spokesman for Magnum Hunter said board members couldn’t be reached for comment. Directors Jeff Swanson, Raleigh Bailes Sr., Victor Carrillo and Joe McClaugherty didn’t return phone messages.
Evans’s compensation from GreenHunter was $1.23 million last year and $1.52 million in 2012, according to a regulatory filing. Evans’s compensation from Magnum Hunter was $3.16 million last year and $3.99 million in 2012, a filing shows.
During 2009, 2010 and 2011, GreenHunter also did accounting work for Magnum Hunter, according to Magnum Hunter’s amended annual report for 2011.
Last year, PricewaterhouseCoopers LLP raised questions about Magnum Hunter’s valuation of its oil and gas properties and reserves, taxes and loan agreements. Magnum Hunter fired the accountants, according to an April 2013 regulatory filing. In a letter that month, PricewaterhouseCoopers said Magnum Hunter’s financial reporting had “material weaknesses.”
The SEC opened an inquiry. Kevin Callahan, an agency spokesman, declined to comment. Magnum Hunter reviewed internal controls and plans to improve them, according to a regulatory filing. A federal judge in New York dismissed a shareholder lawsuit alleging the company misrepresented internal control and accounting problems, Magnum Hunter said in a June 24 statement. The company has won dismissals of five separate lawsuits and is working to defeat the last one that remains, it said.
The SEC requires companies to disclose transactions with company insiders so investors can assess the independence of the board, and Magnum Hunter has done so.
Still, board independence appears to be a problem for Magnum Hunter, said Nell Minow, founder and a director of GMI Ratings, which evaluates governance risks at public companies. Magnum Hunter’s payments show the board isn’t concerned about the appearance or existence of conflicts of interest, she said.
“When we see these kinds of very insidery deals, it’s hard to understand what the benefit is for shareholders,” Minow said. “Most companies that were permitting deals like that have cleaned up their act.”
Not all investors have stuck with Magnum Hunter. Randall Yurchak, portfolio manager at Insight Capital Research & Management Inc., said the possible conflicts of interest led him to sell his shares earlier this year.
“Whenever you’re in a hot industry, investors are going to give a pass to related-party conflicts and management issues,” said Yurchak, who helps manage $470 million for the Walnut Creek, California-based firm. “If the tide never goes out, you won’t know what’s going on underneath.”
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