I’ve always wanted to visit Alaska but have never found the right occasion to take the lengthy flight from the East Coast.
My opportunity finally came in mid-July when a large FedEx package containing a tackle box arrived at Energy & Income Advisor’s global headquarters in Alexandria, Va. Inside the tackle box was an invitation to an analyst day hosted by Miller Energy Resources (NYSE: MILL) at the Hilton in Anchorage and the company’s nearby oil development on Cook Inlet. The agenda also included a salmon-fishing excursion on the nearby McArthur River.
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The invitation to attend Miller Energy Resources’ facilities included an offer to cover my round-trip airfare and two nights’ stay at the Hilton in Anchorage, as well as meals, cocktails and transportation related to the event and bait and tackle for salmon fishing.
I informed the event’s organizers of our policies regarding editorial independence and was assured that acceptance of their invitation to tour Miller Energy Resources’ facilities would not obligate Energy & Income Advisor to mention or recommend Miller Energy Resources’ stock.
Although management outlined the bullish case for Miller Energy Resources’ prospects, I never felt pressured to shill for the stock in my conversations with the management team, the company’s employees and the other analysts in attendance.
Site visits and face-to-face meetings with analysts and management teams are an important part of our work and help us to keep abreast of trends in the energy sector. We usually pay for these trips ourselves or our company, Capitalist Times LLC, foots the bill. Whenever companies pay for these visits, we disclose this fact as part of our commitment to transparency and independence.
Miller Energy Resources operates in two areas: the Appalachian region of eastern Tennessee and the Cook Inlet region of Alaska. Cook Inlet accounts for about 87 percent of the firm’s annual hydrocarbon production and 98 percent of reserves.
Our site visit began at 8:45 am with a half-hour plane ride southwest of Anchorage to Trading Bay. The map below shows the region and the crude-oil pipeline that parallels the shoreline.
Source: Bloomberg, Energy & Income Advisor
On Jan. 1, 2012, Chevron Corp (NYSE: CVX) sold this pipeline and associated fields in Cook Inlet to Hilcorp Energy, a company that billionaire founder Jeffrey Hildebrand built into one of the largest privately held US oil and gas producers. From the window of the tiny taxi plane, we saw several offshore oil and gas platforms.
Source: Elliott Gue
Sixteen platforms operate in Cook Inlet, the oldest of which, XTO A, was installed by Shell in 1964 and the newest of which, the Osprey, commenced operations in 2000.
Much like the shallow-water Gulf of Mexico and other mature oil- and gas-producing regions, the major integrated oil companies explored and developed Cook Inlet decades ago and gradually divested their operations in the region as hydrocarbon output waned.
Today, Apache Corp (NYSE: APC) owns 850,000 acres onshore and offshore in the region and is one of the Cook Inlet’s most active operators. Like many other producers in the region, Apache’s strategy involves using contemporary technologies to identify and exploit hydrocarbon deposits that the majors may have missed in the 1950s and 1960s.
Cook Inlet had become somewhat of a forgotten play in the late 1970s, when the major integrated oil companies shifted their capital spending and attention to the massive reserves in Prudhoe Bay, one of North America’s largest conventional oil fields. (We discussed the history of oil production in Prudhoe Bay in Basic Training: US Oil and Gas Trusts.) This history increases the likelihood that Cook Inlet contains some untapped oil and gas reserves.
Although Cook Inlet is unlikely to surpass its peak production of about 230,000 barrels of oil equivalent per day, recent activity in the area suggests that hydrocarbon output will continue to improve from its nadir of 12,000 barrels of oil equivalent per day.
This map from the Alaska Division of Natural Resources tracks exploration and development activity in Cook Inlet over the past few years, including the efforts of Cook Inlet Energy LLC, a wholly owned subsidiary of Miller Energy Resources.
Trading Bay is remote. Our small taxi plane landed on a dirt and gravel runway. A small supply shed located next to the airstrip was recently mauled by a bear. Although I didn’t encounter any bears on this part of the trip, the animals are ubiquitous in the region; another truck traveling in our convoy spotted two bears ambling along the road.
The weather is more of a challenge to the region’s oil and gas operations than the wildlife, however hostile the bears were to this particular supply shed. Whereas temperatures were comfortable for the duration of my visit, the weather turns frigid in October and the snow begins to fall. As one Alaskan quipped, “It doesn’t snow much in this part of the state, only 10 to 20 feet or so per year.”
Our convoy’s first stop was Miller Energy Resources’ West McArthur River Facility, where the company has a handful of onshore wells, as well as associated pipelines and storage tanks. With no electric grid in this remote area, the company relies on produced natural gas to fire turbines and power its operations.
Miller Energy Resources ships its excess natural gas to Anchorage via a pipeline owned by Hilcorp Energy. Unlike the Lower 48, Alaska doesn’t face a surfeit of this commodity, ensuring that the producer usually receives a premium for its output relative to the prevailing price at the Henry Hub, the delivery point for the natural gas that trades on the New York Mercantile Exchange. In a recent investor presentation, the company indicated that this premium ranges from 100 percent to 400 percent.
The most esciting part of our visit to the West McArthur River Facility was checking out Patterson-UTI Energy (NSDQ: PTEN) rig that’s drilling the Sword-1 well.
Source: Elliott Gue
The 1,500-horsepower rig was idle while we were onsite; the crew switched from a water-based drilling mud to an oil-based one. Selecting the appropriate drilling mud is critical to safely extracting hydrocarbons. When an operator drills a well, the internal reservoir pressure propels the oil and gas toward the surface. Without proper pressure management, the well would spew hydrocarbons uncontrollably; pumping so-called drilling mud into the well during the drilling process counterbalances these geological pressures, preventing a blowout. Equally important, the mud cools the drill bit and sweeps away rock cuttings.
Source: Elliott Gue
As this display in the doghouse (a small, steel enclosure on the rig) indicates, the Sword-1 well had reached 10,156 feet–roughly half the planned depth. Both the drilling crew and Miller Energy Resources’ management team indicated that the well would be completed sometime in September, at which point the rig would move to one or two other well sites in the area.
Source: Elliott Gue
Workers at the site indicated said they’d seen signs of hydrocarbons during the drilling process–not a surprise given that Sword-1 is located in a well-explored area that already includes several producing wells. Management expects Sword-1 to yield between 500 and 600 barrels of oil equivalent, with crude accounting for the majority of this volume.
At this point in the tour, we received some disappointing news: Steadily deteriorating weather prompted the crew on the Osprey platform in Cook Inlet to put a stop on helicopter flights from the shore to the facility.
Instead, our convoy drove to the Kustatan facility, which handles all the volumes extracted from Miller Energy Resources’ offshore Redoubt Shoal field. Connected to the Osprey platform by a series of pipelines (first photo below), Kustatan separates the crude oil, natural and water into discrete components (second photo below).
Source: Elliott Gue
Source: Elliott Gue
Pipelines transport the separated crude oil for eventual shipment to end-markets via barge, while the natural gas not used to generate electricity onsite is sold. The water, on the other hand, is pumped to the Osprey platform and re-injected into the reservoir to maintain pressure and productivity.
The offshore wells served by the Osprey platform represent Miller Energy Resources’ best growth opportunity in the near term. The firm in December 2009 acquired this facility and the surrounding acreage from the bankrupt Pacific Energy Resources for $2.5 million in cash and $2.22 million in contract-cure payments, bonds and other considerations.
This transformative deal included assets that account for almost 90 percent of Miller Energy Resources’ annual hydrocarbon output. Prior to this acquisition, Miller Energy Resources was a tiny bulletin board-listed stock that fetched less than $0.70 per share.
Miller Energy Resources made out well in this distressed sale, taking advantage of Pacific Energy Resources’ weakened financial state and the 2008-09 collapse in commodity prices. Only two years earlier, Pacific Energy Resources had purchased these same assets from Forest Oil Corp (NYSE: FST) for about $464 million.
When Miller Energy Resources acquired these Alaskan assets, most of the wells had been shut in and weren’t producing hydrocarbons. In subsequent years, the company has worked over some of these older wells to enhance output. For example, the firm in 2012 replaced the electric submersible pump (ESP) in the RU-7 well and removed materials that impeded the flow of oil and gas into the well. These efforts boosted production to a peak of about 250 barrels of oil equivalent per day from about 100 barrels of equivalent per day and reduced the decline rate to between 10 percent and 12 percent from 27 percent under the previous operator.
Miller Energy Resources’ recent drilling results at the RU-2A well are also encouraging. This workover involved plugging and abandoning the last few thousand feet of the initial well and drilled an entirely new lower portion. In this way, the company eliminated the portion of the well where blockages and shoddy completion techniques had hampered production.
In July, Miller Energy Resources announced that RU-2A had achieved an initial production rate of 1,314 barrels of oil equivalent per day in the first 21 days after the workover. Better-than-expected results from this well sent the share price of Miller Energy Resources sharply higher.
Miller Energy Resources then used the same rig to perform a similar operation on its RU-1A well, a process that was completed on Aug. 5. Although the company likely won’t provide any hard data on the performance of this well until the end of August or early September, management expressed confidence that the results would help the company to grow its production to 4,000 barrels of oil equivalent per day by year-end–more than double its current output.
After working over and recompleting two additional wells, Miller Energy Resources will turn its sights to drilling new wells to hook up to the Osprey platform.
In the near term, initial production rates from RU-1A, Sword-1 and Olson Creek I will drive Miller Energy Resources’ stock through the balance of the year. The share price could also benefit this fall, when the company updates its reserve estimate to reflect the success of RU-2A.
Management also highlighted two unique advantages of Miller Energy Resources’ operations in Alaska.
The company has a long-term agreement to sell up to 24,000 barrels per day of its oil production to Tesoro Corp’s (NYSE: TSO) Nikiski refinery, which is on the opposite shore of Cook Inlet. Under this arrangement, Miller Energy Resources sells its production for the prevailing price of Alaska North Slope (ANS) or West Texas Intermediate (WTI) crude oil. When ANS fetches a much higher price, the company receives an ANS-indexed price; when the price differential between these two oil benchmarks narrows, the index price is weighted toward WTI.
With ANS still trading at a premium of about $4.00 per barrel to WTI, Miller Energy Resources finds itself in an enviable position.
Moreover, Alaska has enacted a favorable tax regime in the Cook Inlet to help kick-start drilling activity in the region. The state doesn’t tax crude-oil production in the region and offers a 40 percent refund of all drilling and exploration costs, a 20 percent refund of other capital costs and 25 percent of any losses. Although these incentives are unlikely to stay in place forever, these generous refunds and tax credits significantly lower the risks and costs of doing business in Cook Inlet.
At the same time, investors have ample reason to be wary of Miller Energy Resources–that’s why short interest in the stock represents about one-third of its float.
Management has a history of overpromising and under-delivering; for example, the construction and delivery of the rig that the firm has used in its offshore drilling campaign was delayed by almost a year.
Moreover, Miller Energy Resources pitched the same year-end production target of 4,000 barrels of oil equivalent in 2012, but the delayed receipt of its drilling rig ensured that its hydrocarbon output fell well short of this goal.
And in 2011 the company restated its results shortly after hiring respected auditor KPMG to go over its books. Although KPMG blessed Miller Energy Resources’ financial statements for its fiscal 2012, the auditor criticized management’s controls over financial reporting. Miller Energy Resources has taken steps to address these concerns, including increasing the number of employees in its internal accounting and audit department.
More important, Miller Energy Resources didn’t turn a profit last year and likely will post a loss in its current fiscal year, which ends in April 2014. The company only generated a significant profit in its fiscal 2010, the year the firm recorded a pretax gain of $461 million after writing up the value of its recently acquired Cook Inlet assets.
Miller Energy Resources also has significant external funding needs. On Aug. 5, the company announced an increase to its revolving credit facility with Apollo Investment Corp (NSDQ: AINV) to $100 million from $80 million. The firm also reached an agreement with its creditor that will reduce the annual interest rate on new borrowings to 9 percent from 18 percent. However, on Jan. 31, 2014, this interest rate will revert to 18 percent. Meanwhile, Miller Energy Resources’ 10.75% Series C Preferred Stock (NYSE: MILL C) currently yield 12.5 percent–another expensive source of funds.
Of course, Miller Energy Resources could also raise capital by issuing a huge slug of common stock, diluting existing shareholders. The senior management team and key likely wouldn’t be keen on this option–they own 30 percent of the company’s outstanding shares–but prospective investors shouldn’t dismiss this risk.
In addition to the company’s financial shortcomings, nitpicking critics have also alleged that CEO Scott Boruff lives a lavish lifestyle at shareholders’ expense and has misused the company’s jet.
Boruff’s base salary of $500,000 base salary in the most recent fiscal year isn’t out of line with the rest of the industry. In addition, as management pointed out at the Investor Day, much of the senior executives’ compensation comes in the form of options and restricted shares. Many of Boruff’s options carry strike prices over $6 per share. His compensation package includes additional incentives based on revenue and earnings targets and the performance of Miller’s stock relative to eight competitors. In other words, the CEO stands to make a lot more money if the stock rallied significantly from current levels.
The last series of flights I could find for the company’s Hawker Siddeley HS-125-400 twin jet (tail number N624MP) appear to be trips to Anchorage in order to attend the Investor Day conference. (You can track the airplane here.)
My take: Miller Energy Resources isn’t the sort of stock that we cover in Energy & Income Advisor. Not only does the company have a market capitalization of less than $250 million, but we also prefer names that have an established track record and a history of shareholder-friendly actions.
Investors considering any small-cap energy producer should keep in mind Mark Twain’s adage that a mine is a “hole in the ground owned by a liar.” We wouldn’t ascribe any sinister motives to Miller Energy Resources’ management team, but caution is warranted given the risks.
Shares of Miller Energy Resources could make an interesting short-term trade in light of the potential upside related to forthcoming drilling results. However, if production rates fall short of expectations, the stock (and management’s credibility) would take a significant hit. This disappointment would also make it difficult for the company to raise capital to fund its planned drilling activity.
If the company’s recent drilling program produces strong results, Miller Energy Resources’ stock could surge to between $6.50 and $7.00 per share, fueled by a wave of short covering. Investors willing to take gamble should try to get in under the stock’s recent high of $5.40 per share and should not commit a great deal of capital to the trade. Any bet on Miller Energy Resources entails significant risk; investors should be prepared to take a loss before they take the plunge.
For readers wondering about the fishing, I caught two beautiful coho (silver) salmon and look forward to the smoked salmon fillets that are on their way back from Anchorage.
Source: Elliott Gue
It was heartening to see the untamed wilderness and wildlife existing in close proximity to energy-related infrastructure and drilling activity.
Elliott and Roger on Oct. 29, 2018
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