Summary
- Announcement of pipeline and splitter project is transformative for GreenHunter Resources.
- Pipeline to significantly reduce the cost of brine water disposal for producers by 50%.
- No capital required from GreenHunter for the pipeline construction due to creative deal structure with private pipeline company.
- 2016, 2017 earnings could potentially value GreenHunter at nearly $1B.
- Current price target $5.
On June 30th GreenHunter Resources (NYSEMKT:GRH) announced a game changing pipeline and splitter project for Southwest Pennsylvania and Northern West Virginia. The company and their partner, Major Pipeline LLC (a private pipeline and midstream asset operator from Grand Rapids, MI), have begun the construction process of a 38 mile, 3 separate and independent pipe, pipeline. Through much planning and input with GreenHunter's major customers in the region (major customers include: Chevron, Gulfport, Stone, CONSOL/CNX, EQT, Range Resources, and XTO according to the company presentation) the pipeline will be located in proximity to some of the most densely populated current and future well sites in the Marcellus.
Brine Pipeline
The brine pipeline will primarily carry brine water produced from the gas producing region to GreenHunter's barging terminal south of Wheeling, WV. Along the length of the pipe, brine drop off terminals will be located strategically for the shortest trucking hauls possible. The brine water would then be transloaded onto barges and floated to disposal sites the company operates in Southern Ohio.
Fresh Water Pipeline
Presently, access to fresh water is an issue in the area due to the lack of tributaries that can provide the massive amount of required water. The freshwater pipeline will draw from the Ohio River and deliver water to taps strategically located near legacy and future well sites. Oil and gas producers will be able to buy fresh water from GreenHunter in massive quantities for both new drilling and restimulation of old wells. This pipeline will reduce the current expensive trucking of the same water to well sites; typically, water trucks carry between 100-130 bbls at a time.
Condensate Pipeline
The condensate pipeline will carry natural gas condensates from well sites to a future condensate splitter plant located in West Virginia. A splitter plant pre-processes the gas condensates into readily usable feedstocks for both Appalachian and Gulf Coast refineries. The splitting process adds value and marketability of the product for the producer. The condensates in the pipe will contain some amount of produced water making condensate handling and processing a natural fit for GreenHunter.
Why does the multi-billion dollar industry need GreenHunter?
GreenHunter is in a unique position within the oil and gas business in the Marcellus/Utica. Producers are drilling faster than the region's water disposal companies can keep up. Many fluid management companies are ramping up capacity but it isn't as simple as finding an old well and pumping brine down the hole. The Appalachian region has challenges that are unlike anywhere else in North America. As you will see, GreenHunter is poised to be the dominant player in Marcellus/Utica fluid management by presently possessing the largest disposal capacity in the region, hiring the technical expertise that is required, and leveraging local industry experience to enhance strong business relationships.
The disposal industry in the Marcellus/Utica is still fragmented among GreenHunter, Nuverra (NYSE:NES), and many other smaller players. Currently Nuverra is the dominant water trucking/hauling player in the region with over 200 trucks on the road versus 50 trucks for GreenHunter. On the other hand, GreenHunter outpaces Nuverra in disposal capability. Our estimates show GreenHunter could exit 2014 at about 25,000 bbl/day Saltwater Disposal (SWD) well capacity versus 14,000 bbl/day for Nuverra. GreenHunter is attempting to add an additional 7 wells in 2014 to the 9 they have currently. 4 of these new wells are in various stages of work and 3 are in the queue according to the lastconference call.
The formations in Appalachia are unique
The geology of The Appalachian Basin is some of the oldest in North America. The Marcellus Shale is about 400 million years old. This compares to the Haynesville Shale ~151 million years and the Eagle Ford ~90 million years. The additional years, heat, and pressure have created some of the tightest rock with the lowest porosity of any play, which poses a unique challenge to producers. This extremely tight formation and low porosity makes brine disposal equally challenging.
The average disposal well in North America can handle 20,000-25,000bbl/day but the average Appalachian disposal well (technically, many/most disposal wells aren't actually into the Marcellus but the formations of most usable SWD wells are Clinton, Clinton-Medina, Oriskany, etc) handles less than 1,000bbl/day. Commercially viable disposal wells are extremely sparse in the region. Pennsylvania hosts only 2 commercial SWD wells, West Virginia 17 WDs, and Ohio about 200 SWDs (many of which are not in the fairway of production and therefore not a cost-effective option for producers) according to GreenHunter estimates. The lack of SWD capacity in the region creates a massive bottleneck and pushes the cost of disposal to multiples of the rest of the continent. On average, brine disposal cost for producers in the Marcellus is between $3.00-$3.50 per bbl, not including transport. This compares with $0.25-$0.60 per bbl for other North American plays.
The actual well injection of brine is only a fraction of the total disposal cost of brine for producers. The remoteness of many wells in the Marcellus region makes transportation the most expensive variable of brine disposal. Transport by truck from deep inside Pennsylvania to SWD wells in Ohio can take over 2 hours one-way and has cost some producers up to $15 per bbl in transport costs. Each truck load is between 100bbl-130bbl. Range Resources and Shell have both had brine water disposal expenses greater than $18 per bbl for some remote wells.
It is very important to understand what makes up the volume of water that needs disposal.
Frac Water
The large freshwater input of modern hydraulic frac jobs has been reported on by seemingly every media outlet in the US. 3 to 5 million gallons is the current estimate for each shale well drilled. This water is used in the frac, then flows back to the surface where it is recovered. After flowback, it is either recycled or it is disposed of. GreenHunter, Halliburton, Nuverra, and many other companies have methods of recycling this water for future use. Only about 10% of GreenHunter's disposal volumes are flowback water according to the company's corporate presentation.
Produced Water
The shale formations that hold oil and gas deposits also hold millions of barrels of salt water. For every barrel of hydrocarbons produced there are 3-5 barrels of brine water produced along with it. Producers must then separate the mix of gas, oil, NGLs, and condensates, from the salt water/brine prior having the brine trucked to be recycled or to a SWD well for disposal. In Appalachia, the removal of brine is currently completed nearly 100% via truck. 90% of GreenHunter's disposal water volume is this produced water from the formation.
Truck traffic, congestion, noise, and pollution have become a major issue for many of the small towns throughout the Marcellus. Studies have found that it can take 600+ one way truck trips to drill a major well, start to finish.
GreenHunter's disposal expertise and assets carry a lot of weight in the region. Even when 3rd parties assume responsibility for hauling the water, the potential for a public relations and business nightmare still exist for the major players in the oil and natural gas business.
Producers are keenly aware of the risks associated with improper disposal practices. The risks are similar to the drilling of a new oil and gas well itself. Usable/drinking water table damage, spills, truck accidents, and earthquakes all pose risks to the producers. GreenHunter has built a strong reputation with years like 2013, when they didn't have a single transportation incident.
The fear of a major earthquake caused by injection into an unstable geological formation is of utmost concern within the oil and gas majors. This makes professional and expert disposal paramount. There are hundreds of thousands injection/disposal wells in the country that have operated without issue since the advent of drilling (even hydraulic fracturing has been going since the 1940s). The consequences of one mistake (or one coincidental seismic event) has the potential to be disastrous.
"Basement wells" are extremely deep wells that reach into the rocks below the shale formation where the brine was originally produced. These layers of rock are believed to be littered with fractures and faults but are so deep that they are rarely studied. Scientists and geologists in multiple regions of North America have tried to link earthquake swarms to these basement injection sites. More research is ongoing but the jury is still out on whether these earthquakes were definitively linked to the injections. In any case, basement wells are the 3rd rail of the disposal industry.
Opportunity Details
The big question now is what does pipeline, splitter, barging, and increased disposal do for GreenHunter's income statement going forward? We can assemble most of the variables into a basic model for the years 2016 and 2017.
The company has stated that their plan is to reduce the producers' cost of all-in disposal by about 50%. The average cost of disposal for a producer in Southwest Pennsylvania is currently $15-$16 per barrel of brine. We are going use the above math and assume that GreenHunter is going to charge $8 to go from pipe to disposal. Based on the contracted minimum of 450,000 bbl/month, that is $3.6mm of revenue per month or $43.2mm per year. This should be at or above 30% gross margins based off of the known costs of pipeline throughput fee, disposal, and an estimate of barging costs.
The fresh water pipeline is more of an unknown from a revenue perspective. We know GreenHunter has to pay Major Pipeline $3.50 per barrel of fresh water and deliver 300,000bbls/month. I am concerned about the sheer quantity of water that must be sold by GreenHunter. I will give the company the benefit of the doubt that they have a pretty good idea who will utilize this water. I believe it is likely this water has been requested by one or more current producer customers of GreenHunter. The intended use of the water is likely a plan to drill new and re-stimulate old wells in the area which will require a large amount of water. The water requirements are so high for some activities that the Ohio River is the only option to get the volume needed. There are thousands of legacy wells in this area of the Marcellus that may benefit from re-stimulation over the next 10-20 years. I also assume a percentage of this water comes back to GreenHunter as flowback or produced water and is put back into the brine pipe to be disposed. My model estimates the gross margin to be at 5%-10%. If the minimum quantity is sold each month, this produces an income stream of $50k-$100k per month.
The condensate pipe and splitter may be the most transformative pieces of the entire project. Condensates in the Marcellus typically carry lower prices versus Bakken or Eagle Ford condensates because of higher Reid vapor pressures (essentially the measurement of how quickly the product evaporates). The condensates must be processed to stabilize and then split them into their basic products. Unprocessed condensates from the Appalachian region are only used after a refiner has depleted higher quality feedstocks (Eagle Ford Condensates). Processing the Marcellus feedstocks before shipment to the Gulf Coast adds significant value for the producers. The pipeline and splitter plant may turn out to be as important to GreenHunter as their disposal assets.
The splitter plant itself can be looked at as a mini-refinery (see more info on splitters here).
Kinder Morgan and Ergon have both recently announced multi-hundred million dollar splitter projects to increase condensate processing capacity both in Appalachia and the Gulf Coast.
The million dollar question: Where will GreenHunter get the expertise and money to build and operate this project?
The company hired Terry Clark in May of 2014 as the head of GreenHunter Hydrocarbons. According to his LinkedIn page, Clark is a 17 year veteran of Ergon. Ergon is a refiner, transporter, and marketer of oil products and is one of the largest private companies in the US. I think poaching a condensate expert from one of the largest refiners in Appalachia is a huge win for GreenHunter. Clark can build a team that can connect the deep relationships GreenHunter has established with producers, with his connections at Ergon and elsewhere.
To fund the project the company has a few options that I can see. The most obvious would be a partnership with Ergon or another refiner with deep roots in the region. I think this would be the least risky way to get the plant built and operational. Another viable option may be to partner with private equity. I am sure there are many others being considered but these two seem the most obvious. The announcement of the plan for this project should be another catalyst for the stock.
The capacity of the plant has not been announced by the company but I assume it will be close to the daily capacity of the condensate pipeline, 35,000 bbl/d. To estimate the cost of the project we can use two recently announced splitter plants. Kinder Morgan will spend $360mm on a 100,000 bbl/d capacity splitter ($3600/bbl/d) and Magellan Midstream is spending $250mm for a 50,000 bbl/d splitter ($5000/bbl/d). Using this math (utilizing an estimated capacity of 25,000-35,000 bbl/d capacity) we can estimate the cost to be in the $90mm-$175mm range depending on capacity and cost.
Marcellus condensate is currently trading about $80/bbl as of today according to Ergon. Post-split, the individual products as a whole will get a premium to the raw condensate and will be more desirable to refiners. The recent announcement by the Commerce Department to allow export of condensates may help to increase the demand for split Marcellus products.
I assume GreenHunter would get paid on a percentage of this added value that is brought to the product. It is difficult to estimate how much revenue this plant will bring to GreenHunter without more detail from the company. Even if the revenue is only a few dollars per barrel the opportunity is significant based on the estimated capacity. We will be eagerly awaiting more info about the splitter from the company in the coming months.
Barging Controversy
The most controversial aspect of GreenHunter's plan centers around the barging of oil field waste down the Ohio River. Numerous chemicals, petroleum products, acids, coal, and other dangerous compounds float down the river every day via barge. Oil field waste is primarily brine water produced along with hydrocarbons. It also can contain very small amounts of other naturally occurring compounds, trace amounts of natural radiation (crude oil is much more radioactive than brine water), and chemicals from the fracking process.
The US Coast Guard initially signed off on GreenHunter's barging plan in 2013, but after much public uproar from the anti-fracking crowd, and pressure from Democratic lawmakers, the USCG backtracked for more time to examine the plan. Some within the government are now pushing for "Shale Gas Extraction Waste" to be re-classified as hazardous waste. Shale gas extraction waste is a made up-term from the government to describe the brine produced from a horizontal. The brine produced from horizontal wells is nearly the same chemical make up as brine produced from vertical wells in the same area. Fracking flowback (and the chemicals associated) is only 10% of the water handled by GreenHunter. The problem is that the USDOT has been down this path at length and has declared it non-hazardous when it is on the road in a truck. Now we are left in a situation where the government is contradicting itself with the entire US shale oil and gas business in the middle. Obviously this battle is about much more than just GreenHunter's barges. The bottom line is that barging is going to go forward because if oil field waste is deemed hazardous we can declare the shale boom over. The cost to dispose of the brine will make it impossible to drill economically.
GreenHunter Leadership and History
Gary Evans owns about half of GreenHunter's common stock and currently serves as the interim CEO. His leadership and ownership in the company brings serious industry clout to GreenHunter. Evans, of Magnum Hunter Resources fame (both the first and second iterations), is an oil man who brings a history of serious valuation creation for shareholders. Magnum Hunter #1 was sold to Cimarex Energy for about $2.2 billion in 2006. After the expiration of his non-compete he founded Magnum Hunter #2 in 2008 which now currently is valued at about $1.5 billion.
He founded GreenHunter as a green energy company in 2006 with the hope of commercializing biomass and wind assets. After the collapse of 2008, reduction in government subsidies, and the expiration of his Cimarex non-compete, Evans made the move to realign GreenHunter with his expertise in the oil business in February 2012. The move wasn't without missteps. Bad acquisitions and poor personnel decisions slowed the progress for the first few years of the transition. The company has spent the last year selling off non-Appalachian assets and focusing itself on the Marcellus/Utica. The final asset sales have now been completed and announced. The upcoming Q2 2014 earnings announcement will show a much cleaner balance sheet picture.
Preferred
The one hangover from early GreenHunter is that the company hasn't gotten over a $50mm preferred (GRH-C) with a 10% coupon. The preferred has about $40mm currently outstanding and cost the company about $1mm per quarter. Management has a few options for handling this legacy issue. Saltwater disposal wells qualify for MLP status under current IRS rules, but the IRS currently has a moratorium on private letter rulings (PLR). Management has mentioned the possibility of splitting the company up into a parent and an MLP. The details of the mechanics of this have not been clearly defined yet but we know it is on the table. A better solution might be to do nothing with it for the time being. As the company grows, the $1mm of dividends will be less and less of a burden. The preferred has gained ground over the last 3 months and now trades over the $25 per share par price.
Evans owns about half of the company and at least a few million other shares are held in low turnover hands. The true float of the company is most likely under 15 million shares. Evans clearly would have a strong propensity to avoid excessive dilution. Common shareholders have good reason to feel confident that any future financing will be accomplished with their best interest in mind. The need for additional capital should be accomplished with a combination of debt or preferred and a small amount of equity.
Risks
The biggest single risk to GreenHunter is execution. Shareholders have to believe that this management team is the right fit to execute this plan. In just a few years the team in Appalachia has taken the Marcellus/Utica business from nearly $0 revenue to the largest disposal capacity in the play. The plan here is ambitious but has a path to success. The company may only be held back by their ability to grow disposal capacity to keep up with incoming demand.
Regulation change also poses a risk to accomplishing the plan. Obviously barging will need to be cleared and disposal regulations kept reasonable.
The company will need to find financing for the splitter and the growth capital for the accelerated growth of the disposal assets.
Even if the company is unable to execute on all of their plan, the current and near future SWD well capacity in Appalachia supports a higher valuation for the company. The recent non-core SWD asset sales in South Texas support the value of these assets in the marketplace.
Valuation
Our current model (which we are choosing not to share at this point) suggests that the company's growth of disposal capacity will be much higher than Wall Street analysts have previously modeled. The pipeline will allow the company to gather a much larger volume of brine water and allow it to be economically transported to the company's growing disposal field in Southern Ohio. In short, the pipeline transport fees themselves may not necessarily drive large profits. It is the economical gathering, transport, and disposal of much greater volumes that will drive large profitability.
The splitter, when successfully brought into operation, could bring significant upside in addition to the disposal business. I believe the significant increase in disposal revenues, plus smaller profit contributions from the pipelines, and eventual operation of the splitter could drive 2016 EBITDA significantly above estimates and approach $30mm. 2017 may bring 80%-100% EBITDA growth as the splitter plant ramps and brine volumes increase.
These estimates are dependent on brine disposal capacity of about 40,000 bbl/d entering 2016. This is significantly above current analyst expectations which are for capacity of about 20,000 bbl/d, which the company expects to pass before the end of 2014. The analysts from Wunderlich currently have a $3.25 target on the stock with the caveat that "Frankly, if GRH can substantially increase disposal capacity in Appalachia, our price target has a lot of upside potential."
I believe if the company continues to successfully execute this plan, the valuation of the stock could approach $1B by 2017. Obviously there are some hurdles to overcome between now and then for GreenHunter. Even with those hurdles, the company is significantly undervalued at a market cap of $60mm. I believe the company should be valued at about 5.5x 2016 EBITDA (a multiple that will expand as the company's plans are de-risked) or $5.00. This is 150% above where it trades today.
The stock has already doubled over the last month but because of the low share count has only added about $30mm of market cap. The closing of the previously announced asset sales helped to firm up the balance sheet and the preferred stock has traded back to and above par. As the market begins to catch up to the story that is playing out, GreenHunter's stock price will better reflect the underlying value of the company.
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