There are three very compelling reasons why investors would want to buy shares of Magnum Hunter Resources (NASDAQOTH:MHRCQ). However, at the same time the company is still pretty risky. That's why investors shouldn't allocate too much of their portfolio into this one stock. In fact, here are three big reasons why the company shouldn't be a core holding.
Liquidity is tight
Magnum Hunter Resources is paring back its portfolio to cash in on some noncore positions.The oil and gas producer really has no other choice as liquidity is pretty tight these days. The company has about $204 million in total liquidity, but it has spent $272.4 million in upstream capital through the first nine months of the year.
The current plan has it shedding another $200 million worth of assets, on top of previously closed sales of $446 million. Basically, the company has been taking a page from Chesapeake Energy's (NYSE:CHK) playbook, which had been to fund growth by selling assets. That works out just fine until prices drop.
The problem is that the concept of funding growth by shedding assets seems to be going away. Chesapeake Energy, under new leadership, has decided that plan was too risky so it's actually going to fund all future growth within its cash flow. That is something Magnum Hunter might need to consider in the future as it will soon be out of noncore assets to sell.
Utica is unproven
At this point Magnum Hunter doesn't have any proved reserves in the Utica Shale. Instead, it is taking the results from companies such as Chesapeake Energy and estimating its potential in the play. While potential is great for upside, investors want proven results from a core energy holding.
The company is now drilling its initial wells in the Utica. Magnum Hunter ran into some early troubles drilling the first well on its Farley pad. As of the end of last quarter, it was only able to fracture stimulate 10 of the 26 stages. There is a risk that the Utica proves to be more difficult to drill than the company had planned. That could have a big impact on Magnum Hunter's future value.
Good but not great positions
Magnum Hunter has solid positions in both the Marcellus and Bakken. However, it's not in the best position in either play. In the Marcellus, for example, the company can earn an internal rate of return of about 80% with natural gas at $3.62 per MMBtu. Those returns assume well costs of $6.5 million and estimated ultimate recoveries, or EUR, of 7.8 billion cubic feet of natural gas and liquids. That's not bad, but it's not as great as some peers.
For example, Cabot Oil & Gas (NYSE:COG) can earn before-tax internal rates of return of 100% or more. In fact, with natural gas at $3.50 per MMBtu, the company will earn 100% on a well that costs it $6.5 million and 115% on a well that it drills for $6 million. Furthermore, Cabot will recover almost twice as much gas, with an estimated EUR of 14.1 billion cubic feet.
It's a similar story in the Bakken. With oil at $96.77 per barrel, Magnum Hunter can earn between 24% and 55% depending on how much oil it will recover from each well. While its wells only cost about $6.4 million to drill, the company will only ultimately produce between 350,000 and 550,000 barrels of oil equivalent per well. Both are solid, but not as spectacular as Kodiak Oil & Gas (UNKNOWN:KOG.DL).
An average Bakken well from Kodiak Oil & Gas can earn between 54% and 84% depending on how much oil Kodiak ultimately recovers. The company's wells cost $9.5 million on average, but will produce 650,000 to 850,000 barrels of oil equivalent. Kodiak simply has a better spot in the Bakken.
None of this is to say that Magnum Hunter Resources won't continue to outperform the market in the years ahead. Investors are simply taking on more risk in order to potentially obtain that reward. Because of that risk, I don't think the company deserves a core spot in an investor's portfolio.
Fool contributor Matt DiLallo has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.