Over the course of the last two years Magnum Hunter Resources (NYSE:MHR) has rather quietly shifted away from drilling oil wells. The company cashed out of the Eagle Ford early last year and plans to do the same thing in the Bakken Shale before the end of this year with the cash generated from those sales being reinvest in its natural gas assets in the Marcellus and Utica shale plays. In making the switch Magnum Hunter Resources has become one of the top natural gas stocks to watch in the year ahead.
Pure-play natural gas stock
If everything goes as planned, 90% of Magnum Hunter Resources' production could be natural gas by the end of this year. To get there the company needs to sell its remaining oil assets in the Bakken Shale, which might be more difficult to do now that the price of oil has dropped. That said, even if the company does hang on to those properties it is unlikely to invest all that much money there next year because the economics of drilling that acreage isn't very compelling as oil prices need to be $75 per barrel in order for the company to achieve a 9% internal rate of return for an average well on the land it controls.
However, where the company is seeing very compelling returns is in the Marcellus and Utica shale where it can economically produce gas even if the price of natural gas fell down to $2 per MCF. As the following slide shows, the company's base case for new wells can still generate a 10% internal rate of return if gas fell to that level.
However, given where the price of natural gas is today the company has a very nice margin of safety. Currently, as we see in the following chart, the spot price for natural gas has risen to well over $4 even as oil prices have plunged.
This suggests that Magnum Hunter Resources' returns are averaging 37% on the low end to better than 72% on its very best wells. It is because these economics are so compelling that the company has turned its sole focus into developing its shale gas acreage in the Utica and Marcellus.
Ample room to grow
Magnum Hunter Resources is currently sitting on 80,500 net Marcellus shale acres to go along with another 118,000 net Utica shale acres. The company estimates that these acres currently contain 1,438 total future drilling locations. That's a massive growth opportunity because, given the company's rather small size, each new well pad that's brought online delivers meaningful production growth as we see in this next slide.
The only problem is that the company doesn't have a lot of capital to pursue all of this growth. The exit of its oil properties has been one of its big funding sources over the past few years, so if it can't complete its Bakken shale exit then that will have an impact on its ability to capture its natural gas growth opportunities in the Marcellus and Utica. The company's other big funding sources, the debt markets, are also at risk of drying up given the fact that so many oil companies were overly reliant on debt heading into the crisis in oil prices. Still, the company does have cash flow coming online from new gas wells in addition to plans to monetize its midstream assets next year. So, in the near term at least it can still generate solid natural gas growth despite some likely capital constraints down the road.
Magnum Hunter Resources is on the cusp of transitioning into a pure-play natural gas growth company. Its low cost production should enable the company to profitably grow production, albeit at a slower rate. That said, investors looking for a compelling natural gas growth stock idea should take a closer look at Magnum Hunter Resources.
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.