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Hurricane claws back from the dead!
by James Passin
A month ago, the word "hurricane" filled me with nausea.
Forget high winds, floods and floating cow carcasses, it looked like Hurricane Hydrocarbons (HHL/A-Toronto; HHLFQ-OTC BB), my recommended play on Kazakh oil, was about to be handed over to the bondholders by the board of directors. I flew to Kazahstan to try to find out what was going on behind the scenes.
Since then, the outlook for Hurricane has completely turned around. Hurricane is currently generating positive cashflow from operations (in fact, HHL/A is generating US$100 million in cash on an annualized basis).
In my opinion, there were three major drivers behind Hurricane's collapse: the 1998 crash in oil prices, poor financial management by Hurricane's old CEO, and hostile relations between Hurricane and the Shymkent refinery.
All of these factors have reversed. Crude oil is back in the lower US$20s -- and it looks like higher oil prices are here to stay. Hurricane has a new CEO with an avowed commitment to shareholder value creation and experience in managing oil turnaround situations in the former Soviet Union. Hurricane and Shymkent have agreed to a definitive merger.
Good news!
There was a significant risk of massive dilution. Under the terms of the Hurricane/Shymkent merger, Hurricane will own 67% of the merged entity.
The Hurricane noteholders may attempt to block this plan or cut a better deal for themselves. However, since the company proposes to reinstate the bonds and pay all back interest, it is unlikely that the Canadian bankruptcy court would let them torpedo the deal. Irrational behavior in the court by the noteholders remains a significant risk.
Assuming the merger with Shymkent does occur, Hurricane will be one of the only vertically integrated oil companies in Central Asia, with 434 million barrels of high quality (proven + probable) reserves, operating infrastructure capable of producing 80,000 barrels per day without any additional capital investment, cash extraction costs of US$2.50 per barrel, and refining infrastructure with a daily capacity of 150,000 barrels. Hurricane would recapture the entire downstream refining margin, boosting operating margins and radically improving the predictability of cash generation.
Great expectations
According to Shymkent's management, the Shymkent refinery will generate US$40 million in net profits (including a US$10 million foreign exchange adjustment) and US$10 million in depreciation, or US$50 million in cashflow. If you add Hurricane's and Shymkent's annualized cashflows, you get at least US$150 million in annualized cashflow.
Russian vertically-integrated oil companies (such as Lukoil) trade at an average enterprise value/cashflow multiple around 4 (this represents a 75% discount the average Western oil giant). Applying the same valuation multiple, the merged Hurricane/Shymkent enterprise would be worth US$600 million, or US$6.50 per share to Hurricane common shareholders net of debt.
It will take years before the bad blood towards Hurricane evaporates. But if Hurricane merges with Shymkent and exits bankruptcy protection without diluting common shareholders, we will enjoy material and immediate upside from current levels.
It is difficult to predict the outcome of the bankruptcy proceedings; however, the prospects for common shareholders have brightened dramatically. I continue to recommend holding the stock. Keep in mind that the stock will remain dangerously volatile until the noteholders accept a restructuring plan.
While Hurricane has been delisted from NASDAQ, it still trades on the OTC Bulletin Boards under HHLFQ and the Toronto Stock Exchange under HHL/A.
James Passin is a Portfolio Manager with Firebird Management and Contributing Editor to Taipan. Several funds managed by Firebird are currently shareholders in Hurricane Hydrocarbons. James Passins' views are strictly his own and not necessarily the views of Firebird Management or Taipan.
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