Description

Investment Thesis

Black Hills Corporation (“BKH” or the “Company”) represents a stable and growing utility asset that holds a significant potential oil and gas asset in the Mancos shale.  Only a small portion of the Mancos Shale assets have been proved out.  BKH and other drillers are in the process of delineating the prospect.  Initial drilling results have been positive and have led to increased drilling activities.  Historically, BKH has successfully monetized other oil and gas assets, including the sale of itsWillistonBasinassets to QEP in 2012 for a premium price.  BKH is pursuing a similar deliberate strategy in the Mancos.  BKH’s current share price reflects only a small portion of the optionality associated with increased drilling in the Mancos with downside protection from the utility asset base.  Utility risk can be hedged out against the XLU.

Company Overview:

BKH has three business segments.  First its traditional utility business operates inColorado,Iowa,Kansas,Montana,Nebraska,South DakotaandWyoming.  Second, its non-regulated subsidiary produces and sells electricity and coal under long-term contracts to the utility and operates in a utility-like fashion.  Third, its oil and gas operations described in more detail below.   

Valuation

Excludes the optionality associated with an increase in proved reserves, which represents the source of upside here.

Mancos Shale Opportunity

            Drilling activity in the Mancos is picking up steam with Encana, WPX and BKH represent the largest acreage holders and drillers.  WPX drilled two wells in the target areas in 2013 with impressive reported results.  BKH and Encana drilled a number of wells, but have yet to report the results.  In 2014, WPX and BKH both elected to expand their drilling programs to drill another 12 and 6 wells, respectively.  Both companies are sharing drilling data to reduce overall development costs and WPX has stated that by end-2014 it should have delineated 80% of the field.  WPX has also indicated that should its drilling program continue to be successful it would double the company’s gas reserves from 18tcf to 36tcf.

WPX has only found gas in its wells to date.  WPX two wells to date have shown impressive IP rates:

BKH has indicated that its current and prospective drilling activity is in areas where it believes NGLs are present.  Encana has alluded to NGL production in its current drilling activities, but has not yet released its drilling results.  The potential presence of NGLs is supported by BKH’s election to enter into an agreement with Summit Midstream (SMLP) for gas processing: “Red Rock is continuing to develop the 20 MMcf/d cryogenic DeBeque processing plant which will process liquids-rich Mancos shale production under a long-term, fee-based agreement with Black Hills Exploration & Production, Inc. The DeBeque plant is on schedule to commence operations by the end of 2013.” (SMLP Q3 ’13 Conference Call).  While BKH’s wells may be in areas where gas flow rates are lower than WPX’s results, they offer the opportunity for NGL upside. 

In the Mancos, BKH maintains a large, relatively, unproven position for which it gets little credit.  The Piceance produces liquids rich gas opportunity and theSan JuanBasinis dry gas.  In its investor presentation, BKH has laid out its potential reserves as follows:

            BKH’s description of its potential reserves under represents the potential opportunity, due to its failure to update its core operative assumptions.  First, it assumes well spacing of 160 acres; however, WPX and BKH have indicated that well spacing will likely be much tighter than this figure and closer to 80 acres, if not lower.  Second, it assumes EURs per well of 6bcf per well based on the results of prior 2011 test wells.  BKH’s production guidance for 2014 of 13.4 – 14.4Bcf points to higher EURS, which supports management comments at its recent analyst day where it pointed to EURs of between 8-9bcf per well.  The increase in prospective EURs is driven by the knowledge gained through its scientific drilling activities which has led it to increase frac stages from 5,000ft to 10,000 ft, consistent with the drilling strategies employed by WPX.  Third, BKH does not include 20,000 net acres it acquired in the Piceance in 2013 through a drill to earn arrangement.  BKH will complete the two wells required to earn these incremental 20,000 acres.  If one adjusts BKH’s potential reserve presentation, the results would be as follows:

Sensitizing this data and applying a conservative price per potential mcf of between $0.25, one can see the huge leverage in the Mancos opportunity.

The results are still significant even if one assumes a fully-taxed scenario with a $200mm tax basis:

The opportunity in the Mancos is significant for BKH and would represent a 2^nd step in its E&P monetization strategy.  On August 27^th, BKH sold itsWillistonBasin oil and gas assets for $227mm vs. their PV-10 value of $56mm.  BKH has indicated that it will pursue a similar deliberate approach to proving out its Mancos assets prior to monetizing the asset in the most tax-advantaged manner possible.

Risks:

• Gas Price Decline – Given the predominant gassy nature of the assets, declines in natural gas prices could have two effects.  First, BKH could elect to slow down its drilling program, which would extend the development timeline.  Second, declines  in gas prices would also have negative implications on value and the economic viability of the field.  The potential presence of NGLs provides a small offset.

• Limited Information – BKH is currently completing the drilling of two wells.  Both of these wells were situated on fields that it recently acquired in a drill to earn program.  These drilling programs are subject to strict confidentiality.  While it will be possible to see some of the results through changes in their financials in 2014, full details on the well results will only be known around mid-2014.

• Drilling Failures – Any failures in its drilling program would raise questions regarding the viability of the field.

• Acquisitions – BKH continues to have an appetite for acquisitions.  It has been involved in a number of utility auction processes (Missouri Gas and New Mexico Gas) of fairly significant scale (approx. $1bn).  Any such acquisition would like be funded at least in part with equity.    

Catalyst

Catalysts:

• BKH Drilling Results: BKH has not yet released its drilling results from the two wells it drilled in 2013.  The release of these results will be delayed to around June 2014, due to confidentiality agreements with the seller.  The decision to significantly increase capital spending into the Mancos anecdotally points to positive results.   Investors will potentially be able to determine results before June by looking at the quarterly financial statements which should show a significant increase in gas production.  NGL production will be more difficult to determine given likely increases in NGLs from some of BKH’s other assets.  Data from partners, such as SMLP, could provide additional data points through the year.

• WPX Drilling Results - WPX continues to drill in the Mancos shale and is stepping up its drilling program  It has no restrictions on its data releases and should be continue to release drilling results over the next year.

• Asset Monetization – BKH has a demonstrated ability to monetize its asset base.  The Company has publicly stated that the asset base is too large for it develop on its own and it will seek to monetize the asset in a manner that retains the significant underlying option value.  BKH’s historically track record is constructive.