Torchlight Resources, Nasdaq:TRCH, may be the first oil company to go bankrupt in the aftermath of the recent oil price collapse, due to its imminent need for financing that is probably impossible to secure in the current market. However, the burden of proof is high for a short thesis on Torchlight for the following reasons:
1) The stock is already down from a high of $6 earlier this year to a current $1.08 price, down 82% peak to trough.
2) Torchlight is a micro cap oil company, with a $25 million market cap and a $37 million enterprise value
3) The cost to borrow the stock is high, currently around 50%. However, borrow is available.
4) A macro improvement in the price of oil could drive oil stocks higher, particularly stocks that are down a lot like Torchlight
5) Torchlight is spending over $1 million per year on aggressive stock promotion, which had historically and could now drive the stock price higher
Despite the above factors, the following are the reasons to be short Torchlight:
1) Torchlight has over $12 million in senior 12% interest debt, most of which is due March 31, 2015. Torchlight is likely to file for bankruptcy on or before that date.
2) Torchlight has spent approximately $30 million on asset acquisition and drilling and only has 418 boepd of current production to show for it
3) 418 boepd is insufficient to fund Torchlight's overhead and interest payments, leaving the company reliant on raising capital to keep the lights on and to grow
4) Torchlight missed its Q3 2014 production guidance by 58%, reducing the probability of raising additional money
5) Torchlight recently amended its financial statments to disclose previously undisclosed material economic arrangements. These arrangements reduce the probability of raising additional money, and may incur legal liability from previous capital raises for insufficient disclosure.
6) Torchlight's operating partner has said it will slow down drilling activity at current oil prices, reducing the value of Torchlight's non operated working interest.
Risk and expected return from a short Torchlight trade:
The risk to shorting Torchlight is that Torchlight somehow manages to secure financing before April 2015, subordinates its existing debt, and deploys that capital into high return projects that more than cover Torchlight's high overhead and likely exorbitant interest payments. The probability of all of this is exceedingly low. Even if Torchlight raises money, it likely merely delays the inevitable.
The most likely outcome is that the supposed financing that Torchlight has been promising investors for more than a year does not go through. Any potential financing providers that were not scared off by Torchlight's abysmal capital deployment to date are likely being scared off by the fall in the price in oil and the blow-out in credit spreads in the oil producer sector. A $37 million enterprise value is likely well in excess of the liquidation value of assets. More likely, there is insufficient asset coverage for the existing debt and zero recovery for the equity.
With a 50% cost to borrow and a potential $2 margin requirement, there is the potential to earn approximately 90 cents per share if the equity trades to 3 cents per share by March 31, 2014, which should be a sufficiently high return to justify tying up $2-3 per share for four months. The downside potential is a return to $2-3 per share for some period of time, until the weight of high overhead and low returns drags Torchlight back into destress. "Heads I win, tails I don't lose much".
History: Torchlight was previously "Pole Perfect", and reverse merged in 2010 to form an oil company. Torchlight has aggregated unsuccessful oil projects over time. These include a failed project in the Eagle Ford, which then turned into a failed project in the Buda. A project in the Hunton, where payments to friends of Torchlight's management for the right to participate weren't disclosed until recently and may have incurred legal liability. A project in the Mississppi Lime, where Torchlight bailed out another highly promoted company Ring Energy - RING is down 40% in the past 2 trading days. And the Mississippi Lime project cost Torchlight $10 million so far and only generated 22.5 boepd for Torchlight. Will there be more disclosures in the future regarding that relationship? And now a project in the Oro Grande, which supposedly is like the Permian but sat on the market for 2 years while every company active in the Permian basin declined to buy it, and which Torchlight bought with less than $1 million of stock.
Management: Torchlight's CEO was previously an acquisitions consultant. Its President was an investor relations consultant. And its COO was the CEO of a company similar to Torchlight, which had disproportionately high overhead and went bankrupt in 2012, immediately prior to him joining Torchlight.
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