Turnaround stories are usually the ones that generate the maximum amount of returns for investors, but the biggest problem is identifying such opportunities. Investors tend to rely on their gut for picking out beaten-down stocks, particularly within the small-cap and micro-cap space, which significantly increases their chances of failure. The strength of the fundamental business model and strong unit economics are key factors that help identify such companies, and Torchlight Energy (TRCH, Financial) ticks both these boxes, making it a very interesting turnaround candidate.
What is Torchlight’s business model?
At first glance, Torchlight may seem like any other energy player that is engaged in the acquisition, exploration, exploitation and development of oil and natural gas properties in the U.S. However, there is more to this business model than meets the eye. With a capital employed of around $43 million, Torchlight appears to be a small-sized player, but its competition is not with the giants.
In fact, the company’s core strength is its geological expertise, backed by veteran geologist Rich Masterson, and its model is actually supplementary to that of the larger oil companies. To describe it in simple words, Torchlight identifies areas with a high potential of oil and natural gas, digs some wells to determine oil potential, and once this potential is proven, it sells the working rights to larger oil giants. This is very similar to how private equity funds identify smaller private companies, help them build their potential, and eventually divest their stakes at a higher value when the market sees the immense potential in the companies.
Following this business model, Torchlight currently has interests in four different projects: the Orogrande Project in Hudspeth County, Texas; the Hazel Project in Sterling, Tom Green and Irion Counties, Texas; the Winkler project in Winkler County, Texas; and Hunton wells in partnership with Husky Ventures in central Oklahoma.
Why is Torchlight’s stock down?
A downward trajectory is evident in the above chart on Torchlight’s stock price for the past year. A company that relies on the bulk of its revenue coming in large lump-sums from the sale of entire projects is bound to fall victim to negative market sentiment when the sale of one of its key projects is delayed. Torchlight’s management has had problems in selling the Hazel project due to a harsh macro-economic environment, and this drove a lot of investor pessimism against the stock. The huge potential future value of the company’s other projects was not factored in Torchlight’s price as the market has made a convenient assumption that the company will struggle in selling all its projects and that the Hazel story will be repeated. However, when one looks closer, this appears to be far from the truth.
Orogrande is currently the largest project of Torchlight and possibly the biggest game-changer for the company in the near future. The company has been drilling test wells in this 134,000 square feet project since 2019 and met with some success recently. Its Cactus A35 #1H well drilled recently and confirmed the presence of oil in the area, thus almost confirming its saleability as a Torchlight asset.
The company has a 72.5% working interest in this project, which could be divided into about 156 sections with each section yielding between 4 to 6 million barrels of oil as per the estimates of the management. This is a much more conservative approach as compared to the forecasts of Mike Mullen, reservoir evaluation expert from Stimulation Petrophysics, who foresees a potential 3 billion barrels of oil the Orogrande basin, making it potentially one of the largest on-shore field projects. While Torchlight’s efforts at drilling oil in Orogrande will continue, it appears to be a matter of time before this basin attracts the interest of oil majors who end up becoming potential buyers for Torchlight.
Torchlight’s second-largest project lies in the Midland Basin with around 12,000 gross acres and 19 sections, each of which could generate 4 to 6 million barrels of oil as per management estimates. This project has a high proximity to field services as well as oil and gas pipelines, and Torchlight has a higher working interest of around 80%. The proximity to the pipelines could mean lower costs for the oil majors acquiring the same and potentially better saleability of the project.
The third project lies in Winkler County and is among the smallest with a size of 1100 acres and a 75% working interest for Torchlight.
Each of these three projects, along with Hazel, can be treated like private equity assets of Torchlight which are due for divestment in the near future, which is when the company’s investors will realize their true returns.
While its project sales may not have started, it is worth stating that Torchlight’s revenues have doubled in 2019 as compared to the previous year, and the company has a positive gross margin that indicates decent unit economics. While the Midland basin and the Winkler County projects may be at an early stage, the company has definitely made a big breakthrough in Orogrande which has not been factored in by the market.
The poor stock performance can be partially attributed to weak management communication with respect to the developments taking place in each of its projects. Given the fact that the stock is trading at close to 60 cents a share, the jump in the price could be colossal. It must be noted that which the company has a free float of 53.9 million shares, its daily traded volume is below 200,000 shares with a large percentage of active shorts. A sudden positive change in the market perception could well lead to a short squeeze and make the price shoot up, which is an excellent opportunity knocking on the doors of growth investors. Overall, the company looks to have a promising future with some exciting developments.
Disclosure: No positions.
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