Tuesday, 3 October 2017

Revealing Big Oil hurdle rates

Our analysis on cost of capital tends to focus on small/mid cap E&Ps as these are companies we traditionally model and where the deals are material enough to investors that get good visibility on deal metrics. The analysis indicates that costs of capital (as implied by buyers' IRRs) are perhaps higher than many would expect - in the range of 15-20%.

These deals are often characterised by a capital-constrained seller and therefore often a buyer' market. How the deals stack up when deals are made with other large companies or NOCs are probably different and should illustrate the lower end of returns that the buyers are willing to accept.

In this vein, the farm-outs by Pemex to majors should be a good guide to how majors bid in a competitive process for attractive assets with low technical risk. With a farm-out of Maximino in progress, we look back at the last deal executed.

We therefore model the returns expected by the farm-out deal of Trion - won by BHP (BP was the only other bidder and bid almost exactly the same terms as BHP) and find that on our price deck ($70/bbl in 2022), the 2017 IRR is 11.5%. This is significantly lower than most other farm-out deals we have reviewed.

The analysis seems to confirm the lowest returns majors are willing to accept are around 11-12% on our price deck (although these move materially as different oil prices are used).

Thus, our implied cost of capital chart is updated. If we apply long term oil prices used by BHP and BP in their impairment testing (which we believe are high vs analyst consensus expectations), the IRRs are 13.1% and 14.8% - taking them closer towards the trend. Applying the Dec 2016 forward curve gives 8.6%.

Thursday, 17 August 2017

Made a discovery? What are the odds of another?

By Will Forbes

Companies exploring in frontier basins frequently include maps and tables with all the prospects and leads in the acreage in marketing information, often adding the prospects sizes to give an unrisked block resources estimate. There is a risk that these representations are misunderstood by investors.

We agree that managements are right to give investors an idea of the depth of prospectivity in their assets/acreage - more, larger and lower risk prospects give exploration teams the luxury to choose the best chance of drilling a valuable well especially in the case where exploration is mandated by licence commitments. You can therefore understand that a company would want to demonstrate it is drilling from a position of strength.

However, we continue to see dangers in this approach for investors who do not appreciate the complexities in oil exploration. The modern reality is that investors should not use this apparently large resource base as a metric to value the block/company. Companies rarely drill a second wildcat well if the first is a failure. Using Norwegian Petroleum Directorate data, companies have only drilled a licence/block a second time 10% of the time if the first was dry in the last five years or so (see chart below). Frontier exploration failures with no follow-ups are common (just looking at West Africa in the last five years throws up many wells in Morocco, Namibia and elsewhere). 

But is this data indicative of other, more frontier, areas? We think so; from 2011-2015, West African dry wells had a follow up in the same block only 7% of the time.

We have therefore long been advocates of only valuing the first well in a block (unless a campaign is already committed to and more wells are definitely going to be drilled). Managements should be more clear to reduce the possibility that (less informed) investors will attribute value to the cumulative gross block resource estimates.

What about the play opening argument?
Investors and managements have made the argument that if a discovery is made, it significantly de-risks further prospects. This would mean that we should include some value for this de-risking before the first well.

We again look at the NPD for some quantification, but with many caveats. The North Sea was de-risked by UK drilling before widespread exploration/development occurred in Norway and explorers in the basin had higher levels of confidence in the various elements (source, migration etc) before drilling. Commercial quantities of oil are typically much lower in Norway that they may be for more frontier areas offshore (perhaps 50mmbboe for Norway vs 200mmboe for offshore Africa). Every basin is different, so we give this analysis with a pinch or more of salt.

However, looking at blocks in Norway, the chances of a block containing two or more fields given that it already has one is around 40% (where a block is of type 1/3 or 10/11) - see chart below. These blocks are much smaller than those typically seen in Africa. Scaling up to a collection of blocks which are roughly equivalent to Cairn's Deep Offshore block (containing the SNE field) in area, this chance increases to over 55%.

This is for Norwegian blocks, that are substantially smaller than typically frontier offshore blocks

Resulting probability tree
And assuming a 30% CoS (roughly the commercial chance of success for a wildcat in Norway), we can produce a rough interpretation routes to success/failure. Here we also use the observation that if the first well is unsuccessful, the chance of success for the second well falls to 15-20%. For information, if two are unsuccessful, the chance of a third being a success has been 13% (and 6% for a fourth well). Given only 10% of initial unsuccessful wells are followed up, the impact of these CoS on subsequent wells is vanishing small.

Note: We use a 50% chance after a first success here as a simplification of the 40-55% chance of finding more than one field given one has already been discovered (where 40% is over a block in Norway and 55% is for a collection of Norwegian blocks roughly the size of the SNE block in Senegal)

Overall, going from NPD data, the chance of two (or more) successes is 15%, the chance of a first well being successful with no further successes is 15%. The chances of a failed campaign (either because a second well is not drilled or a second is unsuccessful) is 69%. The chance of a first failure is followed up by a success is 1%.

Going from this data, there is therefore a case for including value for play-opening discoveries. For every discovery, further discoveries are have a c.50% chance of occurring, though many more wells may need to be drilled to make another discovery - the implied individual CoS rises by perhaps 15%. 

However, we remain cautious. Investors have to take account of the time to appraise and develop discoveries. When are subsequent wells going to be drilled to enable possible discoveries, are all going to be co-developed or will others be tied-back after first oil or have a longer term phased development?  

In the case of small oil companies, the effect of financing (dealt with in many previous blogs) and possible farm-downs/delays should also be accounted for. Given a failure is far more likely than a success, we are happy to continue to examine only the value of a drill until a result is known. This analysis then gives a possible framework for how an investor (and shares) may then react after a result.

Tuesday, 8 August 2017

Kosmos searching for more investors

by Will Forbes

On 2 August, Kosmos announced that it will be seeking a main-market listing in London during the third quarter in order to access European investors. According to Reuters, the company indicates "There are a number of European investment funds and specialist international oil and gas investors that are currently unable to hold Kosmos' shares due to their listing outside of a European regulated market"

We also believe it is a function of the differing attitudes the investor bases have towards exploration. Given the multitude of onshore producers, US investors typically place more emphasis on near-term cashflows and production. Especially since the advent of shale fracking, exploration risk is smaller and a greater attention is given to cashflows and financial leverage. 

European exchanges tend to see more international explorers focussing on frontier areas, leading to a greater understanding of international exploration and willingness to value it.  European exchanges are more used to taking a risked approach to longer term value ideas such as 2P/3P reserves and exploration. 
This may explain why European analysts have higher target prices given Kosmos' mix of production/ development/exploration assets.

Given these differences it makes sense for Kosmos to list in London. Of the companies operating (or those that had recent drilling) in the West African coast, many of them are European listed. The majors are joined by Tullow, Cairn, Ophir , GALP, Genel, Seplat and many small and micro-cap peers. While recent years have seen the London market paying less attention to exploration, we believe it is a more natural home for Kosmos, which will be exploring for more resource in 2017-2018 than any other E&P (according to the company). 

For European investors interested in exploration, Kosmos may be an attractive prospect.

In 2017-2018 it is targeting six material wells. In Africa four targets represent large opportunities (pre-drill estimates of gross unrisked resources are Yakaar 833mmboe, Requin 833mmboe, Lamarin 833mmboe, Requin Tigre 2.5bn boe). Of these, Yakaar has been a successful discovery which, added to Teranga, opens up 20tcf of pMean gas resource and a large LNG development in Senegal. With partner BP, Kosmos is targeting a 2018 FID and 2023 first LNG. Given the LNG environment at the moment, we would not be surprised to see dates slip slightly, but Kosmos is well placed to monetise these resources.

In South America, Kosmos holds interests in two blocks close to the existing Liza and Payara discoveries made by Exxon. Anapai and Aurora could each hold 300mmboe according to the company.

Additionally, it has production cashflows from Jubilee and TEN, which will be well known to Tullow's base. In May 2017, its presentation indicated around $260m of FCF could be generated at $50/bbl oil (including farm-out proceeds).

Other observations US vs Euro listed E&Ps

If the analysts are a guide to investors' attitudes, it's possible that greater European investor shareholdings could contribute to an increase in the share price, as existing European-focussed analysts for the company have markedly higher average target prices than their US-focussed counterparts.

Source: Bloomberg. Black dot is Kosmos, green dots are European E&Ps

In fact, if we apply only the target prices for European analysts and assume that Kosmos moves towards the trend line in EV vs discount to target price seen in the chart above, it could lead to more than a 20% increase in share price.

Given the relative paucity of European E&Ps (vs US), it is very possible the listing of a $3.5bn EV company on London exchange will attract more investors and interest - only Tullow will be bigger. More analysts are likely to cover the company (Kosmos has 15 at the moment, Ophir 18 and Tullow 27).

Wednesday, 26 July 2017

Killing the goose that laid the golden eggs

By Charlie Gibson

In London, the shares of Acacia Mining (formerly African Barrick Gold, the 62%-owned, listed subsidiary of Barrick Corp) have fallen by almost half in the last 24 hours, after the Tanzania Revenue Authority demanded $190bn ($40bn in alleged back taxes, with the rest in interest and penalty charges).

It is difficult to pinpoint the exact origin of the dispute between Acacia and the government and, arguably, it goes back to Barrick’s first major investment in the country in the late 1990’s. Then, the price of gold had fallen to a 20 year low of US$250/oz and Barrick, which had had some good exploration success in the Lake Victoria goldfield negotiated some very keen fiscal terms with the government to develop its new mine, Bulyanhulu. Had the price of gold stayed where it was, perhaps the current dispute would never have arisen. However, as the gold price rose to US$1,250/oz (via a record high of US$1,900/oz in 2013), Barrick’s tax breaks (duly enshrined into Tanzanian law) became – if you will excuse the pun – a gold mine, effectively shielding its assets from actually paying cash taxes for years, if not decades. As the old saying goes however, wealth begets envy and, while Acacia (as it had been renamed) trumpeted its attractions to western investors, the Tanzanian government looked on ever more covetously as its natural wealth (as it saw it) was shipped overseas. If that was the environment, then it only took a spark to set the plains ablaze. In this case, that spark was provided by the election of a populist Presidential candidate in 2015, John Magufuli, who was easily able to incite lingering anti-colonial resentment to paint a picture of rapacious western investors cynically depriving Tanzania of its natural wealth.

The first Acacia knew of it was when the government passed a law banning the export of metalliferous concentrate in February 2017 under the guise of wanting to develop a domestic smelting industry. That was rapidly followed by the reports of two Presidential committees in the following four months that alleged that Acacia had been under reporting its gold exports in concentrate form by a factor of ten. That is to say, when Acacia declared 100oz of exports, the committees accused them of selling 1,000oz. The implication of the committee’s findings is that Bulyanhulu and Buzwagi each produce more than 1.5 million ounces of gold per year and are the two largest gold producers in the world, that Acacia is the world’s third largest gold producer and that it produces more gold from its three mines than AngloGold Ashanti from 19 mines, Goldcorp from 11 mines and Kinross from nine mines. Suffice it to say that Acacia is a publicly listed company and that its financial, production and gold reserve records are audited to international standards and that it must comply with government oversight agencies in Tanzania, the UK, Canada, and the USA that have the right to impose heavy penalties on companies that do not report their production and financial results accurately. Despite requesting it, Acacia has yet to be given a copies of the reports, nor has it been provided with details of the sampling protocols followed by the committees.

At the same time as the Tanzania Revenue Authority (TRA) ceased providing Acacia with VAT refunds, parliament then passed the Natural Wealth & Resources Contracts (Review & Re-Negotiation of Unconscionable Terms) Act and the Natural Wealth & Resources (Permanent Sovereignty) Act. The former allows the government to dissolve existing contracts deemed prejudicial to the interests of Tanzanians, while the latter prohibits the involvement of foreign courts or tribunals in disputes between the government and investors and compels companies to process minerals within the country rather than exporting them as raw materials. New laws have also increased the royalty rate applicable to metallic minerals by 2% as well as imposing a 1% clearing fee on exports, while President Magufuli has ordered the Energy & Minerals Ministry to neither issue new mining licenses nor renew expired ones.

With the dispute apparently escalating, earlier this week, Acacia announced that it had received a series of Notices of Adjusted Assessment from the TRA for historical corporate income tax, covering the period from 2000 to 2017, which assert that it owes the Tanzanian government approximately US$40bn of alleged unpaid taxes and approximately a further US$150bn in penalties and interest. To put that in context, the GDP of Tanzania is only about US$50bn! At the same time, local regulations now require miners to list operating assets locally and to achieve a 30% minimum local shareholding by 23 August. Finally, as if to add insult to injury, the Tanzania government appears to be deliberately sidelining the company by insisting on negotiating solely with its parent, Barrick, rather than with it, directly.

Resource nationalism has a long and bleak history, from the Russian Revolution in 1917 through the tribulations of British Coal from the 1940’s to the 1980’s and, latterly, all manner of government taxation initiatives and interference from countries as far afield on the political spectrum as Australia and Guinea. Almost none has been blessed with any success and almost all have consigned their mining industries to years, if not decades, of underperformance, inefficiency and underinvestment, with the result that governments have rarely (if ever) reaped the benefits for either themselves or for their populations that they had envisaged. Hitherto, Tanzania had been one of the relative success stories in Africa of a country that had created a stable and trustworthy environment for international mining investors. It would be a shame if it became the most recent candidate to mistakenly (and unnecessarily) kill the goose that laid the golden egg.

Friday, 14 July 2017

Oil and share prices for mid-cap E&Ps

By Will Forbes

With the tribulations of the London-listed E&Ps with the oil price slide, investors have seen large moves in the share prices. 

What has been the  relationship between moves of oil price (in GBP) and shares? Since January 2015, cairn has been materially less volatile than the others. This is not surprising given its cash balance, lack of debt and exposure to immediate oil prices through production. This will change as more and more of its value is dictated by production.
How tight is the relationship?

Friday, 30 June 2017

AIMing high: London listings more liquid than Australia and Canada

By Will Forbes

Companies often ask us our opinion on listing whether they should consider listing on other exchanges to boost liquidity and move their shares closer towards their perceived fair value. The answer is a complex one, market timing, industry and peer group as well as overall market sentiment and always have an impact on the answer. However, the chart below indicate the added liquidity that companies see in London (vs Australia and Canada).

Source: Bloomberg, Edison Investment Research
Of the 35 examples we found (the vast majority in the oils and mining spaces), only ten saw higher share values traded in the two non-London exchanges examined. In all other, London trading dominates the shares. Below is the ratio of value of shares traded (30 moving average) between London and Australian/Canadian listings. In many cases, it may be better to ask why list on any other exchange at all?

Thursday, 25 May 2017

Conservative Energy Policy - 2017 manifesto - shale gas and oil rig decommissioning

Given the current polls (with the Conservatives leading Labour by 47% to 33%), we assume that the Conservatives form the next government and therefore take a look at what (if anything) we May glean from Theresa's manifesto.

Full excerpts from the manifesto are at the bottom, but unsurprisingly perhaps, there are few specifics. Shale gas takes top billing, with an assertion that it could play an important role in "re-balancing our economy". 

To enable this, the manifesto proposes a change in planning laws for shale drilling. "Non-fracking drilling will be treated as permitted development, expert planning functions will be established to support local councils, and, when necessary, major shale planning decisions will be made the responsibility of the National Planning Regime." 
We interpret this as suggesting that initial exploratory drilling will be able to progress much faster and may be made at the national level (aided by a new Shale Environmental Regulator), rather than the current emphasis on local decision making. This may be because of a number of local decisions not to allow drilling (for example in Lancashire in 2016). 

Initial exploration wells (that can prove up the existence of shales, take cores and provide greater insight on resources), would have to be followed up by fracking wells to more definitively gauge the flow rates of any shales discovered. From the manifesto, it is not clear at this point how local objections/councils would be involved in these decisions. 

However, it seems clear that if these proposals go through, it will be potentially easier and quicker to drill wells targeting shale gas deposits. If so, it should benefit existing players in the area (Egdon Resources*, Cuadrilla Resources, IGas, Third Energy, Ineos and Total)

The government expects the North Sea to be the first major basin to decommission, and the manifesto promises support to a decommission industry, a multi-use yard and the UK first ultra deep water port to aid in this growth. If the UK can build world leading decommissioning expertise, we would expect material contracts to flow over coming decades as massive offshore structures are decommissioned in Europe, Africa and America. We would imagine that this capability will be fiercely changed by existing shipyards and deep water ports around the world (particularly in Asia for example).

Full text relating to oil and gas in the 2017 manifesto
"The discovery and extraction of shale gas in the United States has been a revolution. Gas prices have fallen, driving growth in the American economy and pushing down prices for consumers. The US has become less reliant on imported foreign energy and is more secure as a result. And because shale is cleaner than coal, it can also help reduce carbon emissions. We believe that shale energy has the potential to do the same thing in Britain, and could play a crucial role in rebalancing our economy.

We will therefore develop the shale industry in Britain. We will only be able to do so if we maintain public confidence in the process, if we uphold our rigorous environmental protections, and if we ensure the proceeds of the wealth generated by shale energy are shared with the communities affected.

We will legislate to change planning law for shale applications. Non-fracking drilling will be treated as permitted development, expert planning functions will be established to support local councils, and, when necessary, major shale planning decisions will be made the responsibility of the National Planning Regime.

We will set up a new Shale Environmental Regulator, which will assume the relevant functions of the Health and Safety Executive, the Environment Agency and the Department for Business, Energy and Industrial Strategy. This will provide clear governance and accountability, become a source of expertise, and allow decisions to be made fairly but swiftly.

Finally, we will change the proposed Shale Wealth Fund so a greater percentage of the tax revenues from shale gas directly benefit the communities that host the extraction sites. Where communities decide that it is right for them, we will allow payments to be made directly to local people themselves. A significant share of the remaining tax revenues will be invested for the benefit of the country at large."

Supporting industries to succeed section
"Other industries, like the oil and gas sector, are transforming. The North Sea has provided more than £300 billion in tax revenue to the UK economy and supports thousands of highly-skilled jobs across Britain. We will ensure that the sector continues to play a critical role in our economy and domestic energy supply, supporting further investment in the UK’s natural resources. We will continue to support the industry and build on the unprecedented support already provided to the oil and gas sector. While there are very significant reserves still in the North Sea, it is expected to be the first major oil and gas basin in the world to decommission fully, and we will take advantage of that to support the development of a world-leading decommissioning industry. We will work with the industry to create a multi-use yard and the UK’s first ultra-deep water port to support this industry."

Comparison - text on energy in the 2015 document
"We will continue to support the safe development of shale gas, and ensure that local communities share the proceeds through generous community benefit packages. We will create a Sovereign Wealth Fund for the North of England, so that the shale gas resources of the North are used to invest in the future of the North. We will continue to support development of North Sea oil and gas. We will provide start-up funding for promising new renewable technologies and research, but will only give significant support to those that clearly represent value for money."

*Note: Egdon Resources is a client of Edison Investment Research