Philip O'Sullivan's Market Musings

Financial analysis from Dublin, Ireland

PetroNeft (PTR.L) – Siberian Tiger

with 27 comments

(This is the tenth installment in my series of case studies on the shares that make up my portfolio. To see the other nine articles, on Irish Continental GroupIndependent News & MediaTotal ProduceAbbeyGlanbiaIrish Life & PermanentDatalexTrinity Mirror and Datong, click on the company names)

 

While PetroNeft was only incorporated as recently as 2003 and made its debut on the Dublin and London stock exchanges in 2006, the origins of this story stretch back as far as the 1950s, when Soviet scientists made the first of a number of discoveries of oil in the West Siberian Oil Basin in the areas that now comprise PetroNeft’s areas of operations, Licence 61 and Licence 67. At the time these finds were deemed too small to exploit by Soviet officials, who preferred to focus on bringing larger fields into operation.

 

PetroNeft acquired 25 year leases over Licence 61 in 2005, and Licence 67 in late 2009. The terrain where these licence areas are located in is extremely challenging. As PetroNeft itself says, “the region is characterized by waterlogged soils, shallow lakes and extensive swamps. Winters are severe and last seven to nine months of the year with mean temperatures ranging from about −15° C to −30° C. “The climate is strongly continental, characterised by long cold (as low as −50°C) winters and short warm summers. Blizzards and heavy snowfalls persist from October till April. The average soil freezing depth is 1.2m. The maximum frost penetration depth in swamps is 0.5m. The snow cover reaches 1.5m. The heating season lasts from mid-September until May. The Licence area is uninhabited , with access via winter roads of compacted snow, or by helicopter or waterways. A long winter makes for greater progress in the exploration and development of the oil fields. Seismic acquisition activities take place in the winter months. Drilling activities can take place year round provided the rig, supplies and heavy equipment have been moved to site during the winter months“. Not your ideal holiday destination, in other words!

 

PetroNeft’s priority in its early years was to re-analyse vintage seismic and other data, build a central processing plant and export pipeline, and commence drilling development wells. The company spent close to $100m on capex relating to these efforts in the five years to the end of 2010. There have been a number of positives from this, in particular the significant increase in the independently audited 2P (proven & probable) reserves, from 27.9m barrels in 2005 to 96.9m in 2010. In 2011 the group announced the discovery of new oil fields in both the Licence 61 and Licence 67 areas. It has also completed a 60km pipeline connecting its Lineynoye oil field to Imperial Energy’s facilities at Kiev-Eganskoye, storage facilities and a processing facility that can process a minimum of 7,400bfpd (PTR has stated that capacity at this facility would increase to 14,800 bfpd by the end of last year, but I haven’t seen any confirmation that this increase has come on-line – either way, with current production running below 7.4kbopd it’s not a crucial point at this stage).

 

As with all young energy companies that are focused on bringing new facilities on-stream, funding is key. Since the start of 2006 PetroNeft has raised $127m in gross proceeds from the issue of shares, while it also has a $75m debt facility from Macquarie. Given the scale of the capex noted above, along with the running costs of the firm, the latter facility has become especially important to the group. At the time of the firm’s H1 2011 results the firm disclosed that it had swung into a net debt ($12.9m) position. I estimate that it exited 2011 with net debt of $31.3m.

 

Of course, debt and equity are not the only sources of funding. In 2010 the group moved from being an exploration company into being an exploration and production company. At the time of its FY10 results, management hailed output of 3,100 bopd and guided that output would rise to “a range of between 7,000 and 8,000 bopd by the end of Q1 2012”. However, soon after the group ran into production difficulties, turning to a fraccing programme to boost output. H1 2011 output averaged only 2,182 bopd as wells were taken offline to facilitate the fraccing. The share price tumbled on the back of output missing previous guidance. In early December 2011, the company struck a different note, saying that the initial results from its post-fraccing wells were “encouraging”, and that output had picked up to about 2,500 bopd.

 

Just when things had started to look up for PetroNeft, the company suffered a fresh blow when management revealed last Friday that current production levels had tumbled to 2,300 bopd having touched 3,000 bopd at the end of 2011 as reservoir pressure at a number of the fracced wells had declined. This led to a near-40% one-day decline in the share price, as investors reeled from the impact of another production disappointment (PetroNeft had guided in December that output would hit “4,000 to 5,000 bopd by the end of Q1 2012”).

 

So, with the shares having been on the receiving end of a severe kicking last week, what should be the response of investors like myself? To begin to answer this question, over the past few days I’ve built a model from scratch for the company and incorporated some pretty conservative assumptions into it. On the output side, I see only 3kbopd on average being produced this year, rising to 5kbopd in 2013 and 6kbopd in 2014. I suspect the risks to my 2013 and 2014 estimates are to the upside, but given the production disappointments to date, I see no harm in being cautious. In terms of the oil price, I assume a long-term price of $85, which I also think is extremely prudent.

 

The obvious question arising from the above assumptions is – “How on earth is PetroNeft going to fund itself if your estimates are correct?”. In my model I have assumed that it will pursue a ‘shareholder friendly’ strategy, in which the company reins in capex to $25m/year for each of the next 3 years (from what I estimate was $40m in 2011). This sees net debt peak at $125m at end-2014, which is clearly well in excess of the current debt facility, but if PTR is able to continue its record of adding to its reserves (I wouldn’t bet against that given the track record noted above) and/or oil prices outperform my conservative forecasts (very likely) I think it’s realistic to assume the company can secure extra credit facilities using its reserves as collateral (as it has been doing up to now). However, this assumes that management, which has presided over an increase in the number of issued shares from the 207.5m average for 2007 to the present 411.6m, will not raise fresh equity either to keep debt levels down or maintain capex at the 2011 rate. This may well turn out to be a heroic assumption.

 

Standing back from these assumptions makes it clear that making long-term forecasts for PetroNeft, given the relatively early stage its operations are at, the disappointments to date and the possibility that existing shareholders could be heavily diluted (given where the share price is at), is fraught with risk. My model has spat out a NAV of 60p/share, which is 6x where the shares closed at last night (10.0p). Based on my conservative estimates, the biggest risk is that of a large scale equity fundraising, but with 500% theoretical upside on my numbers I have to ask myself if this risk is priced in?

 

Looking at it another way, PetroNeft had independently audited 2P reserves of  96.93m barrels of oil at the end of 2010. Given the modest production levels and encouraging news on discoveries since then, I think it’s safe to say that these reserves have grown since then. But, for argument’s sake, taking the 2010 reserve figures as a baseline, yesterday’s closing market valuation and my forecasts for 2012 this puts the group on a current EV/BOE of $1.28, meaning that the market is applying a valuation of only $1.28 to every barrel of oil PetroNeft has in the ground. So, the stock does look cheap on this measure.

 

Cheap as it may appear, clearly, there are significant risks to this company, and its track record to date doesn’t inspire a lot of confidence. Perhaps the beaten up valuation reflects all of this. Perhaps not. Until management demonstrates that it has overcome the production problems PetroNeft will, in my view, likely remain well outside of ‘suitable for widows and orphans’ territory. However,  not being a widow or an orphan, I need to make up my own mind about what I should do about this stock. My model tells me that PetroNeft won’t necessarily have to raise additional equity to execute its strategy, and on that basis, the shares look like they’re remarkably good value here. However, even if I’m wrong, and existing shareholders get diluted by, say, 50% (yes, I’m picking that number completely out of thin air), the upside is still a multiple of where the shares are trading at. To this end, and while noting that the risks are substantial, I think I’ll be adding to my existing position. Whether this turns out to be a brave or foolish decision, only time will tell.

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Written by Philip O'Sullivan

February 23, 2012 at 9:30 am

Posted in Sector Focus

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27 Responses

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  1. Hi Philip,
    As far as I can tell PTR receive a maximum of US49 bbl – based on H1 2011 accounts, so I believe you have overstated cash inflow in your calculations.

    Total 2011 H1 Rev US 15.97m at 2182bopd grossed up by 17.5% (MET) = US 49.

    Would you agree with that?

    I agree with your production profile for the next few years. Not so sure about McQ agreeing to allow debt to reach US140m though. Given the successful 2010 placing I’m thinking they will tend towards that route once the sp has “hopefully” risen on the back of reserves upgrades.

    David MacInnes

    February 24, 2012 at 7:44 am

  2. Hi David

    Thanks for visiting, and commenting! We’re both right in terms of PTR’s cashflows – my piece referenced the gross entitlement, but in my model like yourself I adjust to get to the net entitlement after royalties etc.

    As regards Macquarie – that’s the “known unknown” for sure – and as noted above, the possibility of a further share issue is quite high. But even if it does happen, like you say, the trajectory in the share price will be key to determining the extent to which investors are diluted.

    Philip O'Sullivan

    February 24, 2012 at 8:36 am

  3. Thanks for the response Philip,

    I can’t find anything with regard to royalities in Russia. I think only MET should be used to gross up (and the crippling export duty, but that’s not applicable in this case). I use the Ernst and Young tax guide as a reference. It’s a good one and covers pretty much all countries.

    I’ve copied the below from another site while trying to find something else on royalties, and this, as expected agrees to the EY publication.
    “The fiscal regime is a blend of corporate profits tax (20%), mineral extraction tax (roughly 22% of the value of production in excess $15 per bbl.) and export duty (35 to 65%, with Urals at $88, the duty is $45 per bbl.).”

    If you have a link to royalties then would you mind posting it here, as it would make a difference to my calculations.

    Thanks again.

    David MacInnes

    February 24, 2012 at 9:23 am

    • Apologies for the loose language, I used “royalties” as a generic term for taxes. What I would say in response to your points above is that the Russian government’s tax policy for smaller fields such as PetroNeft’s is a little different (http://www.bloomberg.com/news/2011-06-14/russia-to-grant-tax-breaks-for-small-fields-kudryashov-says.html). In terms of my model I have incorporated a number of assumptions on the tax rate and oil price which of course are open to review should the outlook for either of them change materially.

      I also would highlight that investors’ focus on PTR at the moment is concentrated on production rates.

      Philip O'Sullivan

      February 24, 2012 at 12:17 pm

  4. Assumptions are an important part of any model. In terms of tax rate/royalties very little assumption need be made in though. The tax review you linked above is in regard to “new” small fields and they receive a 46% discount of the 17-22+% MET. So, it won’t apply to current output.

    I also agree that production rates are the focus, that is why it’s important to value them correctly. I still can’t understand how you get from a gross US 85 bbl to a sensible net per bbl given the known figures – namely their current revenue per bbl and published tax rates. But that’s ok. I did find the rest of your review useful, so thank you.

    David MacInnes

    February 24, 2012 at 1:40 pm

    • With respect, I think you’re taking my words a little too literally! Having spent several years working as an equity analyst, I’m pretty familiar with the importance of assumptions – my point was more that there are massive inherent uncertainties when it comes to forecasting for an early stage company over a LT time horizon such as the licence period for PTR’s Russian operations. I have taken a similar, but somewhat more conservative, approach to Canaccord, and their NAV comes out at 71p.

      For an overview on PTR’s taxes, see Appendix 2 here: http://petroneft.com/upload/iblock/5a5/5a5aeca5a4de73521670ab70e05c388e.pdf

      I’m not 100% sure about whether this tax will apply only to ‘new’ small fields, and reading reports like this makes me wonder about it: http://www.independent.ie/business/world/russian-tax-cut-sparks-petroneft-share-surge-2829604.html Some broker notes I’ve read (notably, Goodbody Stockbrokers, my former employers) also take the line that PTR will benefit from a change in the regime.

      Either way, it is only one component of the narrative – both quantitative and qualitative – that informs the investment case. To me this stock is like an option – as I outline, you can plug in assumptions that suggest existing shareholders will be wiped out, or you could make assumptions that result in significant upside from here. I’ve weighed everything up and concluded the latter is what I see happening, and I’ve placed my bet accordingly. Whether you agree with every step of my analysis or not is your call – that’s the great thing about the market – it’s where all opinions collide! And finally, have a good weekend, and if I’m right in assuming you’re a Scot from your surname, best of luck against the French!

      Philip O'Sullivan

      February 24, 2012 at 5:36 pm

  5. […] series of case studies on the shares that make up my portfolio. To see the other ten articles, on PetroNeft, Irish Continental Group, Independent News & Media, Total Produce, Abbey, Glanbia, Irish […]

  6. […] of case studies on the shares that make up my portfolio. To see the other eleven articles, on PetroNeft, Irish Continental Group, Independent News & Media, Total Produce, Abbey, Glanbia, Irish […]

  7. […] case studies on the shares that make up my portfolio. To see the other twelve articles, on Ryanair, PetroNeft, Irish Continental Group, Independent News & Media, Total Produce, Abbey, Glanbia, Irish […]

  8. If there was significant purchases by directors at these levels it wouild be a big vote of confidence…..

    aidan walsh

    April 10, 2012 at 12:50 pm

    • Hi Aidan, thanks for visiting the blog, and for posting! I was thinking the same thing as you over the weekend while looking at the ‘director purchases’ section of the FT. That would certainly help ease some of the present concerns.

      Philip O'Sullivan

      April 10, 2012 at 1:07 pm

  9. at its stated production level of 2300bpd at a price of less then 90pb petroneft is facing into a serious cash shortage to finance its cap exs going forward. a rights issue is out as no finance house would underwrite such an issue with the companys failure to meet set targets. furthermore at the current share price the very maximum that could be raised is e16million which sum is insuffient. so this leaves mcquaire as the best bet providing production of at least 5000bpd is achived in qrt to end of sept 2012. if this is not forthcoming a takeover must happen which in turn wiil mean at least a 80pc reduction in present shareholders equity.oil values must always be counted in the bank and not in the ground which is the case with petroneft .

    beingthere

    May 2, 2012 at 6:48 am

    • Is the meeting on Friday a scheduled meeting?

      aidan walsh

      May 8, 2012 at 1:48 pm

      • Hi Aidan, according to Goodbody the company is due to release its results that day.

        Philip O'Sullivan

        May 8, 2012 at 2:22 pm

  10. […] up my portfolio. To see the other thirteen articles, on Marston’s, France Telecom, Ryanair, PetroNeft, Irish Continental Group, Independent News & Media, Total Produce, Abbey, Glanbia, Irish […]

    • What time are petroneft reporting at? Is it today?

      aidan walsh

      May 11, 2012 at 9:22 am

      • Hi Aidan, both Goodbody and Morningstar had reported that PTR would issue results today, so I had expected to see something from them. In the absence of anything appearing I’m at a loss as to when we can expect to see the numbers.

        Philip O'Sullivan

        May 11, 2012 at 3:55 pm

  11. Morningstar reporting June 10 as reporting date.

    aidan walsh

    May 30, 2012 at 2:40 pm

  12. […] my portfolio. To see the other fourteen articles, on RBS, Marston’s, France Telecom, Ryanair, PetroNeft, Irish Continental Group, Independent News & Media, Total Produce, Abbey, Glanbia, Irish […]

  13. […] To see the other fifteen articles, on AIB, RBS, Marston’s, France Telecom, Ryanair, PetroNeft, Irish Continental Group, Independent News & Media, Total Produce, Abbey, Glanbia, Irish […]

  14. Petroneft have secured a $15m loan from Arawak (Vitol) this will fund the drilling of 10 production wells at Arbuzovskoye. The initial well is flowing 350 bopd.

    They have also breached banking covenants and Macquarie have requested repayment of $7.5m but are giving the company time to make the repayment. Debt with Mac is circa $27m.

    I think most of the funding ‘issues’ are already priced in to the stock price – as ever ‘the market’ seems to know problems far ahead of official announcements. The positive, in my view, is that Petroneft have a strong partner in Vitol and this has been overlooked by the market in evaluating the financial risk.

    If all goes well with the drilling programme Petroneft could be generating about 5000 bopd by year end.

    They also state they are seeking out JV deals, looking for alternative funding and pursuing other corporate options. A takeover cannot be ruled out in my view.

    The shares could be an interesting bet around current levels, certainly the $15m funding will tie them over for the time being which negates the immediate financial risk.

    oilplayer2009@yahoo.co.uk

    July 7, 2012 at 7:28 am

    • Hi Oilplayer, yes indeed, that is the bull case for PTR here. I’m staying in the stock in the hope that something along the lines of watch you sketch out happens. Not sure though about the prospects of it hitting 5kbopd by year end, but will be delighted if I’m proven wrong 😉

      Philip O'Sullivan

      July 7, 2012 at 9:20 am

  15. […] other sixteen articles, on Bank of Ireland, AIB, RBS, Marston’s, France Telecom, Ryanair, PetroNeft, Irish Continental Group, Independent News & Media, Total Produce, Abbey, Glanbia, Irish […]

    • Petroneft update seems positive. Would not be unusual if they were producing 500 bpd in early to mid 2013. What are the chances of each of the new 10 wells producing 300 bpd each.

      aidan walsh

      August 13, 2012 at 8:05 am

      • I meant 5000 bpd.

        aidan walsh

        August 13, 2012 at 8:06 am

  16. Hi Aidan, apologies for the slow response, your comment was posted just as I was going on holidays. While I would be loath to make any bold predictions given PTR’s “track record” on the production front, like yourself I thought the update was fine and given the conversion of two wells to water injection ones and the near-term replacement of the electric pump, in addition to the new wells you mention above, I think the target of 5000 should be attainable. Time, of course, will tell!

    Philip O'Sullivan

    August 22, 2012 at 10:31 am

  17. […] on Smurfit Kappa Group, Bank of Ireland, AIB, RBS, Marston’s, France Telecom, Ryanair, PetroNeft, Irish Continental Group, Independent News & Media, Total Produce, Abbey, Glanbia, Irish […]


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