PetroNeft (PTR.L) – Siberian Tiger

(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 Group, Independent News & Media, Total Produce, Abbey, Glanbia, Irish Life & Permanent, Datalex, Trinity 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.