Sound Oil - Not so Sound after all

http://www.soundoil.co.uk/
Its been a not so sound start to 2012 for Sound Oil (LSE:SOU) so far. The company has been hit by multiple pieces of frustrating news. Sound is an oil and gas exploration and production firm with assets in both Europe and Asia. To put things into perspective, in 2011 Sound rose from ~1.1p at its low to over 6p at its peak less than a year later. The share price now stands at only 0.39p a massive drop of over 90% from the peak to the current price. The clear question is 'Where did it all go wrong?' Sound has ~2.8 billion shares in issue and a market cap of around £11.5m.

As shown above Sound has dropped significantly so far this year - by over 75%. The chart movement has mainly been a downward trend interspersed with short periods of consolidation. Following a sharp drop in late July, the share has commenced a fast downward fall and now sits at 0.39p. The overall picture for the share price is not particularly bullish currently. To start to look more bullish the share would need to pass through a declining level of circa 0.50p. However, the catch here is that is over 25% from the current price thus you would be missing out upon a large rise. The share is currently at an all-time low having initially traded around 8p following its IPO over five years ago.Eventually this is likely to mean that selling will dry up assuming a lack of news. Over the past year the share price is down ~83%, -72% over 6 months and a massive -63% over the last three months alone. The prospects of Sound may help make an informed decision as to when would be a good time to buy in, if at all.
Sound is listed on the AIM of the LSE, it was admitted in June 2005. It has two main focuses: Italy and Indonesia. CEO of Sound is currently Gerald Orbell. As a resource base, Sound has 17.5 MMboe at a mean level calculating to $300MM at NPV10 - a substantial set of potential resources.

In Italy Sound has ~20 licenses in which it operates through its wholly owned subsidiary Apennine Energy. Sound is operator is all these licenses except one, mostly in which it has 100% or very close to this level stake. Risk factors for these prospects range between 14% and 50%. One positive to be derived from this is that a deal could be done with another small/medium sized firm which could reduce Sound's working stake to reduce expenditure which led to Sound having a pre-tax loss of almost £16m in FY 2012 and £6.2m in FY 2011. Without delving too deep due to the huge number of licenses, the total area of these 20 licenses is 3125.4km2. The company says that potential revenue from t two developments here could reach over $40m going into 2014/2015 (Nervesa and Strombone). The new Nervesa well is due to spud in Q4 2012. For Sound's Badile prospect, it is planned it will be drilled in Q2/Q3 2013 and Sound will try to farm-out this prospect. There are currently three parties in the data room interested in this asset, these are likely to be small-medium in size.

In Indonesia, Sound has two licenses; the Bangkanai PSC and the Citarum PSC. In the Bangkanai license, Sound has a stake through Mitra Energia equivalent to 5%.The license spans over 4500km2. This license is a 'sound' part of Sound's portfolio as its free-carried. This means that Sound has to contribute no costs to any developments and wells to this PSC but gains 5% of the rewards. In terms of funding by partners, this license is secure as fairly large 'Salamander Energy (LSE:SMDR) owns an 80% stake in the license. First gas sales from this license should commence in late 2013 which would provide Sound with a stable source of income which it can spend elsewhere.

The Citarum PSC spans circa 2900km2 and is located very close to the prolific West Java Basin which is home to over 2 billion barrels of oil equivalent. Potential resources here are also high. Sound has a 20% stake (not free carried) in this block which is operated by Pan Orient Energy. The first well drilled on this block was entitled Pasundan-1 - it was plugged and abandoned in late 2008. However, immediate success here is unlikely - the Pasundan well flowed fresh water, albeit at a good flow rate. In total, Indonesia currently potentially holds 332bcf for Sound - referring to the calculations made above, there is no shortage of potential at the company, just cash! However, like all potential it has to be realised to be worth anything, and unfortunately the success rates outlined for the licenses are fairly low. One prospect has a 20/34% possible COS (chance of success) with the remaining COS' around 10%.

Going forward Sound will drill a 9 well exploration/appraisal portfolio at both locations which could contain 374bcf and 6.4mmbbl as noted by the company.

To put this into values i'll use Cove Energy's estimated value per bcf based on its takeover value and apply certain discounts. Cove's takeover valued £228.8m per TCF. To find this for 384bcf divide by 1000 and multiply by 384 giving a supposed £87.8m figure. However, Cove was probably overvalued hence discount this by 20% equalling £70.3m. This figure is substantially higher than the current market capitalisation. Say that only a third of this is found - this still equates to £23m which is far higher than the current market cap. The only problem with this would be that dusters would lower the share price by substantial values also. Taking the £70m value, divide this by the number of shares in issue. This gives a potential upside value of 2.5p/share for just the gas figure. Take the £23m, this gives a potential upside value of £0.82, potentially trebling the current price on just the gas figure. The 6.4MMbls has the potential to significantly add to the commerciality of the resources.

The company itself gives full values although be wary as these are very often too high. Over the next six months, Sound has attributed itself a potential 7.4p/share assuming an all-success basis at the Pmean level. Whilst this is wholly unlikely, it demonstrates the tremendous potential in the assets if (and its a big if) they can be successfully exploited.

The first news of 2012 came in the form of a drilling update regarding the Cataka-1 well in the Citarum PSC. It noted that the well had started drilling in late December with an estimated drilling length of 21 days. The well was targeting 470bcf of which 94bcf would be attributable to Sound. Following this were a couple of small-sized directors purchases at prices that are now multiples above the current price.

A mixed operations report was then released in late January:

Sound Oil is pleased to confirm that, the Casa Tiberi-1 well has been re-entered and the planned test over the interval 571-581 metres successfully completed. The well flowed gas with a final rate of 37,850 scmd on a 5/16" choke (approximately 1.3 MMscfd). The data from the test will be studied in detail to assess the production potential of the well. The good gas quality and the nearby presence of a low pressure gas network provide an opportunity for a commercial fast-track development of this discovery. A further announcement will follow once the test results have been fully analysed and commercial alternatives explored.

Sound Oil has been advised by the Operator that the Cataka-1 exploration well on the Citarum PSC, Java, Indonesia has encountered unstable formation in the top hole section, necessitating a sidetrack. The sidetrack hole has already been drilled to the casing depth at 1,397 feet and the 13 3/8ths casing set and cemented. Now that this part of the unstable formation has been cased off, the well will drill ahead to the objective at 6,995 feet as originally planned. It is estimated that at least two additional weeks will be needed to complete operations beyond the planned 21 day programme.  
The effect of the positive part of the RNS was effectively nulled by the delays to drilling hence meaning further costs would be incurred - this delay was substantial compared to the original time frame expected. In early February Sound announced the completion of a private placing to raise  the necessary funds for drilling the Nervesa well later in 2012. This placing was completed at 1.52p/share - far higher than the current price also.

Another disappointing update from Cataka-1 was released thereafter. The sidetrack failed hence they decided to drill a secondary sidetrack - which also failed due to the same reasons and poor rock formations. Consequently, Pan Orient and the partners decided to abandon the well so that the data could be re-interpreted. In March the main feature of the operations report was the progress at the Badile permit:

All geological and geophysical studies for the project have been completed. Dependent on the mapping model used, the Badile prospect has been determined to have a range of P50 prospective resources from 170-226 Bscf (gas case) or 18-23 MMbo (oil case). A surface location has been identified and a detailed well plan is in preparation. The project is on schedule for a drilling application to be submitted in early Q2 2012 with a view to drilling in 2013. A farm-out campaign for the well has commenced and will include a presentation at the APPEX prospect fair in London, 6-8 March.

A few days later the result of a flow test at the Casa Tiberi-1 well were released. The flow stabilised at a rate of 0.28mmscfd - this is a rather low flow rate, but the well confirmed the presence of hydrocarbons in the area - it is very likely that the 'sweet spot' was not drilled based on the low reservoir pressure. Later in March the spudding of the Jatayu-1 prospect in Indonesia was announced targeting 290bcf of which 58bcf would be net to Sound. The drill would take 30 days.

The final results for FY 2011 were released on the 1st May. As expected they featured vastly increased exploration costs up to £2.4m from just  £430,000 a year earlier. This combined with poor results meant that cash burn was high. In late May more problems were encountered, this time at the Jatayu-1 well. Whilst gas shows were observed, the drill pipe became stuck thus the well had to be plugged back to a higher depth. From potential success to more difficulties with one action.

However, there was a very positive development soon after - Sound had secured Strombone funding that was entirely dependent on success or failure. If the well fails to produce, the loan is not repayable, but if it does produce it is repayable. Effectively this a win-win situation for Sound as at the least the well will generate significant geological data. However, this arrangement was later suspended as per the following: 'The planned unsecured loan funding for Strombone, announced last month, has been called off for now as the permitting process has been talking longer than expected and drilling the appraisal well is expected to occur early in 2013."

Whilst still subject to contract and due diligence, the funding would be provided through a US$6 million unsecured loan, extendable to US$9 million by mutual consent. The loan is not repayable should there be no production from the licence and will entitle the fund to a percentage of the gross revenues from the licence in the success case. Final terms will be announced following contract signature.

In June, at the Jatayu-1 well a 390 feet gas section was found during drilling the sidetrack. Consequently this section would be logged. Dependent on logging results a decision will be taken as to whether to target the Parigi objective, some 1700 feet deeper, or to stop drilling and test the well. It is interesting to read this line though as it proves the partners were not particularly confident with the geology below. In mid-July Sound secured further funding through an open offer and private placing that effectively allowed the company to raise ~£7m. This was a very dilutive action though with over 700m new shares being issued.

More problems were soon revealed at Jatayu probably not to the surprise of investors. Whilst its difficult to interpret what actually went wrong through the RNS it appears that the wireline logging was of poor quality due to the geology - potentially it looks like the reservoir was too low a porosity to be of use. "Jatayu is proving a very problematic well with gas shows over a 600 feet interval and with zones of different pressures. The hole condition makes wireline logs difficult to interpret although we are encouraged by our own analysis that indicates several units with reservoir potential".

In early August Sound signed a contract with an engineering firm (CSTI) for the Rapagnano block in Italy. in the contract CSTI will fund $500,000 and receive 52% of net cash flows for 30 months from the first gas date. The more interesting Bangkanai well campaign (drilled by Salamander) spudded on the 22rd August. This is the PSC where Sound does not have to pay for operations. Yet once again along with this was a poor piece of Jatayu news. More issues had further delayed progress and it looked almost nailed on the well would be a complete failure. Finally, the inevitable was released a week later with Jatayu being suspended.

Investors would now hope that the Indonesian raft of bad news is out of the way. Two problematic wells and multiple fundraisings through placements are what have really hammered Sound over recent months. Any find of significance in Indonesia has the potential to significantly lift the price from the doldrums, but this is by no means guaranteed as proved by Cataka and Jatayu.

The real clear issue with Sound that dictates the rest of its operations is that of funding.  If they had long-term adequate funding, the result of one well would impact far less than what it has. Overruns in Indonesia will not have helped the cause either. Albeit theoretical, there are three steps that I would pursue to attempt to turn around Sound.  Firstly, I would further sell off the interest in the Citarum license towards 10%. As part of this deal I would seek a free-carry status as with the other PSC rather than a cash sum. The geology is clearly problematic, so with a free-carry this would not be as big an issue. Also, the potential return to Sound will be still be significant, especially at the current market cap. The low COS of the Indonesian prospects means that Sound would need to contribute a fair sum to these operations which they cannot particularly afford. The second stage would be to sign a strategic partnership with a medium-sized firm for the Italian asset. Through this I would farmout up to 50% of the exploration assets to reduce the necessary funds required here. This would take form of one company farming into multiple licenses. This would also allow Sound to pursue more developments at once. The third stage to kick-start the share price would be conditional on the success of the first two changes. This would include a reverse stock split of maybe 10-1 to remove the number of shares in issue. Reverse stock splits are relatively cheap and can be the beginning to a turnaround in price action. The price is currently depressed due to ongoing concerns about the operations and people selling back at the break even level/at a loss so they can move onto other investments. I would expect some of thse concerns to be alleviated hence have a buy tag on it.

The long-term potential is there, but the funding is not. If this problem is sorted there is no reason why Sound can't succeed in building future shareholder value.

Three photos courtesy of freedigitalphotos.net

10 comments:

  1. Hi
    Well done you have put in some good research.
    Note that it would appear the non repayayable loan for the Strombone funding was cancelled per RNS 16 July 2012.
    Legalandgullible

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    Replies
    1. Cheers, have amended that - If Sound could reduce their exposure to Citarum and get funding for the Italian prospects they may become a good recovery play.

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  2. good research

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  3. very good piece of work here. thankyou

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  4. Many thanks for your comprehensive overview.

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  5. thank you much appreciated

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  6. Very good impartial article

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  7. Hi
    Would like to say another couple of points.And add some comment
    Re Kerenden/Salamander (Sound Oil 5%)
    1.)According to RNS update 23rd August first gas is expected in late 2013
    2.)At the end of the report you suggest price is currently depressed by investors selling at break even. I think there are very few investors who have succeeded in selling at break even. The price has been only on a steady downward spiral !!
    Comment :-Another key to this whole predicament and not brought too much to the foreground seems to be Sound's purchase of Consul Oil and gas and also Celtique. Considering the companys limited funds it seems surprising to me that they dossed out around £8 million (need to check that figure) of the companys money to acquire these companies.Their reasons if I remeber rightly were because they wanted 100% control.If they back pedal now and farm out or sell off pieces it seems to bring into question whether they needed to spend so much on these two companies in the first place. During 2011 Sound made 13 separate issues of new shares to raise around £19 million.
    Finally there is a huge question overhanging the Sound oil price in respect of the most recent placing of 774 million shares to Astin/Manxdale (paid in arrears). It would appear that Manxdale is gradually disposing of this holding onto the market and probably depressing the price. Since this placement will be spread in 7 equal amounts over at least 7 months this weight on the Sound share price could well continue into next year.
    legalandgullible

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  8. Gerry's wife at Melton Drive12 September 2012 at 18:19

    "farm-outs would reduce expenditure which led to Sound having a pre-tax loss of almost £16m in FY 2012 and £6.2m in FY 2011"

    It was £16m in FY 2010, due primarily to a £14.2m impairment. To answer some of the critics I can tell you that Gerry is working immensely hard to make the company a success and thoroughly deserves his annual bonus this year. The new conservatory and extension will not pay for itself.

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  9. Elite Trader - something like this needed doing & you have done a great job. A good resume for newcomers who can read a condensed history of Sound Oil & make their own mind up using this as part of their research.

    Good job

    Kirk (Crudehope)

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