Sound Oil - A Much Improved Strategy

http://www.soundoil.co.uk/


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The blog first reviewed Sound Oil (LSE:SOU) in early September 2012. At that time, Sound had made a low at 3.09p/share equivalent having fallen over 90%. The company also had 2.8 billion shares in issue and a market capitalisation of £11.50m. The company then released a raft of good news that sent the share price rocketing by 271% by just mid-October (to a peak near 14p/share equivalent) making it easily the blog's biggest success to date. Despite this, in my second update on Sound Oil I pointed out that a variety of issues I had highlighted in the initial article had still not been addressed and thus took a neutral stance at this point. Since this point, Sound has made excellent progress (thanks to the management) with a series of strategic decisions that should make the business model and investment case more sustainable.

This article is a follow-on from the below posts. For full context and information, read these articles first:
http://www.theel1tetrader.com/2012/09/sound-oil-not-so-sound-after-all.html
http://www.theel1tetrader.com/2012/10/sound-oil-update.html



Whilst there is relatively little more information to add to the last chart, the last few days has seen Sound leave its downward channel. For this movement to be confirmed as creating a positive uptrend, I would expect to see a move towards the 11p mark. Failure to do this may lead to the downtrend still being in progress albeit at a shallower rate.

In my first article on Sound Oil in September I came to the following conclusion:

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.

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.

It has been very pleasing to see that Sound has successfully taken the initiative to change its old strategy into one that can be maintained over a longer period of time. Consequently, as noted there is no reason why Sound can't succeed in building shareholder value. This following section will outline the news since the last article was written in October.
courtesy of freedigitalphotos.net
The new format of Sound was initiated via the introduction of a new CEO, James Parsons, who replaced Ex-CEO Gerry Orbell. Parsons has been Sound's Chief Financial Officer for a year, and has previously held roles in companies including less-senior roles at Royal Dutch Shell. Considering he has been with Sound for a year, the transition should have been smooth, and it was consequently allowing for quick progress following the announcement.

The first step of the turn-around from historic lows for the company was to completely sell off its Citarum PSC interest to the operator of the licence - a slightly more cut-throat strategy to what I had suggested (i.e. to reduce it nearer to 10%). Despite this, the reasons were evident, with poor success rates (and over-expenditures), but more importantly the Indonesian project required significant investment on Sound's behalf. The deal that Sound achieved was very good. The main features included:

- Waiving of $2.4m of overdue cash calls
- Paying Sound Oil $10m contingent on revenues from the first discovery
- Paying Sound Oil $6m contingent on revenues from a second discovery

The benefits of this arrangement are clear, Sound was instantly able to reduce immediate expenditure and also was able to generate a pipeline of potential cash in the future assuming that discoveries are made - however, these are not secured yet so could amount to nothing (albeit highly unlikely).

CEO James Parsons commented:
"The Company estimates that its share of the remaining cash spend on Citarum would have exceeded US$5 million. This transaction converts an unsustainable cash burn outside of our control into effectively a carried position, with continued exposure to up to US$16 million of upside. Therefore this transaction secures Sound Oil's existing cash balance for our operated Nervesa and Rapagnano projects in Italy. This transaction is the first step towards reshaping the Company's portfolio."
courtesy of freedigitalphotos.net

Following this, later in November Sound secured funding for its Italian Nervesa project with an engineering firm. "This funding contract secures up to euro 5.5 million of additional funding in exchange for an estimated 7 to 8% reduction in the Nervesa project NPV. It also limits Sound Oil's remaining cash spend on the Nervesa appraisal well to euro 1.4 million, therefore preserving cash for subsequent wells". Further to this, in late November Sound signed a gas sales agreement for its Rampagnano project in Italy ensuring a route to production. The relatively low gas reserves are offset by the outstanding price Sound will get for its gas - $11.2/mmscf. This is multiples higher than in other high income countries.

The next part of the plan was announced in late November. Sound sold off its Subsidiary involved in the Bangkanai PSC to Salamander Energy. This raised $4.5m payable immediately plus a further $2.6m assuming various conditions are met. This further strengthened the financial position of the company - as I noted this was the most significant hurdle that needed to be overcome.  In addition the RNS included the third aspect of the theoretical plan - the company announced that a 10-1 share consolidation (reverse stock split) would take place which would reduce the number of shares in issue from almost 3 billion to just short of 300 million - a move that should reduce the the continual offloading of shares into the market and boost investor confidence. "Sound Oil now has a very clear strategic focus and some US$10.2 million cash in the bank."

In early January the Rapagnano well was tested for production of its 1.3bcf reserves. The well tested at 0.5mmscfd. After this another update on the share placement announced in mid-2012 was given which revealed that further tranches had been completed which put Sound in good stead with a cash balance of £8.5million and no debt.

The next supposedly imminent step of the strategy is to bring gas production online from the Rapagnano well. This should start to produce revenues for the company albeit not particularly large. Further along the timeline, Sound will appraise its 100% owned Nervesa project. The company specifically noted that they had received offers for a farm-in here but these were rejected in order to retain potential upside despite being 'attractive' offers.

Sound Oil has done very well to rise from the depths of 3.9p (equivalent) to its current share price over 10p. Kudos to the BOD. Broker Westhouse Securities has set a price target for Sound of 32p which in my opinion is far too optimistic as it would capitalise the company at £92m. A market cap of between £38m and £45m is more sustainable in the medium-term and is far more likely as it translates to a share price between 13.2p and 15.6p. Despite this, I will continue to have a neutral perspective on the stock as it is more of a medium-term play with the previously 'bombed-out'  share price reason somewhat dissipated. With the equity dilutions of 2012 likely to soon reduce any remaining stock overhang and institutions such as Henderson Global acquiring stakes, there is still attractive potential in Sound Oil going forward. Nervesa represents the next major challenge in the portfolio which if successful could act as a share price catalyst.

9 comments:

  1. Cant wait for nervesa. Go Sound!

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  2. Great reliability, keep it up

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  3. We appreciate the detailed research which you do with all of your selections. how unlike the the 'Tip Sheet' authors who line their own pockets by the 'gossip' they create - thank you.

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  4. Good review. Thanks.

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  5. Like the sound of the prospects for sound in the coming months.thank,s for review of company profile.

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  6. Hi E1ite,

    I know it's been a while since your review on Sound. Was wondering what you think about the recent gas discovery and it's technical position? Do you think it will slide down before full details of the discovery are released or speculation will drive SP upwards?

    Thanks!

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    1. Encouraging is certainly one way to put it. I have been very impressed by the new CEO and the change of strategy is working wonders. Technically the shares are very storng and could be set to test 14p over the coming week(s). I note Parsons comment: "it appears sufficiently large to deliver important cash flows and provide funding alternatives for the 2014 drill programme." Realistically, with 46m net gas pay I would be expecting to see a resource upgrade from the expected 21bscf but that is just speculation based on the numbers given. After all, the gas is across 13 zones, none of which are likely to be huge.

      Before the release of the results, I would not be expecting any significant downward pressure

      El1te

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