Petro Matad - The spike is overdue

http://www.petromatad.com/

Petro Matad Logo

On the back of the recent successful sell call on Kodal Minerals (LSE:KOD), it's worth taking a look at another small cap resource company, Petro Matad (LSE:MATD). Petro Matad (abbreviated as Petro from here onwards) is an oil and gas exploration company who operate in Mongolia. The company's share price has been on a strong run of late, but that seems fully unjustified. Unlike Kodal, that hasn't stemmed from bullish corporate talk, but rather from pure market momentum. There have been quite a few cases of such sharp rises (predominantly in the small cap resource sector) of recent, and Petro is a classic example. These rises are fine when the fundamentals are sound, but when the company is not, you have to be very careful as spikes often form. I reckon this is another example of a spike being formed and that there is clear downside potential from this level. Following the recent price rise, Petro is trading at 9.5p. With 279m shares in issue, Petro has a lofty market cap of £26.5m.


As with all shares that have moved quickly, it's very important to check out both the long-term chart (as above), and an intra-day chart (as below). This forms a more accurate picture of what is likely. As noted in the box with blue text, the momentum would have been aided by the long term price action. When investors see a company that has had a share price multiples higher, in previous years, they often believe that any recovery should be strong as there is the potential to revisit at least a fraction of those heights. That drives the share price as from a historic perspective, the shares look 'cheap' in comparison to 2011. The reality is that taking such a view is very dangerous. The shares have fallen for a reason, and in Petro Matad's case, the reason was fundamental. You can tell from the sheer drop in the share price.

A more accurate assessment is therefore to compare market caps, rather than absolute share prices. Back when the share price was 161p in September 2010, the market cap of Petro stood north of £200m. That is substantially higher than what is currently is. However, the first point to note is that the market's view of oil and gas companies has seriously deteriorated over the past couple of years, and share prices have generally fallen across most of the sector. Currently, access to cash through the equity markets is much more difficult, and even more difficult through the banks. The more important point is that, once again, the fundamentals are so much weaker and such a valuation nowadays, would be ridiculous.

The intra-day chart has a number of similarities to that of Kodal's chart, just before their recent price drop. Firstly, the upward support line has been breached. Secondly, little support formed on the way up, and downward overhead resistance has formed. Finally, volumes are declining meaning reduced liquidity, and a share more prone to see its share price drop off in the coming weeks. As far as I'm concerned, the short-term technical position of Petro lends towards a re-tracement back towards 7p rather than a further extension above 10p.

Onto the fundamentals. What caused that dramatic fall from over 200p to just 2.63p in recent weeks? Petro operates across three blocks in Mongolia; Block XX, Block IV and Block V. Mongolia is a landlocked country located North of China and South of Russia. Not exactly the prime location to operate in! The country has good contract terms (which are intended to attract inward investment), but the weather conditions are a major issue. The location of the country means that exploration work cannot be completed during the winter period (usually November through February, although this can vary). That's an issue also experienced in Russia, and it also causes issues with production as equipment can freeze up. There are also some less common problems. For example, in 2010 an outbreak of foot and mouth disease caused a minor delay in the operations schedule.

In the past, Petro has focused upon Block XX with a number of wells drilled there, wheras Blocks IV and V have only really been subject to seismic and other studies. The three blocks cover an extensive amount of acreage within the country and Petro holds a 100% stake in each. Block XX is seemingly located in a very interesting region, being in the southern part of the Hailar/Tamtsag basin, which is already home to in excess of 100 million recoverable barrels of oil. Looking at the resource estimates, the potential figures are eye-watering (but they always are for wildcat regions - Mongolia is not exactly a prolific oil and gas producer). The total 'deterministic' mid-case prospective recoverable oil figure amounts to 1.7 billion barrels across 26 leads across the 3 blocks. Sounds good? Yes. Will the company ever get even remotely near that figure? Probably not.

The majority of that resource is said to be located in Blocks IV and V (i.e. the blocks in which absolutely no drilling has been done). Those two blocks account for just over 1 billion barrels. That figure was derived before the recent seismic acquisition which makes me very sceptical over how realistic those figures actually are. Seasoned investors in the oil and gas sector will know full well that every figure needs to be taken with a huge dose of salt. The remaining 677 million barrels are within Block XX. Once again, that sounds excellent, until you start looking at their past drill results for this block. The 11 well campaign started in 2010 and was very compacted which provided plenty of speculation and optimism. Each well was called Davsan Tolgoi:

- DT-1 found oil shows but no commercial hydrocarbons. In light of a later well result, the oil shows were said to be residual. The flow test yielded poor results. The first test interval flowed 107 barrels of fluid per day (BFLD) with 80% of that water. The second interval flowed at less than 1 BFLD at 10% oil, and the 3rd interval flowed 1300 BFLD with only traces of oil
- DT-2 found hydrocarbon shows and suggestions of oil migration. No commercial hydrocarbons were found and the shows were said to be residual
- DT-3 found live oil shows with 5.5m of potential net pay. However, former CEO Douglas McGay commented: "the results from DT-3 have not proven very positive for hydrocarbons...at this location". After a later well result, the shows were said to be residual
- DT-4 experienced a 5 month delay part way through, due to the weather. Live oil shows with the potential for 6m+ net pay was observed. The primary interval only yielded a flow rate of 2 BOPD and fracking would be required. The 2nd test interval was not deemed to be of interest to frack
- DT-5 only found 3m of potential cumulative net pay. No oil shows were found and the rock was found to be of low porosity
- DT-6 found no movable hydrocarbons and reached a total depth of 1923m
- DT-7 found 3 zones of possible 4.8m net pay. These pay zones were interspersed by water-bearing sandstones. Potential dismissed
- DT-8 found live oil shows and 8.5m of possible net pay. The well did not flow hydrocarbons upon testing
- DT-9 found live oil shows and 8m of possible net pay. Unsuccessful flow test. "Exceedingly fresh water" led to an inaccurate net pay estimate
- DT-10 found no movable hydrocarbons
- DT-11 only found residual oil and no oil was recovered upon testing

Clearly looking at the history of a company's drilling success is of utmost importance. A company can have huge resource estimates, but if past exploration performance is poor, the figures are meaningless. After all, there is no guarantee whatsoever that Petro's acreage has commercial amounts of oil within it. Ironically, block IV has a major shale resource, but Petro have noted that the extraction technology required, has not yet been proven to be economic.

If that wasn't bad enough, there has been a complete board overhaul during the last couple of years and that was driven by a significant number of resignations. Those who left their posts (in some cases, probably forced out) included the CEO, CFO, the exploration director (who dropped into a non-executive role after only 15 months) and 3 other directors. That signals a lot of unease amongst the board, and a lack of confidence in the company and its future. Arguably, it can be seen as a positive, as the previous management were those that led the company through the series of drilling failures. Nonetheless, the high management turnover detracts from the investment proposal simply because it gives off the impression of instability.

The geological issues are not the only concern though. The company has had to defer expenditure due to its weak cash position. Below is the table that the company outlined as planned expenditure in, early 2013.


The one thing that's for sure is that the company did not spend the amount of money that they had pencilled in for 2013. As noted, that means time scales are slipping back. The cash required to commit to this plan is extremely large compared to Petro's market cap. In total, it amounts to $72.4m which is equivalent to £44.2m. If they have to fund the programme themselves, there is no chance they will spend that amount. The last cash placement was undertaken in June 2013 at a price of 3.56p. That as completed through their major supportive shareholder, Petrovis. Petrovis is a petroleum products manufacturer in Mongolia. However, even when the placing was undertaken, Petrovis required a ~25% discount so there is little backing to the current share price in that respect.

The last cash reading available was for June 30th and was £4.27m. Net cash used during an inactive H1 totalled £1.54m so, once adding in the cost of the seismic program, Petro are getting close to running out of cash, and they will probably need to raise funds before the end of H1 is out. That is regardless of whether or not they reduce their equity stake in the blocks. That makes the current rise an ideal time for Petro to complete a placing, and I certainly wouldn't rule one out. I actually believe they should do a placing now, as the price is likely to drop back anyway. The cash would give them a buffer to cover the short-term pain, although I'd remain sceptical over how much exploration work can actually be done with it.

Aside from expenditure deferral (which won't create returns for shareholders), another way in which Petro can reduce their future commitments is to farm-out their current 100% stakes. That is a path that the new management have pursued. They first hinted at this process in September 2012 and then hired Macquarie Capital in February 2013 to aid the search. Prospective partners were able to receive a meaningful stake in one or more of the blocks in return for funding the block's 2013 -> 2015 work programme. The farm-out process closed in June 2013, but management have not been able to conclude a deal yet.

Following the experience that Aminex has given, I have become more astute about how these processes work. For example, Petro said that 'international oil and gas companies' had visited the data room. I expect that they had a look, and left! The dismal drilling track record (no commercially viable resources across the 11 wells drilled) in Block XX is not a tantalising opportunity especially since Petro want the partner to fund the forward work programme. Similarly, Blocks IV and V have had minimal work done, so expecting the forward work programme (up to 2016) to be covered is fantasy. Had Petro had a good deal, from a good partner, they would have bitten their hand off by now. It also says a lot that Petro are completing seismic now. Reading between the lines, that means the partners were unimpressed by what they had seen in the data room and there was not enough work done on the prospects to give them ample confidence. The process is unlikely to be helped by the expiry of Blocks IV and V during the summer. Chances are they will get an extension, but it won't help the cause. When a farm-out lasts this long, it's not usually a good sign.

The plan for 2014, which was outlined in 2013, is as follows (it won't be met):
- IV = Drill 2 wildcat wells
- V = Drill 2 wildcat wells
- XX = Complete 2D seismic on the southern frontier
And for 2015:
- IV = Complete 3D seismic on any discovery
- V = Complete 3D seismic on any discovery
- XX = Drill 2 exploration wells

The final, and crucial point in the short-term is that an RNS was released stating:
"Petro Matad notes the recent increase in the Company's share price and confirms that it is not aware of any reason for the sharp movement. As previously announced the Company is in the process of seeking a farm-in partner for its acreage in Mongolia and discussions with a small number of parties are continuing. Interpretation of the recently acquired seismic data from Blocks IV and V is on-going and expected to be largely complete by mid-February. The results of the interpretation will enable the Company to design a drilling programme, which subject to funding and permitting, can be conducted during the 2014 drilling season."

Put simply, not only has the rise been on the back of hot air, the company has now cast doubt about being able to complete the 2014 drilling programme. That means any share price catalysts are pushed further down the road. On the other hand, if they opt for an equity raise at the current level, there will be a massive discount, plus the market cap would be boosted (all other things being equal there are more shares in issue at the same price). It's difficult to justify that a £26.5m can be sustained. The chart signs all point to a reversal, and the fundamental situation of the company cannot support this valuation. There aren't enough near-term catalysts to keep investors interested, so like Kodal I am expecting a reduction in liquidity to lead to a downside turn. What's a fair valuation? Sub £20m without any shadow of a doubt. I have therefore put a Sell tag on Petro Matad at 9.50p in anticipation of another short-term correction. Another case of asset overvaluation by the market.

UPDATE (26/03/14) - I have moved Petro Matad from Sell to No Rating this morning after the price has spiked and drifted down to 5.25p. That totals a 44% profit for the site's review results table. The decision to move it off sell was the result of the need to free up space in the portfolio. The sell thesis remains strong

5 comments:

  1. Wow a 0/11 strike rate!

    ReplyDelete
  2. Very good! This site is an invaluable resource.

    CraigJ

    ReplyDelete
  3. I see that the Petro matad share price has nudged up to 10.25p today, but I hear your reasoning loud and clear. Worked on Kodal so will stay clear of this one. I hope that is the right decision ;-)

    Regards, Jeremy

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