Petroneft Resources - A New Chapter

http://petroneft.com/

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The junior oil and gas sector within the London Stock Exchange has picked up in recent days, fuelled by production success at companies such as Leni Gas & Oil (LSE:LGO), Caza Oil & Gas (LSE:CAZA) and Empyrean Energy (LSE:EME). As a result, share prices are generally up across the board, and there has been renewed appetite for companies offering forward potential. One company, Petroneft Resources (LSE:PTR), looks to have gained a new lease of life having signed a transformative farmout agreement in mid-April, which should see the company start to emerge from the doldrums, having spent two years making little headway. Petroneft is currently trading at 5.925p, so with 707 million shares in issue, the company is valued at just shy of £42m.


Petroneft's share price chart displays the characteristics of a classic recovery play. Despite failing to meet many promises in the past, it is the future potential that will drive share price upside. The chart reflects this and is highly bullish in nature with an underlying uptrend stretching from the lows made in H2 2013. There is distinct potential for a bowl formation (of sorts), and these plays tend to be popular with technical traders given their high reliability. On a shorter-term viewpoint, there is a strong technical uptrend matching the lows, and there has been a build-up in momentum over the past few trading sessions, which suggests a break of 6p is likely again. That would provide clear headway up to the top of the trading range, which is 7.5p. Overall, the charting outlook is particularly rosy, but that can be overridden by fundamentals.

The spread on Petroneft is also appreciably narrow currently, stretching from 5.90p on the bid to 5.95p on the ask, so less than 1%. Importantly, the company has a very strong institutional holding base, and this should help underscore future upside. Natlata Partners holds 14.75% of shares, Macquarie Bank holds 6.06%, Athos Limited holds 4.84% and Davy brokers holds 8.37%. Recently, Ceres Environmental Consultants (most likely for an underlying individual/party) has also acquired a stake of 3.39%. There are other director holdings (and relatives of directors holdings) totalling a further 6.61% of the shares in issue. There are a further ~11m warrants in place with exercise prices between 5.3p and over 7p. The institutional backing is important for one core reason - it demonstrates that institutions are willing to back the company, even when it was trading through an extremely rough patch. Now that the fundamentals are starting to brighten, it would therefore make sense for institutions to become more interested. That interest is underscored by a $4.2m equity raise in March (at 5p) being oversubscribed. A trade for 8m shares was also processed today, which suggests large background holdings changes.

I first looked at Petroneft back in 2012 when the market cap was around £27m and the share price was just lower than 7p. Clearly, with the share price now at 5.93p, and a market cap of ~£42m, there has been dilution. Oil production rate targets have repeatedly failed to be met and have effectively been stuck at 2300bopd for a considerable period of time, well short of internal targets, which were multiples higher at times passed. Oddly enough, almost two years on, the group production rate (pre-farmout) is most likely between 2300bopd and 2500bopd, so there hasn't been a whole lot of change on that front and that is ultimately disappointing. However, it is that stagnance that provides a compelling opportunity. The investment proposition now is far superior to back in 2012, plus the share price is lower. I will re-cap the operations of the company.

Petroneft is a Russian focused oil and gas explorer, which is listed on AIM. The low market cap and level of institutional interest emphasises the value that the company has, although that has not been realised. Petroneft has two core licences: Licence 61 where it formerly had a 100% interest, and Licence 67 where it has a 50% interest. For the sake of this review, until stated later, all figures are expressed at the pre-farmout level where Petroneft had 100% of Licence 61, compared to 50% post-farmout. Licence 61 is Petroneft's main asset at the moment.

The two licences cover ~7,500km2 in Tomsk Oblast, a region in Western Siberia, where there is prolific oil and gas production. The company's acreage borders those of major companies such as TNK BP, Rosneft and Gazprom, and there is little doubt that the area is highly prospective for oil and gas. There are of course inherent concerns with operating in Russia (such as corporate governance issues and harsh weather conditions), but these are not of material concern. Importantly, the board of the group is not constituted of solely Russian individuals - this can lead to communication issues, such as those at both Ovoca Gold (LSE:OVG) and Orsu Metals (LSE:OSU). Indeed, the large institutional interests provide comfort. In addition the board does contain highly experienced individuals, even if the production rate across the assets over the last 2 years fails to demonstrate that.

Moreover, the assets are not only located close to excellent infrastructure, but they have excellent infrastructure within after large CAPEX by Petroneft in the past. Aside from long-distance oil and gas pipelines and an all-weather road, within Licence 61, the Lineynoye oil field has a processing facility for 15,000bpd, storage capacity for 37,740 barrels of oil, power and diesel power generators, and export pipeline capacity of 20,000bopd. Lineynoye acts (and will act) as the central processing hub for the a number of satellite fields, such as Arbuzovskoye. One of these satellite fields is Sibkrayevskoye, which contains a 50km2 structure and has 2P (proved and probable) reserves of 53mmbls alone following several drills. Numerous other large leads exist, such as Emtorskaya where there could be in excess of 40 million barrels. In total, Licence 61 has 7 discovered oil fields within with 21 leads and prospects to be explored, many of which are drill-ready. There is a similar situation in play at Licence 67. The Russian government unsurprisingly also remains supportive of the sector and cut the "Mineral Extraction Tax" (MET) in 2013 on reservoirs with certain characteristics - this will particularly aid Petroneft's Licnce 67, but the broader implications of government support is what matters. There are already talks about a potential reduction in oil export duty.

To put this into perspective, the company already has 2P reserves of 131.1 million barrels and P3/P4 potential resources of over 600 million barrels. This is a huge resource for a company of Petroneft's size, and would justify a much higher valuation. Of course though, these net reserve numbers will be cut significantly (but by less than 50% as Licence 67 has not been farmed down). The large P3/P4 numbers mean that, over time, more resources are likely to be transferred to the 2P category where there is greater confidence in resource estimates. In the wider scheme of things, this large resource should not come as a surprise - the asset is located relatively close to the Somotlor oil field, also located in the West Siberia oil and gas basin, but which initially held 27 billion barrels in original reserves.

The company does have a strong track record of reserve growth too, with the base rising from 27.9 million barrels in 2005, to the 131.1 million barrels in 2P in 2012. There is potential for that to rise considerably further in time, not least because 40% of that figure is Sibkrayevskoye alone.

The flow rates achievable are also good, but the company has had difficulties in ramping up the production rate significantly. At Arbuzovskoye, initial production rates across the six drilled wells ranged from 100bopd to 540bopd, all at less than a 2% water cut. Production is boosted through water injections, although there is strong potential for substantially higher flow rates through the drilling of horizontal wells - a method that Petroneft has not pursued thus far, but which it will in the future. Substantially in this context means as much as 4x higher initial flow rates compared to vertical wells, so there is huge potential, and it anyone's guess as to why the board have not followed this strategy in the past.

So what has been the issue? Why did the share price fall as low as 2.5p in 2013? Why is the share price still only valuing the company on very low resource multiples? The reason has been a large debt burden that has been hanging over the company for a very long period of time. Looking at the 2013 interim results (for end June 2013), the company had:
- Negligible cash of $131,000
- Net Payables (incl. inventories) of $7.4m, albeit this has existed for a long period of time
- Total debt of $33.5m, split between Macquarie Bank and Arawak

It is that debt pile that has been the root cause of the company's long-term pain and the reason why a $5.2m equity raise and $1.5m debt raise was undertaken in March this year. These debt packages had interest rates near double digit levels and given the size of the debt, much of the cash flows from operations were being diverted into interest repayments. The debt was a large drain on cash resources with, for example, the Macquarie debt requiring $650k/month in payments, and a significant $8m+ bullet payment in May 2014. The Arawak debt agreement was similarly punitive. With dwindling, near-zero cash balances and a ballooning debt pile with near-term repayment deadlines, the company was stuck between a rock and a hard place, so was priced for bankruptcy. The Macquarie debt was secured on Licence 61, and the Arawak debt was secured on Petroneft's 50% of Licence 67. Ultimately, if Petroneft couldn't pay, it would be stripped of its assets and cease to exist.

The board therefore initiated a farmout process on Licence 61 in a bid to resolve its long-term financing issue, unlock the inherent potential of the licence and meet the May 2014 debt deadlines. In March the company announced that it was making 'solid progress' on a farmout with a 'large international oil and gas company' and that the proposed deal would pay down all debts, leave cash for working capital and results in there being significant funds to invest in Licence 61 in the years ahead.

Despite that promising announcement, one shareholder wasn't satisfied, or at least saw there to be a possibility of making a move to control the company. That shareholder is the 14.7% holder, Natlata Partners. Natlata called an EGM to try and oust the board, as they believed that any farmout would most likely not be in the company's best interests. In a document released to shareholders, Natlata raised some valid points. They argued that the board have had their chance to create value, but had failed, so it was time for them to step down. Whilst I would agree that the numbers promised were grossly overstated, the fact is that the debt burden was a major restricting factor. It restricted CAPEX into new wells, and the interest payments meant that exploration into the licences was scaled back materially. However, other criticisms do have merit. For example, a lack of 3D seismic used on the blocks, and a lack of horizontal drilling feature. A further point was that the pay packages of ~$1m between three executive directors was excessive. That is true given the poor performance, albeit it was down year-on-year.

Natlata therefore suggested that a new board be implemented. The key problem with these moves, particularly in Russia, is that they tend to be centered around the interests of the activist party, with the care of shareholders a distant second priority. Therefore, that deal was immediately unworkable in my opinion - it is much better to propose working with the current board by introducing 1/2 new directors as opposed to a complete overhaul. Natlata suggested that they buy out Macquarie's loan note and convert it to equity, plus complete a share raise on the side. In essence, the Natlata proposal was unconvincing and acted as a distraction for the board, but also for investors. Crucially, they said, "[Natlata] will support the farmout if it is on attractive terms".

The bottom line is that a transformative farmout was indeed forthcoming, and the Natlata action failed. The farmout had these key features:
- 50% of Licence 61 farmed out to Oil India. Reserve and resource numbers therefore have to be reduced by 50%. Oil India is one of the largest oil and gas companies in India having produced 130,000 boe/day in 2013
- Oil India will commit to up to $85m (£50.6m) of inward investment, constituting:
        - $35m upfront cash payment. This will clear the Macquarie and Arawak debt, leaving the group debt free
        - $45m in forward costs, through which Petroneft if carried. This essentially gives "free" future upside
        - $5m bonus contingent on production from Sibkrayevskoye reaching 7,500bopd within 5 years

These terms are transformative for the sole reason that it completely reduces Petroneft's funding needs and eliminates the debt position. The loss of 50% of the equity still gives the company access to massive upside, at much reduced downside. The saying "50% of something is better than 100% of nothing" springs to mind. This is undoubtedly a real value creation opportunity for Petroneft - they have a clean slate. Petroneft will remain the operator of the licence, but Oil India reserve the right to second 2 technical experts into the on-ground team to help develop the assets. This makes perfect sense, and should be welcomed.

However, it is perhaps the less obvious points, which are most important. Oil India essentially paid £50.6m for 50% of the licence. By simple symmetry, that would place a minimum core value of £50.6m on Petroneft's share of the acreage. Petroneft still trades at a 17% discount to that minimum core value. That completely excludes the value of Licence 67 too. I deem that to be the 'core' value since Petroneft were negotiating with a weak hand. With debt maturity dates due within a couple of months, they certainly would not have been able to extract full value from the licence during the farmout. Less tangible benefits include the introduction of a strong, well capitalised industry partner and the alleviation of financing in the long run. Aside from that, it also validates the prospectivity of the acreage, and gives credibility to the board in that respect. Regulatory approvals for the deal are expected to be received in early June and could catalyse a further more upward.

Once the farmout has been closed, an already devised plan will be followed. The first horizontal well in the company's history will be drilled at Tungolskoye - this could unveil strong flow rates given the expected potential of the horizontal drills. This would be brought into production in 2015. The company will then proceed to drill up to 5 production wells at Arbuzovskoye in an effort to break free of the range-bound production rates experienced historically. A delineated well will then be drilled at Sibkrayevskoye before seismic is acquired across a range of prospects and leads. All drilling equipment for the drilling programme is already procured and is ready to go. Drilling is expecting to commence in July, prior to which, interest will build.

As it stands, the company is trading on very low £/boe multiples. Using a conservative £5/boe for proven and £2/boe for probable resources, there are intrinsic asset values of £58m and £145m respectively, even after the completion of the farmout. That attributes nil value to the 3P and 4P potential resources, which could and probably will be converted into 2P. At the current market cap, the blended £/boe figure is roughly £0.498, which is particularly low and perhaps emphasises that Petroneft is a genuine takeover target. The assets would be a strong strategic fit for nearby operators given the good facilities already in place, and scalability. The debt pile would previously have been a major deterrent, but now that it has been removed, the chances of any takeover are enhanced. In addition, a report from Canaccord in 2013 showed Petroneft to be trading at among the lowest percentages of full NAV of the oil and gas sector, with one of the largest discrepancies between the valuation at the time and the core NAV (value of producing and developed assets).

In the interim results for 2013, Petroneft revealed production of 445,949 barrels, which amounted to +13% year-on-year, giving an average of 2,464 bopd. The average oil price achieved was $42.48 reflecting the cheap domestic oil in Russia. The gross margin typically ranges between 12% and 15%, so the incremental cash flows start to kick in with every 100bopd above 2000bopd. An operating loss of $3.4m was booked for the period, although that should start to reverse given the reduction in ongoing financing costs (i.e. interest repayments) and the promise of higher future production.

Petroneft is entering a new chapter of its development. The company has finally resolved its financing issues and is now exposed to much lower risk, high reward upside through either production growth or exploration success. The farmout has enabled the company to form a solid footing, off which it can still gain access to more lenient funding arrangements if necessary. With the aid of Oil India's $45m in cash, Petroneft should be able to push up production levels and thus start to unlock the value of the 2P reserves. The company still trades on low asset multiples and, with a very bullish technical outlook, I would expect the company to continue upon its upward path as the recovery story turns into reality. Ironically, the move by Natlata is likely to have acted as a wake-up call for the board, and it may well be preferable if Natlata maintain their holding to keep the pressure to perform on the company. No doubt that pressure will also be exerted by Oil India. The first step is to get the farmout formally approved and closed. Davy Research has set fair value price of 11p/share rising to 14.2p when including the exploration assets. I have set an initial share price target of 10p taking a 6-12 month time frame. There is clear value in the assets and despite Petroneft still being medium risk, there is potential for high rewards. I have therefore put a Buy tag on Petroneft at 5.925p.

UPDATE (10/10/14) - In light of wider market weakness (and oil price weakness), which I noted in the latest quarterly portfolio review, I have moved Petroneft to No Rating at 6.2p for a circa 5% gain as a precautionary measure

5 comments:

  1. Well written and researched summary,let's he the horizontal drilling is successful.

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  2. great article with good detail and sound reasoning. Recovery play in motion. Need the farmout signed off within two weeks

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  3. Hi El1te.

    Fab article as usual. Really interesting choice of play and looks very undervalued based on the assets in the ground that seem derisked with Oil india 'validating' as you say

    CraigJ

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  4. Thanks for putting up this very comprehensive and well-informed article. Having followed PTR for about 4 yrs as a small p.i. this helps to put in perspective the current situation and prospects. I'm definitely sticking it out with my approx. 50,000 shares having read this : )

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  5. Brilliant day in the park for Petroneft shareholders

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