Weighing the Risks in International Oil Plays
Explorers and producers need to go where the oil is. But how do you balance resource upside potential with jurisdictional risk? Amin Haque of Stonecap Securities argues that jurisdiction risk isn't a deal-breaker if management knows how to mitigate it. In this interview with The Energy Report, Haque shares some companies that meet those criteria, favoring redevelopment plays that avoid exploration risk. Find out which teams are using new technologies to turn proven reserves into economic international projects.
The Energy Report: Amin, you started your career in the consumer credit industry, where you were involved in risk management at a major bank. How does that translate to the securities industry?
Amin Haque: The company I worked for was MasterCard International Inc., and as director of risk management, my focus was on macroeconomic risk management in international jurisdictions. That gave me a very good foundation for evaluating sovereign, political and currency risks. In my four-year career with MasterCard, I focused on countries in Africa, the Middle East, South America, the Caribbean and the Asia Pacific. These are the same regions where many of the exploration and production (E&P) companies I'm interested in operate. My previous experience is proving quite useful as an oil and gas analyst.
TER: When you look at a company, do you consider the jurisdictional risk first?
AH: Jurisdictional risk differentiates a company focused in North America from one that operates internationally. For the latter, geology, exploration history and reserves matter as much as they do for a North American company, but equally important considerations are geopolitical or currency risks. These issues affect operations as well as profit repatriation.
TER: Do you focus on the downside?
AH: No, I try to look at the company as a whole. In the oil and gas business, one has to be an optimist. As an analyst, I try to be a rational optimist. I use risk as a tool to screen management. I make a list of all the jurisdictional risks as I understand them. If management addresses the risks I have identified and they have a program to meet and mitigate those risks, then I feel more confident about the quality of the management.
But if the management paints too rosy a picture and glosses over the risks, which seems unrealistic for even a layman like me, then I try to steer away from that company and its team. But I don't always start with the downside.
TER: You seem to be concentrating on a theme of oilfield redevelopment.
AH: Yes. Of the six companies, four are focused on redevelopment.
TER: Do redevelopment projects inherently carry less risk, because reserves in the ground are already established?
AH: That would be a fair statement. I play to my strength. I do not have a background in geology or petroleum engineering. I'm trained as an electrical engineer. I can relate to the basics of oil and gas science, but I am not an expert.
But if you start with a proven reserve that has not been extracted for various reasons, then you have a head start on the companies with exploration risks, where the outcome could be binary. You either find oil or you drill a dry hole for up to $50 million ($50M) per well.
If you have a proven reserve, then the outcome is not binary. There are risks. There are challenges in extracting the resources, both operational and geopolitical. But if you have competent management in place, then you have the confidence that they'll find ways to meet those challenges, mitigate those risks, extract that oil and find a way to sell it.
TER: Is this redevelopment theme dependent on technology that we didn't have a decade ago?
AH: That's an absolutely fair statement. With most of these old fields, development success is predicated on applying new technologies and new ideas. We take new technology for granted in North America, but not so in these international jurisdictions.
Let me start with examples. Two of my Nigeria-focused companies, Oando Energy Resources Inc. (OER:TSX) and Mart Resources Inc. (MMT:TSX.V), are working mostly on oilfields that were discovered some time ago but have not been fully exploited. Mart has been in West Africa for quite some time, but its latest success was due to its use of three-dimensional (3-D) seismic data that was acquired some 15 years ago. It then used new technology to reinterpret it and the company found success. Oando is on the same path, and so are many other Nigeria-focused independent E&Ps.
A company in another part of the world, Azerbaijan, is Greenfields Petroleum Corp. (GNF:TSX.V). Azerbaijan has been producing oil and gas for at least 100 years. The field Greenfields focuses on has been producing at a very marginal level for the last 30 years because operators were still using Soviet-era drilling rigs and completion technologies. Greenfields acquired new two- and 3-D seismic data and new ways to model the reservoir. It is also using new drilling technologies. That's how it hopes to find success.
TER: Define "marginal field" for me.
AH: Different countries have slightly different definitions. Generally, it is a field that has been discovered years ago and may have been producing for some time. But the initial leaseholder, which in most cases is an international oil company of substantial size, does not find it economic for continued development.
Therefore, these fields get marginalized and do not receive any new capital expenditure. That's what's happening right now for many fields in Nigeria, for example. Fields are declared marginal under new laws and regulations, and the original discoverer farms it out to, in most cases, a smaller outfit. That smaller company puts in new resources to start producing from it. Marginal fields are economic for smaller E&Ps because they operate with a shoestring budget and often introduce new technology. The government gets royalties and taxes, and the original operator gets some farm-out royalties. So it's a win-win for everyone.
TER: It sounds like once the low-hanging fruit is gone, it's necessarily going to cost more to drill these wells. Is that fair?
AH: It could go both ways. There are many marginal field opportunities like that. If a marginal field is large enough, then from the first well drilled to the, say, fifth or 10th well, the development cost actually declines over time. But when people start hearing about these new, unexplored opportunities, new companies come in and bid up the price for assets.
Even if not a marginal field story, let us think about Colombia, for example. About five years ago, Canadian energy companies went into Colombia and found success. More and more companies began flocking in, bidding up the price for new fields. That adds to the cost. That makes it more expensive for even established companies to expand and obtain access to new assets. So that's a challenge.
TER: You follow junior E&P companies, where investors can hopefully get a large return on their money. Can you give us some of your favorites?
AH: Yes. Let me start with Mart Resources. Only recently, the institutional investors have been paying some attention to Mart. In June, the company declared a very generous dividend payment to its shareholders of $0.05 per quarter.
TER: Even after the dividend was paid on July 19, the stock still behaved quite well. At times, after a one-time dividend, shares fall. But investors have favorably viewed this stock.
AH: You're correct. I'd like to note that when management declared this dividend, it made a strong statement about its commitment to return of capital to the shareholders. Although it was a one-time special dividend, management spoke of continuing special dividends in times of good cash flow.
TER: Can the regular $0.05/quarter dividend be sustained?
AH: I believe so, despite some of the risks the company faces. Since the end of October, Mart has not been able to produce and pump oil because of pipeline disruption as well as flooding in the Niger Delta area. Losing 15–20 days of production from its only producing field made for a challenging quarter. But Mart has a large stash of cash it can use to pay the dividend as well as continue its development program. In the future, it expects to increase oil sales with the help of a second pipeline, at which point a $0.05 quarterly dividend should not be a big challenge.
TER: Does Mart have prospects for increasing its reserves and production?
AH: Let me address the production issue first. The field is averaging about 12,500 barrels per day (bbl/d). Depending on Mart's entitlement production, the production allocation to Mart goes between 50% and 82% but averages about 65%. It has drilled 10 wells so far, but the problem is that the field cannot produce to its maximum capacity.
The field has pipeline constraints. Five different producers in the area share the same pipeline, so there is a rationing of pipeline capacity. Unless that restraint is removed, Mart cannot produce to its maximum capacity, which I believe to be on the order of 15,000 barrels per day (15 Mbbl/d).
The company's management is working on two things to remove the constraints. First, it is negotiating with the pipeline company that it uses right now to expand the capacity. In addition, Mart and its partners, along with other E&P companies in the area, are building a second pipeline that will connect to a Royal Dutch Shell Plc (RDS.A:NYSE; RDS.B:NYSE) facility. A second pipeline should do two things—provide the company with redundancy and excess capacity, as well as giving it access to a second export terminal. That should allow Mart to significantly increase its production, which I expect to be achieved gradually between the beginning of 2013 through the end of the year.
TER: What is it about Mart's management team that impresses you?
AH: First, they have done a good job of building relationships in Nigeria. Mart's two partners for the Umusadege field proved to be sound partners. In Nigeria, many joint ventures by international junior and intermediate E&Ps have failed because of partnership issues. Secondly, the Umusadege field is one of the few marginal fields that have succeeded. Mart's management has shown that the marginal field is a viable concept and it works.
I'd also like to make one other point about Nigeria. The country is making some tangible progress in building a corporate culture, in building a civil society. It has created a middle class that's generating its own energy demand, which is good for natural gas production in Nigeria. With increasing demand for electricity, entrepreneurs are looking at natural gas as a source for electricity generation. If smaller E&Ps get a chance to sell their natural gas, that's a separate and new revenue stream for them. So the timing is also good for Mart, Oando and other independent junior E&Ps.
TER: Mart's market cap is now just over $600M. At that market cap, this is a company that now can be owned by mutual funds. Do you expect to see this transition from it being a retail story to an institutional story?
AH: Yes. Institutions expect to buy a sizable chunk of shares and the market cap is getting to that level. Also, Mart did not have any institutional coverage before. Institutional investors expect some institutional broker support while they take an interest in a company.
TER: Could you talk about another story that you like?
AH: Sure. A similar story to Mart, also in Nigeria, is Oando Energy Resources. One risk about Mart is that its production is from a single asset. For Oando, the picture is different. It has interests in nine different blocks. It produces from two. So it's not that dependent on a single field or a couple of fields. It has production and cash flow. At the same time, it has some very lucrative exploration blocks. Its management has worked for Schlumberger Ltd. (SLB:NYSE) and other international companies. But at the same time, it's a Nigeria-based company, so the management team has more appreciation of the issues on the ground.
TER: You have a really nice target price with over 100% implied upside from current levels. But I see that 95% of outstanding shares are held by one entity, its parent, Oando Plc (OANDO:NSE; OAO:JSE).
AH: You are correct. But other than Mart, there are not many opportunities to get exposure in Nigeria. Oando will need additional capital to develop these assets. My belief is that it will come to the capital markets, and that will create an opportunity for investors who have interest in Nigeria.
TER: As an investor, you're not concerned that 95% of these shares are owned by one entity?
AH: I think that should change over the short term. Oando Energy Resources came into being as a spinoff of the upstream assets of the parent company, Oando Plc. The current shareholding structure is a result of how this company became public, through a reverse takeover and through a spinoff of assets. But my strong belief is that that's not the ideal situation for any of the parties involved and that situation is going to change.
TER: Is there another story you'd like to talk about?
AH: I mentioned Greenfields Petroleum earlier. It has assets in Azerbaijan, the Bahar project, where it has a one-third interest. An Azerbaijani company holds the remaining two-thirds. Azerbaijan is a country that has the longest history of producing oil and gas. But in the middle of the last century, when Azerbaijan was part of the Soviet Union, all the capital was shifted from Azerbaijan to Western Siberia, so it did not receive any new capital, new ideas, technology, focus or interest.
But the resources are there. It was very astute on the part of the Greenfields management to find this particular asset. Greenfields' management team is trying to prove what can be done in an old field using new technology. When you are operating in a country that has not seen the introduction of new energy technologies for over a half a century, you face challenges—getting trained people, moving equipment, procuring supplies, etc.
The project has been delayed by a year or so, but it looks as if everything is lined up and drilling should start within a couple of weeks. Greenfields should be able to get some good results out of its current drilling program.
I would also like to mention that several key people in the management team of Greenfields have worked in Central Asia—in Azerbaijan and some of the neighboring countries—for over a decade. So management has connections there. They know the country and the people. I would say those relationships and that knowledge are extremely important for any junior E&P getting into a lesser-known international jurisdiction such as Azerbaijan.
TER: Another you might mention if you wish?
AH: The last one I'd like to mention is Touchstone Exploration Inc. (TAB:TSX.V; TCHSF; OTCPK). It is located in Trinidad and Tobago, which is a country with a very long history of petroleum production. Again, it's a redevelopment story, where production went down in some fields because there was no infusion of new technology or capital.
The state oil and gas company, Petroleum Company of Trinidad and Tobago Ltd. (Petrotrin), owns this concession. Touchstone went into an arrangement called a lease operatorship agreement whereby Petrotrin would still hold the concession but Touchstone would get a percentage of the production when it brings in new capital and increases production. But one major challenge in Trinidad and Tobago is its vast bureaucracy.
What I like about Touchstone is its dogged persistence. In the last year, it has faced many challenges. But it still has been able to increase production from 500 bbl/d to about 2 Mbbl/d currently. Consider that there are thousands of old wells that can be recompleted and brought into production. Even if they contribute 15–20 bbl/d, you are talking about a very large level of incremental production at a low cost. That's what Touchstone is targeting.
TER: Did you want to mention one more?
AH: Another company on my list is New Zealand Energy Corp. (NZ:TSX.V; NZERF:OTCQX). For Canadian companies, New Zealand is a comparatively new jurisdiction. There are a couple of Canadian companies active there. New Zealand Energy had some impressive initial successes. It has a large land position right now. The thesis is that it can replicate the initial success in the remaining land base.
TER: The stock has suffered over the past six months. It's down about a little bit more than one-third. What were the issues that contributed to that?
AH: The first three wells were quite successful, but the decline rates were high. So current production has come down. I guess the market is waiting for new wells to start augmenting production.
TER: It's been a pleasure. I thank you for taking the time.
AH: Thank you. It's been a great pleasure talking to you.
Amin Haque joined Stonecap Securities' oil and gas research team in Calgary in October 2011. He provides research coverage of international explorers, producers and oilfield service companies. Haque brings 14 years of financial market experience, seven of which have been devoted to equity research analysis. He worked as an analyst both on the buy and sell side, focusing on energy and other resource sectors. Prior to joining Stonecap, he provided independent valuation services to oilfield services, logistics and related companies.
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February 23rd, 2019
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