NZ Oil & Gas (NZO)

[peterfindlay]

I thought the latest research prepared by John Kidd of from McDouall Stuart on 9 November 2009 may be of interest. It appears very well thought out, and takes a view contrary to that recently expressed by First NZ Capital et al, who have not considered the imminent drilling prospects to represent a quantifiable present value, and in some cases, not of relevance to their buy/sell/hold recommendation. Please note the tables could not be reproduced, and where outlined in text form is shown in italics.

NZ Oil & Gas (NZO)

We’re the first to admit that we talk about NZO a lot. There are a number of reasons for this: as well as being a company that we know very well and a core holding of many of our clients, we also consider it to be currently the most undervalued NZX15 stock on the market.

In this commentary we attempt to lay out a rationale for why we think this is. We do so now to address a number of enquiries we have fielded from investors regarding investment downgrades to NZO from other brokers over the past few weeks, and also because we think this could quite possibly be the last opportunity we get before events leave theory behind.

Existing assets

Our argument starts with NZO’s existing assets. In our 2 October update (NZO: Business Time) we valued NZO on existing assets at $1.88/share. The main variable component to this value is the contribution of NZO’s 30% stake in PRC; our valuation assumes contribution from PRC at our current PRC DCF valuation of $1.61/share. If PRC’s contribution was included at its current price of $1.07/share, our NZO sum-of-parts valuation would reduce to 1.73/share, a slight premium to its current $1.70/share.

In other words, on our base case assumptions, our view is that NZO at current price represents relatively fair value on its existing assets. In saying this, we consider there to be a number of factors that serve to support our view that risk to our base NZO valuation lies to the upside. These include PRC’s severe discount to valuation, a higher oil forward curve (our base assumption is US$70/bbl; NYMEX 12 month forward currently sits above US$82/bbl) and the prospect of a modest reserve revision at Kupe.

News Flash: NZO is an Oil Explorer!
The Rationale for Accounting for Exploration Upside Oil exploration is a risk game. Unlike other more predictable industries where investment decisions are made on parameters that have a much greater degree of forward certainty, oil exploration carries with it a substantially higher risk profile. The corollary is that the returns of success in the oil exploration and production business are typically far higher than those available in other sectors.

Oil companies intent on growing their businesses must invest actively to retain and grow their reserve positions. As Tui did for NZO and its JV partners during 2007 and 2008, surging production can generate outstanding returns, but it also exacerbates the problem of replacing a reserve base in relatively quick decline.

Despite the sharp risk/return profile of the oil business, E&P companies behave like any other in making investment decisions on the presumption that they will generate positive returns from their capital spend. This can be difficult to rationalise on a well-by-well basis, because drilling of individual wells tends to be hit or miss (i.e. individual wells tend to either succeed or fail). A recent fail example was the Kupe JV’s drilling of the Momoho prospect last year. Despite a relatively high probability of success (‘POS’), Momoho was subcommercial, meaning that the JV essentially realised a zero return on a $50m outlay.

The POS of an individual prospect depends on the characteristics of its geology and its drilling history. For a wildcat well drilled in geologically promising but previously undrilled territory, POS may be as low as 1 in 10. But for a well being drilled in an area that has already been explored and has proven itself to be productive, POS may even be better than 1 in 2. Drilling multiple wells and holding sensible equity positions across a diversified exploration portfolio greatly increases the potential value and success of a company’s exploration programme.

The key point is that E&P companies make drilling decisions on the presumption that success will be achieved and returns made, not necessarily just on an individual well basis, but across the portfolio. Rightly or wrongly (wrongly, in our view) the local market does not tend to price-in exploration upside to their valuations of listed E&P companies. This contrasts quite markedly with other more sophisticated markets which do make provision for exploration-led upside in an E&P stock valuations.

The usual way that this often-called “speculative upside” layer is priced in other markets is to take a risk-adjusted approach to valuing a company’s exploration portfolio. This sees risk factors applied to the potential returns from individual prospects, which are then added together to arrive at a risk-adjusted value for a company’s exploration portfolio.

For example, another Tui-like discovery would present a whole-of-life NPV (on a 100% equity basis) of around $2 billion. Assuming a pre-drill 1-in-10 POS could see just 10% of that value ascribed to the prospect, so in NZO’s 12.5% Tui equity case, just 6cps. In our view, not even this single risk-adjusted hypothetical field is accounted for in NZO’s current price.

The risk-adjusted approach is both simple and defendable, but has significant limitations. By definition, the approach drastically understates the returns that could be expected from a successful drill. The example above is a clear case in point; a successful drill would be worth the full $2 billion to the JV, not the risk-adjusted $200m. In NZO’s 12.5% equity case, share price response would not be 6cps, but more like 65cps.

This serves to reinforce why industry expertise is such a critical determinant to assessing the relative quality of a company’s exploration book. Applying hypothetical risk and return assumptions to possible outcome scenarios is easy; understanding the characteristics that separate low from high quality prospects is the hard part. Deciding where exactly to drill is ultimately what separates successful from unsuccessful exploration.

The NZO Case in Point

The NZO case precisely demonstrates the exploration upside conundrum. As we’ve noted, in our view only NZO’s existing assets are accounted for in its current share; there is (in our view) no ascription of any value for its exploration programme. This despite the company being less than a week away from spudding its first well on what will be a long and potentially very exciting programme that offers for it and investors the prospect of very substantial exploration-led upside.

NZO’s programme includes drilling by both rigs operating in NZ waters over this summer. The ENSCO-107 jack-up rig, which has just finished its duties at
Maari, is expected this week to mobilise to the Albacore permit to spud Albacore-1. The Kan Tan IV semisubmersible rig will arrive from the Bass Strait in late January, immediately following which it will drill Hoki-1 then move onto the Tui permit to drill at least two wells.

We have previously stated that, based on our estimated POS for each well (50% for each of two Tui wells and 15% for each of Albacore and Hoki) there is an 80% likelihood of NZO making at least one successful discovery from its four-well summer campaign. That probability would lift to above 90% if the Tui JV chooses to drill another Tui well, which we consider a distinct possibility.

The market taking the approach of not accounting for any exploration upside means that the value downside from an entirely unsuccessful campaign is very small, and supported by a firm floor. It also means that the value upside from an even modestly successful campaign is substantial.

We estimate that NZO’s upcoming drilling programme will cost it $35m, which equates to just 9cps. If NZO's campaign is entirely unsuccessful and it opts to write-off its full outlay in FY10, the after-tax expense would be the equivalent of just 6cps.

The value of success would depend on the characteristics of the accumulation encountered, and in particular, the composition of tapped hydrocarbons (liquids are much more valuable than gas), the infrastructure required to bring the resource to market (expensive onshore facilities like Kupe vs cheaper offshore facilities like Tui) and equity held in the permit area in question.

Another way of thinking of the potential value of reserve upside is to benchmark possible discoveries against what the market values oil and gas reserves at. Currently the average across peer companies sits at just under NZ$28m EV per mmboe. NZO pitches slightly below that average at 25.3m/mmboe, again supporting the view that exploration upside is not factored to share price.

Applying the average benchmark to NZO generates similar value conclusions to what a POS approach implies. Assuming a Tui-scale find across each permit
points to value upside of between 36cps and 144cps per find (i.e. Albacore $1.44, Hoki $0.36, Tui SW $0.45, Tui NE/SE $0.45).

Investment View: Don’t Sell !

In terms of a formal investment recommendation, we do not encourage investors to reduce their NZO positions. To the contrary; investors who have enjoyed some of the annualised 27.5% pa returns that NZO has delivered over the past 3 years and understand how the company has been able to deliver these returns should consider increasing their holdings to access what we consider as a strong chance of more-of-the-same. The value downside of such a strategy would, as we have hopefully demonstrated, have a strong floor beneath it.

Finally, be conscious that with NZO likely to spud it's first well at Albacore this coming weekend, the window to act is closing fast. Because of its equity position Albacore presents by far the largest value potential to NZO (Fig 7). Albacore-1 will be a relatively short 18-20 day drill, meaning news can be expected in the first week of December. Act fast.

[777]

Another positive report...

http://www.stuff.co.nz/business/3059...an-oil-bonanza

Investors willing to back the discovery and development of New Zealand oil reserves could be investing in a country at the same stage as Norway in the pre-North Sea era, says a leading US money manager.

Renowned for his bullish views on New Zealand's petroleum prospects, William Buechler insists New Zealand is set for an oil bonanza that will eclipse Britain's North Sea oil boom.

"New Zealand is at the beginning of a country-changing event; the challenge is going to be to embrace the change and get it right. Activity and momentum are increasing but going under the radar screen."

For more than 25 years, New Zealand has thrived on the hydrocarbons produced by its Maui oil and gas field, prompting little in the way of new exploration. However, as global reserves dwindled and the price of crude soared, new exploration has began in earnest.

More offshore wells have been drilled in the last two years than the rest of the decade combined: 35 on and offshore wells were drilled between January 2008 and July 2009 alone.

Helping drive this activity some $200 million of exploratory drilling is planned this summer has been a sea change in government attitude to the petroleum industry's potential, says Buechler, lead portfolio manager of the Kiwi Pacific Fund.

"Crown Minerals has been gathering seismic data and offering it for free and that's allowed companies to look at data on a decreased risk basis."

Buechler says the scope for economic success from oil is "unquestionable" but investors must act now to get in ahead of overseas backers.

Only last week, Todd Energy chief executive Richard Tweedie confirmed Maari and its adjacent Manaia field in offshore Taranaki were home to 100 million barrels of recoverable oil, making it New Zealand's largest crude oil field and twice the original 50 million barrels found at the Tui fields.

The world's biggest sovereign wealth funds are backing oil and gas exploration in the Asia Pacific.

At $598b, Norway's global government pension fund is the world's second largest wealth fund. It has snowballed in size after Norway's decision to treat oil proceeds and royalties as investment capital and not revenue like Britain.

"If New Zealand is truly going to benefit in the long run from the discovery of oil, is has to make this decision," says Buechler.

[friedegg]

so if theres a negative 6cps result for all drills to be unsuccessful there surely lies an insight into the mentality of the average nz sharemarket investor?take hanover shareholders for instance

[notie]

Another positive report...



"If New Zealand is truly going to benefit in the long run from the discovery of oil, is has to make this decision," says Buechler.

Maybe they should have asked him when the last new oil and discovery was in NZ.

It has been about 5 years since anything new was discovered.
Unrealistic chatter like this doesn't help NZ. More investment might, although certain companies aren't going to the the ones making the big discoveries.

mcdoull stuart's summary is more slack analysis. NZ first capital got it about right

[brucey09]

why would any person listin to macdougall stewart - they have a vested interest ? prc nzo etc etc?

[digger]

Maybe they should have asked him when the last new oil and discovery was in NZ.

It has been about 5 years since anything new was discovered.
Unrealistic chatter like this doesn't help NZ. More investment might, although certain companies aren't going to the the ones making the big discoveries.

mcdoull stuart's summary is more slack analysis. NZ first capital got it about right

Notie the latest oil discovery was about two months ago with CUE holding 5% of the field as per my post above.About 50 million extra barrells were added.And i am sure you will join me in the confidence that NZO will add a similiar amount in the next few months.

[notie]

Notie the latest oil discovery was about two months ago with CUE holding 5% of the field as per my post above.About 50 million extra barrells were added.And i am sure you will join me in the confidence that NZO will add a similiar amount in the next few months.

both maari and manaia are not new discoveries. These were both found in the 70's+80's.

[arjay]

both maari and manaia are not new discoveries. These were both found in the 70's+80's.

Maari was discovered in 1983 by Petro-Taranaki's Moki-1 well. As Digger points out, the Manaia discovery is new.

[arjay]

With the upcoming drilling action coming up I reckon some blue-sky NZOE options would be fun. Say, 1:2 distribution with a conversion price of $3, 24 months out. Lots of fun for speculators and no dilution unless we hit the jackpot.

[Crypto Crude]

Arjay-As Digger points out, the Manaia discovery is new.

Im with Notie on this one...
Manaia was discovered in 1970 by shell...
It flowed oil at 575 BOPD...
and the research that Id done pointed to a sucessful producer...
The reasons being, updip more oil contact...
Still didnt really get rewarded for knowing it was a close to 100million barrel field...
in the end the market took it as a given...
pffft....

.^sc