Feature Stories | Jul 21 2006
By Greg Peel
Hardman Resources (HDR) is an emerging oil exploration and production company that has evolved from simple explorer to an actual oil producer given the development of the Chinguetti oil field. Hardman owns 19% of the project, which is operated by Woodside Petroleum (WPL). Woodside owns 47%.
Hardman also has similar levels of interest in other significant hydrocarbon discoveries of Banda, Tiof, Pelican and Tevet. These, along with Chinguetti, are all located offshore from the West African country of Mauritania. Hardman is also undertaking exploration in the oil fields of Lake Albert, in land-locked Uganda.
In short, Chinguetti has been a nightmare. This has been to the great disappointment of management which was so fired up as recently as December. In the quarterly report of that month, Hardman’s CEO and Managing Director Mr Simon Potter commented:
"Chinguetti production, bringing strong revenues boosted by the high oil price, is close at hand. During 2006, we shall begin deploying these revenues to accelerate development of the group. Across the Mauritanian acreage we have a continued exploration programme, with the focus moving to prospects in shallower water. In Uganda, we have started the year well, as the operator of an exploration programme which has already produced a discovery. 2006 will be a year of progress for Hardman with our emergence as a producer allowing us to maintain and indeed step up our traditional exploration activities as well as continuing to develop our operating capacity."
Over the course of 2006, Chinguetti production targets have been continually downgraded. This has frustrated and even angered oil analysts, who rely heavily on company guidance in order to place a value on the company and advise their clients accordingly. While giant Woodside has businesses diversified over a number of areas and can better absorb the Chinguetti downgrades, little Hardman is really just a one-trick pony at this stage.
Who is to blame for a supposedly misleading production target? Credit Suisse analysts certainly have a view:
"To underperform so early after a field start-up and by so big a margin, we believe, is indicative of something missed in the development planning or implementation".
Hardman Resources provides a perfect case study for the vagaries of valuing an oil company. Oil has been big news ever since it started approaching a big price. With the oil price at these levels oil production companies have seen their share prices skyrocket. Investors have been clambering over each other to jump on the oil bandwagon.
And there has been a lot of disappointment. Producing oil is just not the same as producing widgets. If widgets are in high demand it’s not too difficult for analysts to assess price assumptions, cost assumptions and production capacity. But oil is not a widget.
Exploration is a hit and miss affair. Estimating an oil field’s reserves comes with high margins for error. Oils, as a wise man once said, ain’t oils. Different wells around the world produce different grades of oil ranging from heavy to light. As well as oil, a well might contain gas, water, sand or other impurities. The cost of producing refinable oil varies immensely.
The bellwether oil price is that of West Texas Intermediate, which is a "sweet, light" crude. Although we refer to the price of WTI as "the price of oil" every well produces a grade of oil that is different to this benchmark. Sweet, light crude is the easiest to refine, whereas heavy oils take more effort. Chinguetti oil is at the heavy end of the scale.
Consider this report from UBS, regarding one of Hardman’s test wells in Uganda:
"In late June 2006, Hardman re-entered the Waraga-1 well. The lower most oil zone was flow tested at approximately 1,500 bopd of 33.8 degree API oil through a 36/64" choke. Following a shut-in period, the zone was re-flowed at a stabilised rate of approximately 4,200 bopd through a larger 1" choke. The oil is waxy with a low gas to oil ratio."
Is that clear now? Okay hands up – what value would you arrive at for this well?
This is the task facing an oil analyst. At the end of the day, analysts must rely heavily on data provided by the company (and demanded by the ASX) which may have been gleaned from rigorous testing by eminently qualified people, but that is still no more than speculative.
Shaw Stockbroking’s John Colnan points out, nevertheless, that the biggest stumbling block for Chinguetti production has been a simple matter of equipment.
As the oil price pushes higher and higher the scramble has been on to find and open new wells, reopen older, previously uneconomic wells, and generally try to get as much of the stuff out of the earth as quickly as possible before the great price bonanza ends.
Given that excess production capacity was not considered a pressing issue up until recently – when China turned the world upside down – there has been a lack of investment in capacity and infrastructure that is only now being exposed. This has been the case with all resources. Equipment is scarce, materials are scarce, experts are scarce. And this all adds up to spiralling costs for producers.
It is hard enough for oil companies to acquire and install the right sort of equipment at an existing oil field close to hand, let alone to do the same thing off some far-flung shore on the wilds of West Africa. Much of Chinguetti’s production downgrade has been due to such problems.
And this is not just an overnight proposition. It might take four years to get a well to start-up and seven to get it to full production. In all this time the oil price is moving around. Were the oil price to collapse, as unlikely as that might seem, the costs could ultimately render a project uneconomical.
Merrill Lynch analysts have been ticking off the market all year when it comes to Chinguetti, and the subsequent share prices of Hardman and Woodside. "You’re all getting too carried away", they said, figuratively speaking, "You’re pricing in the full value of Chinguetti upside and ignoring the fact that there are invariably problems and risks associated with developing an immature oil project".
In other words, Merrills is suggesting that one must price risks into a project’s value so as not to end up disappointed. As more production downgrades have been announced, the Hardman share price has suffered. Having peaked near $2.50 in April it bowed to the May correction and hit $1.50. A struggle back to pass $2.00, backed by a US$70/bbl plus oil price, has been exhausted again. Hardman was trading at $1.59 at the time of writing. Analysts have effectively cut Hardman’s near term earnings estimates by half.
This is what ABN Amro’s analysts said in a report last month:
"We met HDR and WPL in Perth recently. Our key takeaway on HDR was that production at the Chinguetti oil field is still falling and may bottom close to 30,000bopd in the next month before stabilising around August. Three new production wells are planned to improve output from the southern portion of the field, but given constraints around completion equipment for the wells, drilling is unlikely to be before October. Rehabilitation costs are estimated by management to be US$30m-35m per well. We forecast production could reach close to 60,000bopd by year-end or early 2007 if everything goes according to schedule."
That last line was the most prescient. Things are not going to schedule and Chinguetti production was downgraded yet again this week. Obviously it is extremely difficult for an analyst to value a company when company guidance is of little help.
But that’s just the production side of Hardman Resources. The company is also involved in exploration and testing elsewhere, upon which the main focus is presently Uganda.
Now I don’t think I need to expand on the sort of risks that might be involved in oil production in this volatile African nation, located in an area between the Republic of Congo, Kenya and Rwanda. There is actually oil seeping visibly into Lake Albert, yet no one has been game to touch the place since initial tests were begun by a British company back in 1938.
Brokers are at odds over the value of the Ugandan project. Merrill Lynch has long argued that the key to Hardman’s value lies not in its current production, but in the upside provided by exploration. However, there are certain problems associated with the Ugandan site.
Says ABN Amro: "While recent discoveries in Uganda, at Mputa and Waraga (HDR 50%), have been positive, HDR is going to have major difficulties commercialising the oil, in our view. Key issues include the fact that Uganda is a landlocked African nation and the expectation that the crude is waxy."
Merrill Lynch counters with: "Given the strong production from this initial flow test, we believe that recovery factors may prove higher than initially thought, lifting recoverable reserve estimates for the field. We are currently assuming a resource estimate of 30mmbbl each for Waraga and Mputa, contributing 14cps and an additional 12cps of Ugandan exploration potential in our A$2.20ps valuation."
Back to ABN Amro: "Until HDR proves up a viable commercialisation option for its Ugandan oil, we are happy valuing it at close to zero."
What’s the UBS analysts’ take on all of this?
"We believe this discovery and Hardman’s onshore Uganda acreage is given little (if any) value in Hardman’s share price. Why?"
Why indeed. UBS goes on to explain the problem, and it is this problem that has brokers in different minds about the value of Hardman’s Ugandan oil.
Every broker agrees that there is possibly 30 million barrels of oil to be tapped in Uganda. UBS reckons this could be worth as much as 15c to the Hardman share price. But Uganda is a land-locked country and to make the oil production viable, an export pipeline would need to be built to the coast. Unfortunately 30 million barrels is just not enough to justify the construction of such a pipeline. Who, then, will buy Ugandan oil?
Well what about Uganda? Only one problem – no refinery. There is an old refinery in Kenya but it isn’t really all that inspiring. Hardman is possibly facing the old dilemma of "supposing you threw a party and nobody came".
But wait. UBS believes the real opportunity might lie with another Ugandan oil field – Ngassa. Ngassa is not located on Lake Albert, it’s located in it. UBS suggests Ngassa might be the key to commercial Ugandan oil export. But there are drawbacks.
Offshore oil rigs are far more complicated and costly than onshore ones, and it would be a very costly exercise to source the right equipment, get it there, and set it up. Notwithstanding cost, Hardman would be drilling through major fault zones. That’s enough to send shudders through a Beaconsfield miner.
So here we have the dilemma. Hardman’s actual production has proven a big disappointment. Failing that, its exploration program provides potential, as long as reserves can reach commercially viable levels. How do you put a value on all of that?
We’ll let the Citigroup analysts provide a view:
"We rate Hardman Resources Buy, High Risk (1H) (previously 2H), with a revised target price of $2.08/share (previously $1.91/share). The target price reflects the near term production issues at the Chinguetti field, the development quandary at Tiof, and the political risk in Mauritania. In addition, we allow some value for Tevet and Lebeidna oil reserves and Banda oil reserves and the recent Waraga oil discovery in Uganda. Although some may give value for a potential LNG development at Mauritania within the next 10-years, we haven’t at this stage, as a commercial quantity of gas reserves has yet to be delineated and a Production Sharing Contract for gas has yet to be agreed upon and ratified."
Reading that you start to get the picture of just what a complex equation must result from entering all the elements of the company’s valuation. Each analyst at each broker has to go through the same exercise, and it is not hard to imagine wildly different outcomes.
Over to Citigroup again:
"In assigning a target price we have used the valuation of reserves methodology, taking account of the risks on the size and timing of the separate field developments. The underlying DCF [discounted cash flow] includes producing fields and those where a formal decision (FID) to proceed with development has been declared as has occurred at Chinguetti. An oil field DCF is based on the 2P (proven and probable) reserve estimates as booked by the companies.
"The upside DCF includes projects where a FID decision has yet not been made, but has however been flagged by the company as a production opportunity. These projects are separately modelled and then risked to reflect the probability of proceeding to full development."
This methodology is not peculiar to Citigroup – it’s pretty standard stuff. The vital element here however – one which can affect a range of valuations from different analysts – is the concept of "risking".
Risking involves making an assumption about the possible value of a project and then applying a probability factor to that value actually being achieved. Citi uses this method to give the Tiof well a 60% chance, Tevet 70% and Lebeidna 30%, for example. The Ugandan project only scores 25%. The analyst arrives at monetary value per share of a project and then reduces that value by said probability factor.
Risking is not an application taken lightly. It is not simply a matter of saying "It’s got a good beat, you can dance to it, I’ll give it an 85". You might actually be surprised at just how many risks there are.
In evaluating the Chinguetti project alone, Citi (and fellow analysts) consider:
1. Oil price risk – low. Production has been hedged.
2. Funding risk – low. ANZ has provided a loan and revenue is due shortly.
3. Construction risk – low. Construction is complete.
4. Marketing risk – low. Production pooled with British Gas, Premier and the government of Mauritania.
5. Contract risk – medium. There is a new government in place.
6. Reservoir risk – medium. There are problems at the north end of the field which need to be resolved.
7. Reserve risk – medium. If production can just hold steady for 6 months this will drop to "low".
Now that’s just Chinguetti. The same process has to be implemented for all Hardman’s other projects. Then the analyst has to look at the company as a whole, and assess:
1. Commodity risk – low. The oil price is easily hedged.
2. Finance risk – low. Debt is low and cashflows should soon be strong.
3. Business risk – low. It’s only a one-project company at this stage and it has no controlling interests.
4. Political risk – medium with a bullet. The government changed last year.
5. Exploration risk – high. But this will decline as the production base is established.
6. Takeover risk – high (which is a "good" risk). The company has an open register and is not overvalued.
If Uganda is opened up, the analyst will have to go through the whole process again.
Are you beginning to feel exhausted? It’s just as well someone invented the computer.
Now, the analyst has gone through all this work, spending late nights burning the midnight oil, toiling away with pen and paper, but at the end of the day the one thing that significantly affects the valuation of an oil production company is purely and simply – you guessed it – the price of oil.
In fact, wild variations can be achieved without having to move the oil price up or down too much. And the further into time you make your assumptions, the wilder the price fluctuations become. But oil companies must be valued out to long dates, because it takes a long time to get full production up and running.
What’s the price of oil? Never mind what it is today, what’s it going to be tomorrow?
If you don’t know this then any valuation you make of an oil company is not going to mean all that much. And you don’t know this.
The best estimation for the oil price into time is what’s known as the "forward curve". A forward curve is transparently provided by the futures prices of WTI on New York’s Nymex exchange. At the moment that price is trading around the low seventies in the near month, up closer to eighty towards the next year, and tapering off after that.
The reason the curve rises in the centre is because although oil supplies are relatively stable at the moment, no one is prepared to assume that there won’t yet be some price shock around the corner, driven by Iran or North Korea or Nigeria or Venezuela or whoever.
The reason it tapers off in to the distance is largely twofold. Firstly, analysts work off the basis of the lessons of history. One of those lessons is that commodity prices are cyclical. Demand rises, so prices rise. Supply eventually catches up so prices fall. Up, down, up, down. What this provides us with is an average historical price trend. That trend is the mean of all the ups and downs. To make a price assumption into the distance an analyst will simply revert to the mean historical average.
Now you would be forgiven for saying "But hasn’t that all gone out the window lately, with China and Iran and all? Aren’t we stuck with high oil prices from here on in?"
The reality is that analysts have been step-jumping the reversion price for a couple of years now. Whereas three or so years ago the long date price might have been about US$25/bbl, most analysts are now working of around US$45/bbl. But even US$45 seems like a world away when we’re banging around US$75.
The second factor, which is closely related to the first, is "substitution". The oil price simply cannot keep going up forever. Eventually it will reach a point (and we’re there now) when the world starts looking for alternatives to producing oil (eg coal conversion), and alternatives to oil itself (eg ethanol, hybrid cars). When such alternatives become more developed the price of oil must fall and stay that way.
When Citigroup revised down its Hardman earnings estimates last month based on company guidance on Chinguetti, the analysts actually raised the stock valuation by 9%. They did this because at the same time they had increased their long term oil price assumption from US$40/bbl to US$45/bbl.
This increase had far more impact than near term earnings projections. The further out in time you fiddle with prices, the bigger the effect is going to be on today’s valuation. It’s a bit like the butterfly and the storm.
Take this example. On FN Arena’s request Shaw Stockbroking’s John Colnan graciously provided a valuation comparison.
Chinguetti oil is afforded a 4% discount to WTI. Hence if WTI is worth US$70/bbl, Chinguetti oil is worth US$67/bbl. On this basis John values Hardman using an oil price curve of (all in US$/bbl) $63 for 2006, $57 for 2007, $49 for 2008 and $43 for 2009.
This provides a valuation for Hardman of A$1.71. (Valuation, as opposed to a target price).
If we assume the oil price to stay where it is, that is US$70/bbl WTI, then John would plug in US$67/bbl for each year and arrive at a valuation of A$2.53. This is 48% higher.
Okay, so just how accurate is forward curve pricing? The answer is that it isn’t – it’s just guesswork.
So if we remember back to all the work the analyst put in to try to ascertain some sort of value for the oil company, we realise now that one little adjustment in guesstimate on the oil price renders everything else fairly meaningless anyway.
Who’d be an oil analyst?
One thing that does work in the analyst’s favour however is the fact that Hardman hedges its oil price exposure. To complicate matters it does that against the Brent crude price, rather than WTI, but it doesn’t matter as the two are quite close.
Hardman has bought put options between US$42-46/bbl for each of the years 2006-09. This means no matter how far the oil price might fall in this time, Hardman can at least sell its oil at this minimum price.
The company has financed the cost of the put options by selling call options at (all US$/bbl) $71 in 2006, $72 in 2007, $71 in 2008 and $69 in 2009, give or take a couple of cents. This means that even if the oil price goes to US$100/bbl in this time Hardman can only ever achieve these maximum prices.
Once again, this affects the share price valuation, but at least these numbers are known, not assumed.
So taking ALL of the above into consideration, an analyst arrives at a valuation, and target price, for Hardman resources. A cynic might suggest that throwing a dart at a dartboard blindfolded would be equally as meaningful, but that would be being terribly unfair to hardworking oil analysts.
For the record, the FN Arena database currently shows eight brokers calling a Buy on Hardman and one a Hold (JP Morgan). The Morgan analysts have made it know that they’re simply fed up with Chinguetti downgrades and won’t call a Buy until the truth comes out.
The average target price is $2.21, on a spread of $2.00 to $2.43. This is a 21% spread. When you think of all that we’ve just discussed, that’s remarkably tight.
So next time you are wondering why your oil company share price is not doing what you expected it to do, think about what went into your investment valuation in the first place.