Karoon Remains An Exploration Play

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This story features KAROON ENERGY LIMITED.
For more info SHARE ANALYSIS: KAR
The company is included in ASX200, ASX300 and ALL-ORDS

By Chris Shaw

Oil and gas exploration play Karoon Gas Australia ((KAR)) delivered disappointing results from its Kontiki-1 well, an outcome that has caused a de-rating of expectations in the market with respect to the potential value of the company. But according to Morgan Stanley, the current share price can be justified by resources already discovered by the company and a conservative valuation for the company’s remaining exploration acreage.

This explains why the broker has initiated coverage with an Overweight rating against an in-line sector rating.

While the Kontiki-1 well disappointed, Morgan Stanley notes key assets remain the prospects the company owns in the Santos Basin in offshore Brazil, the Browse Basin in Australia and some holdings in Peru. The Browse Basin assets are of particular interest in its view given the Poseidon-1 well has already discovered gas and there is potential for additional discoveries as the drilling program continues.

The upside from additional drilling success at Poseidon-1 is substantial in the broker’s view, as if it confirms pre-drill estimates of  as much as seven trillion cubic feet of gas, this could underpin a brown-field LNG expansion at Darwin. Given this Morgan Stanley values the discovered resource and acreage and cash at $12.22 per share, which alone is well above the current share price.

The group’s other acreage is also unusual in that it contains large leads and prospects, so while this means there is significant risk if the exploration work is not successful, it also offers scope for any discoveries to have a material impact on the share price.

Ass an indication of the risks involved the failure of the Kontiki-1 well saw Bank of America Merrill Lynch move its success case risk for the Kontiki field to 5% from 15% previously, while the potential size of the field has been cut to two trillion cubic feet from six trillion previously.

Given some interdependence between  the Kontiki and Grace fields, BA-ML has also lowered its chance of success for that field to 10% from 15%, meaning its base case valuation for the company excluding both Kontiki and Grace now stands at $7.37. Assuming a two trillion cubic feet discovery at Kontiki, BA-ML would add around 80c to its valuation for the shares. On the other hand, a failure there and the cancellation of Grace would have a negative impact of around $1.70.

BA-ML continues with its Buy rating as the disappointment at Kontiki doesn’t have any flow through impact on the value of Poseidon, which on an unrisked basis could be as high as $14.70 on its numbers. This is predicted on a proposed brownfield LNG development.

Credit Suisse puts the outlook for the stock in simple terms – if exploration is successful enough to support gas development potential, the valuation upside is significantly greater than the current share price, but if the company fails to define a gas resource there is significant downside.

To reflect this, CS’s target price has been cut to $8.15 from $17.00 as the stockbroker has removed the non-Poseidon upside it had factored into its model. Credit Suisse has taken the view that the Kontiki-1 failure makes a more positive outcome less likely. The change in its target has caused the broker to downgrade its rating to Underperform from Outperform previously.

Such a target is too conservative according to Morgan Stanley. MS has set a target of $9.80, which is still well below its base case valuation on the stock of $12.22. This is based on Poseidon finding seven trillion cubic feet of gas valued at 18c/Gj. The variance in value depending on exploration results is substantial, as evidenced by the broker’s bull case valuation of nearly $24.00 and its bear case outcome of around $5.62.

The next results should be known relatively soon, as the existing drill rig is to be moved from Kontiki-1 to the Poseidon-2 well, with a further two wells to be drilled after that.

Among brokers in the FNArena database only Bank of America Merrill Lynch and Credit Suisse cover the stock, meaning a split of one Buy and one Underperform rating, with Morgan Stanley’s Buy adding weight to the positive case. As with the range in ratings there is also a range of price targets with Credit Suisse’s at $8.15, Bank of America Merrill Lynch at $9.07 and Morgan Stanley the most bullish at $9.80.

Shares in Karoon today are stronger and as at 12.15pm the stock was up 72c or almost 10% at $8.02. Over the past year the stock has traded between $1.645 and $12.10.

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