Karoon A High Risk, High Reward 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 is a high risk game but the upside from success can be significant, a case in point being Karoon Gas Australia ((KAR)). According to Bank of America-Merrill Lynch, which has initiated coverage on the stock with a Buy rating today, the pure exploration play offers potentially transformational growth given its substantial upcoming exploration program.

The program is targeting 21 trillion cubic feet of gross unrisked gas reserves in Western Australia, which on the broker’s numbers could, if successful, see the stock re-rated to as much as $12.80.

Credit Suisse identified the same upside potential when it initiated coverage on the stock with an Outperform rating last month. Another attraction noted by the broker was the fact that while the Browse Basin offered upside there were other projects in Brazil, Peru and offshore Australia that could also generate significant value. This means the stock is not a single asset play.

Despite this spread of assets there is clear risk associated with the stock, Merrill Lynch estimating if the current  Browse Basin program doesn’t prove successful the shares would likely be valued at something between $1.30 to $3.20.

But even allowing for the risk that the current program doesn’t produce as expected, what sets the company apart in the broker’s view is the depth of experience and quality of the management team in place.  As well there is the potential of the overseas assets, which are focused on Brazil and Peru and include pre-salt plays in Brazil’s Santos Basin. This is the same basin where Petrobas has recently made some significant discoveries. Upside potential for Karoon includes post-salt targets offshore that could hold reserves in the 100-200 million barrel range.

Investors shouldn’t have too long to wait for the first sets of results as the company should reach target depth at its Poseidon-1 well in the offshore Browse Basin in the next few days, with the first results to be delivered in the next two to three weeks.

Success here could add as much as $2.25 to the share price on Bank of America-Merrill Lynch numbers. However, success can also see management turn to the market for additional funding. BA-ML sees potential for the company to seek $200-$300 million for additional work on the field. Any share price weakness resulting from an equity raising could be a good entry point into the stock in the broker’s view.

Assuming success in the exploration program, the broker estimates the company could eventually need as much as $5 billion to fully develop its assets. This would require a new financial structure given the company currently has a market capitalisation of just less than $400 million. As part of this the broker sees scope for asset sales or the sale of some equity in the company’s projects.

Looking ahead, the next well planned is the Kon Tiki-1, which should be spudded sometime in May, followed by the Grace-1 well in July. The broker notes success at Poseidon-1 would increase the probability these subsequent wells are successful.

On the broker’s numbers, the market is currently pricing in a probability of success for the company’s exploration program of 15-20%, while management is slightly more optimistic and suggests the chances of success are more like 1-in-4. This suggests some share price upside if management’s assessment proves to be closer to the mark.

To reflect this Bank of America-Merrill Lynch has set its price target on the stock at $5.11, while Credit Suisse’s target from last month stands at $6.00. To date these are the only brokers in the FNArena database to cover the stock.

Shares in Karoon today are slightly higher on the back of a stronger overall market and as at 10.35am the stock was up 3c at $2.61, which compares to a trading range over the past 12 months of $1.645 to $4.90.

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