The small and micro cap oriented RMG2 Value Catalyst model portfolio posted a loss of 26.65% for the quarter ending September 30th, 2008. As of the end of the third quarter, the year to date loss was 31.80%.
The portfolio is largely composed of small and micro cap securities, and the majority of the businesses, based upon portfolio weightings, operate outside of the United States. The public peer group that I benchmark against are also small cap oriented internationally themed mutual funds. Their returns as of September 30th were as follows:
Trailing Returns as of 9/30/08
| Ticker | Fund Name | 3 Mo. Return | YTD Return | 1 Year Return | 3 Year Annualized | 5 Year Annualized |
|---|---|---|---|---|---|---|
| PVADX | Allianz NFJ Small Cap Value Admin | (4.57%) | (6.79%) | (10.26%) | 4.92% | 12.86% |
| PASMX | Pacific Advisors Small Cap A | (12.16%) | (18.35%) | 9.58% | 18.43% | |
| NTKLX | ING Intl SmallCap Multi-Manager A | (28.34%) | (35.20%) | (41.44%) | (1.66)% | 10.16% |
| IEGAX | Thomas White International | (25.30%) | (36.88%) | (39.76%) | 3.35% | 17.44% |
| OSMAX | Oppenheimer International Small Co A | (41.59%) | (50.28%) | (52.30%) | (4.33)% | 11.20% |
| RMG2 VC | Value Catalyst | (26.65%) | (31.80%) | (29.07%) | 11.34% | 33.01% |
Returns assume reinvestment of dividends and distributions. Performance data quoted represents past performance. Past performance is not a guarantee of future results. Investment returns and principal value will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. Current performance may be lower or higher than the performance data quoted.
All of the peer group have posted negative results for the year to date. This is reflective of both market volatility, and the lesser liquidity generally attributed to small cap securities. However, for the first time in a number of years, RMG2 VC has soundly underperformed its peer group.
I believe that there are several reasons for the current level of underperformance.
1. RMG2 VC has a more focused and concentrated portfolio than many publicly available mutual funds. Most publicly available mutual funds will often hold several hundred securities, and seldom less than 50. They will also endeavour to distribute overall portfolio assets broadly, often limiting any specific holding to less than 5%. By way of contrast, I tend to hold no more than 25 securities in RMG2 VC, and often less. The portfolio also will overweight securities that I consider as having the potential for long term performance superior to small cap indexes in general.
This deliberate emphasis on concentration and overweighting of preferred investments will often magnify returns, but can also magnify losses periodically. Concentrated portfolios are generally used more among several well known value oriented hedge funds, rather than mutual funds. It is also the methodology of icons such as Warren Buffet.
Value oriented hedge funds and private capital (Buffett et al) are able to adopt this style. They are able to "lock" investors into timeframes sufficient to prove out an investment thesis. The risk of underperformance over shorter timeframes typically precludes most mutual funds from employing this methodology.
2. Most of the key investments in RMG2 VC are far less liquid than the median small or micro cap company. During periods of extreme volatility, illiquid securities often move in an exaggerated fashion. The top two investments in RMG#2 (by portfolio weight) generally only see a few thousand shares per day trade. Some days, no trades will occur.
Any portfolio that is overweight in illiquid, or less liquid securities, carries with it the potential (and risk) for greater than average volatility. This has certainly been the case for the virtual account. Economic recessions are always accompanied by reduced liquidity. Accordingly, during periods of broadly based decline, volatility will be more pronounced for illiquid securities.
This is not the first period of short term underperformance for RMG2 VC vs. peers, and certainly won't be the last.
Reflective of my investment methodology, I deliberately pay little attention to liquidity issues in the marketplace. In the last recession, RMG2 VC had another six month period whereby the returns were below peers. The portfolio fell off, and then muddled along for a while. I grumbled a bit, and wondered why great stocks traded for such poor prices. Then the turn came and liquidity improved. Values of key stocks rose to reflect the fundamentals.
While a concentrated and focused style carries the potential for short term underperformance, I have no intention of changing my stripes in this recession.
There are a host of simple reasons for this.
1. Global equity markets generally have far more "up years" than down. Downturns fill investors with angst, but they don't tend to last very long. Stock prices also generally lead economic turns. Those who move out of stocks during recessions run the "opportunity risk" of missing the new bull cycle. As I'm not smart enough to know with 100% certainly when we are going into recession, I certainly can't call the turn out. Therefore, I am generally fully invested at all times of the economic cycle.
Both the mainstream media and the investment industry are less than helpful in recessions. Most widely economic indicators supplied are typically "lagging". Leading indicators are mostly just guesses. It has also has been my experience that stocks often move up inexplicably, often while the media is still reporting doom and gloom. These broadly based historical moves, often without good news, often sneak up on investors.
2. Investors sometimes use the "50% down-100%" up rationale, as a reason not to ride out swings in equities. This is a mantra of market timers. If refers to the fact that when an investment falls 50%, it must subsequently rise by 100%, to get back to break even. The investor theorizes that it must take at least 2X as long for a stock to rise by 100% to recover the loss.
While I understand the principle, I don't subscribe to it. In fact, I consider this to be just another misconception. In my years of investing, I have seen a great number of stocks rise by far more than 100%; faster than they fell 50%. Market timers often miss the ten baggers, in their efforts to avoid downturns.
3. Great companies look to capitalize on downturns through transformative acquisitions, or with organic expansion. Some companies, such as American Pacific (APFC), have broadcasted their intention of making an accretive purchase for a while now, but were unwilling to pay high prices. I have little doubt that in this buyers market, management can do something substantial.
Other companies are more closely guarded with their long term strategies, for competitive reasons. However, I want to own a business before the transformative purchases are made, not after the fact.
Next week, I will start to rollout my specific investment thoughts on the companies contained within RMG2 VC. Like my recent blog for RMG1, I will start highlighting three companies per article. I'll supply my investment rationale, what I am looking to see from the businesses over the next 36 months, and also spell out what I consider to be the bear case thesis.
]]>Brazil is on the verge of a new era in offshore oil and gas development. Speculation abounds that one, or more, of the largest discoveries in the last 25 years has been found in Brazilian waters. While one elephant sized field is generally all that is required to turn a company into an oil "major", concessions largely owned by Petroleo Brasileiro S.A, or Petrobras (nyse: PBR $70.5), the Brazilian oil company, may potentially be home to an entire herd of elephants. Ultimately, production from the Campos, Santos and Espirito Santos basins may rival that of the North Sea.
Oil production from the new deepwater finds isn't likely to commence before 2011. However, companies that provide infrastructure to offshore rigs are already profiting from recently awarded contracts. Petrobras, as a partially state owned firm, has an informal mandate to distribute oil wealth throughout the domestic economy. Brazilian companies that supply goods and services to Petrobras will be first in line to benefit from this corporate largesse. Just as in other rushes, owning low risk businesses which provide "picks to prospectors" might, once again, represent an easy way to earn big returns over the long haul.
One local firm positioned to profit from this boom is Wilson, Sons (Bovespa-WSON11, 21.8 Brazilian Real). All amounts are converted from Brazilian Real to US dollars. The company operates two container terminals and an oil terminal, builds and owns drilling supply vessels (DSV) and owns the largest and most modern towing fleet in South America. A fast growing logistics division manages 1.5 million square feet of warehouses, and handles shipping and storage for a variety of multinational and domestic companies. The company was founded in 1837 and raised $117.8 million in an IPO on the Sao Paulo Stock exchange in April 2007. Wilson's Brazilian Depository Receipts (BDRs), were listed at a price of $11.74 US, 10.6X the trailing 2007 EV/EBITDA ratio.
Perhaps due to its limited history as a public company, this rapidly growing small cap is priced at what I consider to be value multiples. The discount certainly can't be attributed to a weak balance sheet. Total liabilities were just $55.6 million on March 31, 2008. There are 71.2 million shares outstanding for the market cap is $950 million. From 2005-2007 revenues grew from $258 million to $404 million, an annualized increase of 18.9%. EBITDA grew from $49 to $91.4 million, an annualized increase of 28.8%. Net profits grew from $25 million to $57.8 million, an annualized increase of 43.8% over the past 36 months.
With funds raised from the IPO, management embarked upon a major expansion of all operations. $220 million of capital spending is planned for 2007-2008. This represents a substantial increase over the $78.4 million invested in the two years preceding the IPO. Port handling capacity will increase by 55%, to 1.4 million twenty foot equivalent units (TEU) per year, up from .9 million TEU in 2007. The terminals had been running above capacity and had turned away substantial business in the past. Much of the newly added capacity will be immediately utilized.
Expansion plans in other divisions are equally well defined. Wilson is adding 12% more towing vessels to its fleet this year. The wholly owned DSV fleet will grow by more than 130% in size by 2010. All supply boats will be chartered to Petrobras. A $100 million four year contract to build supply vessels for a Chilean firm has recently been awarded. Petrobras has also announced a new 24 DSV tender. Wilson intends to bid for a further 8 vessels in this round, the maximum award any one company can receive per bidding round. Additional tenders for 122 more DSVs are likely during the next 6 years.
The expansion of high profit container ports, offshore platform supply businesses and towing services should produce strong revenue gains and improved operating margins. By 2011, revenues could exceed $610 million. EBITDA may surpass $180 million. If my forecast is met, three year EBITDA growth of 96% is possible, on revenue gains of 51%.
Despite all this potential, Wilson, Sons sells at valuations below that of slower growing peers. Trico Marine (nasdaq: TRMA, $38.39), Hornbeck Offshore (nyse: HOS, $52.70) and Gulfmark Offshore (nyse: GLF, $61.57) sell for 10.5X, 9.9X and 10.5X my 2008 forecast EV/EBITDA ratio. Wilson could generate $110 million of EBITDA in 2008, which prices the shares at 9.1X my forecast EV/EBITDA ratio. Arguably, a faster growing company with a stronger balance sheet than peers deserves a premium valuation.
I prefer owning overlooked companies capable of doubling earnings in three years, without leveraging up their balance sheets. Wilson nicely meets my criteria. Net profits may grow to $120 million by 2011. Management intends to pay out 25% of net annual profits in the form of dividends. The current payout of $.225 per share (1.8%) could increase by 100% by 2011. My three year price target is $26.80 per share, roughly 102% above the current quote.
Wealthy people often attribute success to simply being in the right place at the right time. If this is the case for individuals, can't this also be true for entire companies? It certainly appears to me that Wilson, Sons, a fast growing firm prior to the Petrobras discoveries, is about to embark upon an extended run of good fortune. The biggest two year capital expenditure program in corporate history will be completed by late 2008. Results of these investments should be apparent to all in 2009. Furthermore, Wilson's logistics division should produce superior returns as the Brazilian economy prospers. Finally, as a local company, Wilson will have the important "home field" advantage over foreign competitors, when attempting to generate more business with Petrobras. Intrepid global investors will find this small cap stock to be right up their alley
Wilson, Sons can be purchased by a wide variety of brokerage firms. I was able to place an order with my full service broker as easily as with any other foreign. The shares trade on the Bovespa (Sao Paulo Stock Exchange) in Brazil under the ticker symbol WSON11. Shares are quoted in Brazilian Reals and converted to US funds at purchase. The corporate website can be found at www.wilsonsons.com
]]>BMB MUNAI (AMEX-KAZ, $6.95)
Investors seeking an international junior oil producer with rapid growth potential should consider an investment in BMB Munai. This company has a 100% interest in a 460 square kilometres concession in western Kazakhstan, known as the ADE block. This block is located within 28 km of oil pipelines and is fully covered with modern seismic undertaken in 2003. Infrastructure, rail and roads allow the firm to quickly bring oil production to markets. In addition, BMB has the right to explore an adjacent area known as the "extended territory".
The ADE block consists of carbonate Triassic formations, typically found at 3100-3800 metres (10,161-12,500 feet) below surface. Exploration drilling at the ADE block to date has proved up two oil fields, known as Aksaz and Dolinnoe fields. To date, a total of 8 wells have been drilled at these fields. Production from 4 Aksaz wells to date average 216 bpd. The 4 Dolinnoe wells have produced an average of 99 bpd.
Investors have found some Kazakhstan oil plays to be a frustrating experience
Kazakhstan exploration and production companies have sought to develop both sandstone reservoirs and carbonate reservoirs. There has been a clear correlation between the success of a junior in Kazakhstan and the type of oil reservoir targeted for development. Historically, companies in Kazakhstan that developed sandstone reservoirs generally grew production steadily, were highly profitable and eventually were bought out.
Kazakhstan companies that develop oil production from carbonate reservoirs have, on the other hand, often experienced difficulties in trying to coax oil flows from the "tight" shale like deposits. Wells plug up frequently and are tricky or expensive to stimulate. Production can be highly erratic. Some juniors find carbonate reservoirs to be problematic, and financial results have been disastrous in certain cases. Accordingly, sophisticated investors prefer sandstone reservoir producers.
BMB's newish discovery has the potential to be, by junior standards, a "company maker"
Until 2006, BMB was considered one of the "carbonate" companies, and traded at a steep discount to global peers based upon reserves. The discovery of a sandstone reservoir in the Kariman prospect may have changed fortunes for the better. A total of 6 wells have been drilled over the past 2 years in a relatively uncomplicated sandstone formation. Average production has been surprisingly good, at 528 bpd per well. BMB intends to drill at least 4-6 more wells into this structure within the next 12 months. I am confident that equally high levels of productivity might extend to future wells in the Kariman field.
Proven reserves are likely to grow rapidly in 2008
BMB reported 14.95 million barrels of proven reserves in 2007, which included 2.7 million barrels attributed to one successful Kariman well.
Since that report, a total of 5 more Kariman wells have been drilled. All were successful.
Probable and possible reserves attributed to Kariman were 20.1 million barrels in 2007. A shift of some of these reserves to the proven category should have occurred in 2008, based on this success.
Production looks to be on a steep growth curve, albeit from a modest base
In 2006, production averaged 624 bpd. Average production for 2007 was 882 bpd. For the fiscal year ending March 31st, 2008, it appears that production averaged 2400 bpd.
This year, production might average 3700-3800 bpd. Next year, I forecast 5600-5800 bpd of average production. In 2010, production could surpass 10,000 bpd.
EBITDA looks to be increasing at an equally fast pace
I report a fully outstanding share count of 55.6 million shares. I include a variety of "in the money" options, warrants, share grants and a $60 million convertible debenture that verges on being "in the money". BMB has net liabilities of 10.4 million, after assuming conversion of the debentures. This results in a current enterprise value of $391.2 million.
For fiscal 2007, EBITDA was $2.5 million. In 2008, EBITDA was approximately $38.7 million. For 2009, EBITDA could surpass $61 million. At this level of EBITDA, capital expenditures and SG&A look to be about fully met. In 2010, EBITDA could surpass $90 million.
Based upon my forecast, BMB is selling for roughly 6.4X my 2008 EV/EBITDA ratio and 4.3X next years' forecast EV/EBITDA ratio. This represents a discount to valuations for 11 other international junior E&P firms in my sample.
Management's interests seem to be fully aligned with common shareholders, a rarity in Kazakhstan
BMB is considered to be the first public oil and gas company listed in the US that is operated and controlled by Kazakhstan citizens. Management and insiders control roughly 34% of the outstanding common shares. BMB's CEO is Boris Cherdabayev, a well known member of the Kazakhstan oil community. The Cherdabayev family has ties with many of the leading public and private companies now operating in Kazakhstan.
As a largely Kazakhstan company, BMB may be better prepared to operate in the Kazakhstan oil business than foreign run firms. Unlike many junior oil and gas firms that I have followed in Kazakhstan, I am impressed with management's attention to detail during the exploration and development stages of the field concession. Often, juniors take shortcuts in their efforts to quickly get production flowing. In Kazakhstan, shortcuts generally cost a firm its concession. A rigid oil ministry often pulls licenses for failing to comply with exploration contracts to the letter. When this happens, local Kazakhstan firms readily swoop in and claim potentially valuable assets for themselves.
BMB, thus far, has taken great pains to exceed all terms and conditions of its concessions, at the expense of short term production growth. Many of the ADE and extended territory wells can produce from multiple horizons. Management carefully tests all productive zones and shuts in wells periodically to satisfy conditions spelled out by the government. Current rates are being reported from just one zone in each well. It seems clear to me that rates from all fields will jump during the production phase.
One caveat to this story is that tax rates for BMB will jump dramatically in the latter half of 2009
Investors should note that oil producers in Kazakhstan are required to sell 20% of all oil production to local markets, at local prices. This is priced at 25%-27% of quoted Brent. Remaining output may be exported at world prices.
All export production in Kazakhstan is now subject to a recently imposed export tariff of $14.95 per barrel. BMB export sales also have freight and shipping charges of $14.15 deducted from quoted Brent prices.
BMB presently pays a modest royalty (2%-6%) on production, as the firm is in the exploration phase on its oil fields. Production licenses are to be sought on July 9th, 2009. Upon conversion of the concessions to a production license, the fiscal terms change considerably. In addition to increased royalties, an export rent tax, based upon a sliding scale will apply during the license phase. At current prices, this tax is 33%.
To put this into simple terms; while in the exploration phase, BMB should receive roughly 63% of Brent benchmark prices for its output.
For all of 2009, taking into account that BMB will have lower taxes until July 9th and higher taxes thereafter, the firm should receive an average of 54% of Brent benchmark in that year.
In 2010, after the license agreement is fully in force, BMB should receive roughly 46% of world prices after all government taxes, levies and shipping charges apply.
In order for BMB to simply remain as profitable in the license phase as they are at present output will need to increase by 36%, or 1332 bpd. For many junior companies in Kazakhstan this would represent a real challenge. As I estimate that BMB's oil output may grow by a further 6300 bpd over the next 24 months, the new taxes should not be problematic.
It is possible that BMB will shortly become a self funded producer
In the next 24 months, accelerated development at Kariman might push total oil production from all fields to above 10,000 bpd. It is possible to envision 2010 EBITDA of $120 million. At that rate, BMB could dramatically step up development of all fields, without having to issue more shares or add debt.
BMB is my top Kazakhstan oil pick for US investors
Unlike a number of US junior firms which have "tried and failed" in Kazakhstan, local management at BMB is intimately familiar with the workings of the oil ministry. BMB has at least one uncomplicated field with some real upside (Kariman), which is all a junior generally needs to become self funding. Management also seems keen on the outlook for the Aksaz and Dolinnoe fields. I consider any potential success from these fields to be an added bonus. If production growth meets my forecast, BMB could be fairly valued at $15 per share, or 6.5X my 2010 estimated EV/EBITDA ratio.
I have recently purchased BMB for RMG#2 as an overweight position.
]]>Arawak Energy (PinkSheet: ARWKF) $2.26 US
All estimates and prices are in US dollars. Current share price is converted from Canadian to US currency at the rate of .9918.
Fully diluted shares outstanding (includes proposed 8.36 million share payment for Saigak Investments BV): 195.56 million
Total liabilities short term cash and equivalents: $105.2 million.
Enterprise Value: $547.2 million
EBITDA for 2007: $97.8 million.
2007 EV/EBITDA ratio: 5.6X
2005 average production: 5,667 bpd
2006 average production: 7,905 bpd
2007 average production: 10,180 bpd
2008 forecast production: 13,700*bpd-14,817 bpd**
2008 forecast EBITDA: $153.2 million-$158.8 million
2008 forecast EV/EBITDA: 3.5X-3.6X
Thesis
Investors seeking a rapidly growing oil producer in Kazakhstan and Russia at an inexpensive valuation should consider a purchase of Arawak Energy. Due to rising oil prices and increased production, the firm has been transformed from a capital intensive explorer, to a positive cash flow generating producer.
Currently, the shares are selling for a significant discount to peers, based upon 24 months of modest under execution.
I forecast that in 2008, production and financial targets will be met or exceeded. Recognition that current growth plans may look to be about fully funded from operations could remove concerns about further dilution, or leveraging of the balance sheet.
Arawak should carry a valuation comparable to the median smaller mid cap international developer. A return to investor favour could occur as soon as the release of 1st quarter results. This could be on or about May 14th, 2008.
Company Description
Arawak Energy produces oil in Kazakhstan and Russia. In addition the firm has a minority non operated interest in Azerbaijan, which produces a modest amount of natural gas. 2007 revenues were $202.7 million.
The Vitol Group, a major oil trading firm based in Switzerland, holds 67.3 million common shares.
Kazakhstan is where Arawak generates the bulk of revenues
Arawak produces oil from 3 fields in Kazakhstan in which it holds a 100% interest. Oil produced is medium grade crude that sells for a healthy discount to Brent. 80% of produced oil can be sold to export markets, with the remainder being sold to domestic markets.
At year end 2007, there were 72 producing wells in three fields; Akzhar, Besbolek and Karataikys. A new exploration concession, Alimbai, demonstrated productivity from 2 reworked Soviet era wells, and 1 recently drilled exploration well was also successful.
In 2007, average production from these fields averaged 5898 bpd.
Russia is Arawak's secondary source of oil production
Arawak owns a 50% interest in two producing fields, Sotchemyu-Talyu and North Irael. The remaining 50% interest is held by Lundin Petroleum. These two fields generated (net to Arawak) average production of 4282 bpd in 2007. Oil produced is a relatively low grade light crude. Roughly 45% of crude oil is exported, and the remainder sold to domestic markets.
At year end, there were 70 producing wells in Russia.
Arawak has a modest concession in Azerbaijan
The firm has an effective 29.736% interest in exploration properties and 10 productive oil and natural gas wells in Azerbaijan. This profit sharing agreement (PSA) is operated by a third party, whose controlling interest is China National Petroleum. Oil production averaged 20 bpd in 2007.
Natural gas sales were converted to oil equivalents by Arawak. For accounting purposes, this added 130 bpd. However, as Azerbaijan natural gas sells for about $1.25 per mcf ($7.5 per barrel equivalent), this represents purely a theoretical exercise.
In the past, detractors have criticized Arawak for lack of reserve growth and poorly defined reserves
At the start of 2006, proven and probable reserves in Kazakhstan and Russia stood at 40.41 million barrels. Since that time, the company has made an acquisition and invested more than $132.1 million of capital in operations.
As a result of these expenditures, Arawak has been able to increase proven and probable reserves, in the past 24 months by 5.46 million barrels. The firm had also produced 6.6 million barrels of oil.
Arawak has also booked large natural gas and associated oil reserves in Azerbaijan. However, many investors and analysts have largely ignored these reserves. This reserve base is poorly defined. Furthermore, most of this Azerbaijan reserve is natural gas, difficult to produce and sells for little more than breakeven. No development or exploration drilling is planned in Azerbaijan until late 2008 at the earliest.
Given the funding requirements, the geological complexity of the region, and the lack of proper modern seismic over much of the concession, it seems that investors are actually penalizing Arawak for continuing to hold and fund the Azerbaijan PSA. I completely exclude any valuation for Azerbaijan reserves.
Net of production, the 2006-2007 capex spending improved Kazakhstan and Russian 2P reserves by 30%
At year end 2007, proven reserves in Kazakhstan and Russia were 32.2 million barrels, up from 22.2 million in the prior year, mostly producing. Probable reserves fell to 13.6 million barrels at year end 2007, as compared to 22.1 million barrels at year end 2006.
The decline in probable reserves was entirely due to a conversion to proven, with development drilling.
My confidence level attached to the proven reserve estimate is high
Most of the proven reserves in Kazakhstan estimated by Arawak are contained in shallow, highly porous fields. They are easy to access through infill drilling, and well covered with modern seismic. In Russia, while the reserves are deeper, they are equally well defined, and the firm has proven to be capable of extracting the oil with modern reservoir management.
A significant amount of the $132.1 million in capex was for infrastructure in key fields, not drilling. Much of this development cost has been completed. Stripping out these expenses indicate that F&D costs become 1st quartile.
Overly optimistic production forecasts by management have been the other sore point
In the last 3 years, Arawak increased net oil production by 79.6%.
While this would normally be a cause for celebration, executive has continually confounded analysts on a quarter to quarter basis. Management has used such terms as "peak" oil production for any given period, or "productive capability" in conferences and press releases. These terms have been repeated over the past 2 years, to the point whereby investors have been led to believe a high water mark on any given day represents the net average production for a quarter. Consequently, production rates have failed to meet the rosy estimates in every quarter since 2006.
Annual information forms (AIF), supplied by Arawak have also proven to be erroneous.
For 2006, executive estimated that annual production would average 8,780 bpd. At year end, production averaged 7,905 bpd, a miss of 11%.
For 2007, management provided original guidance for average production of 11,024 bpd, and averaged just 10,180 bpd, a miss of 7.7%.
In fairness, more than 30 of the 54 wells drilled in 2007 were defined as exploration wells. These will always carry a lower success rate than development wells. Nevertheless, management should have taken this into account, when outlining a production estimate.
Investors now seem cautious to accept production forecasts at face value
For 2008, Arawak predicts average production 13,700 bpd. Based upon the prior two years failure to hit targets, retail and institutional investors may be penalizing this forecast by about 7.7%-11%, to be safe.
A long delayed acquisition of a small oil field interest in Kazakhstan may close in the 2nd quarter of 2008
Vitol, the majority shareholder of Arawak, had agreed sell a 40% gross interest in the Saigak producing block in Kazakhstan. The cost was originally set at 8.353 million shares of Arawak + additional shares for working capital adjustment.
At the time that the deal was announced (June 6th 2007), Saigak was reported to be producing 3500 bpd gross. At present, the gross production is 2500 bpd. This implies an annual depletion rate of 38%.
Based upon the original estimate of proven and probable reserves annual production, Saigak would add about 2 million barrels of reserves for Arawak. The acquisition cost, at the current share price, works out to be $9.8 per barrel of 2P reserves. Alternatively, based upon a 620 bpd forecast 2008 average, the cost is about $31,665 per flowing barrel.
A 20,000 bpd pipeline is planned to link the Akzhar field to a main pipeline
At an estimated $25 million capital cost, this pipeline has the potential to reduce transport costs at Akzhar by $3-$4 per barrel. If completed by mid 2009, it could save about $6.5-$8.8 million per year in costs. The excess capacity might create a further source of revenue, if utilized by neighbouring producers.
For the first time in years, it appears that management may be accurate with 2008 forecasts
Management intends to drill 52 wells in 2008, up from 46 wells the previous year. In 2007, 55% of the wells were considered exploratory, resulting in 11 dry holes.
For 2008, the emphasis will be more focused upon development drilling. Only 38% of the proposed 2008 drilling program will be for exploration. This should add greater certainty to the 2008 estimate.
Kazakhstan: average production of 9040 bpd is projected by Arawak.
2008 Akzhar production is estimated by management to be 5389 bpd. Production from 36 wells in the field was about 4700 bpd at year end, and had risen to 4725 by March 2008. Management was planning to drill a further 8 wells in the first quarter of 2008. It takes about 6-8 weeks to bring an Akzhar well on stream. A further 11 wells are planned for 2008.
Based upon the timing of the drilling, and assuming that 2007 development and exploration success rates are matched, this estimate seems entirely reasonable. The number of productive wells might increase by 35% in 2008.
2008 Besbolek production is estimated by management to be 3273 bpd. Production at year end was 3000 bpd, and averaged 3150 bpd in March. Management intends to drill 15 more wells at this field in 2008.
As the total number of wells at Besbolek might increase by 50% in 2008, production forecasts might be conservative by 200-300 bpd.
The 2008 Alimbai concession is estimated by management to produce 216 bpd. There are already 3 producing wells now reported at Alimbai, producing an average of 195 bpd in March. One of these wells was simply a reworking of an old Soviet era well and has modest production. Assuming a 70% success ratio, the proposed 3 well program + present production, suggests that 320 bpd is a more realistic target.
2008 Karataikyz production is estimated by management to be 202 bpd for March, down from 216 bpd. As no drilling is planned at this small field, I assume that normal depletion will bring this average down to about 170 bpd for 2008.
2008 exploration plans for East Zharkamys III, a major new concession, indicates that 5 exploration wells will be drilled in late 2008. No success rate has been built into this program at present.
Judging by 2007 results at Akzhar, Besbolek and recent success at Alimbai, it appears that overall production forecasts might be conservative by 300-500 bpd. Any success at East Zharkamys would be incremental to this forecast.
In aggregate, I forecast Kazakhstan production of 9340-9540 bpd over 2008. If Saigak comes on line, it will be backdated to January. This would result increase overall production to 9960 bpd-10,160 bpd.
Russia: oil production estimates for 2008 are forecast to be 4657 bpd.
Average production for 2007 was 4282 bpd. March average production was 4410 bpd. Arawak intends to try and maintain constant production at Sotchemyu-Talyu with workovers, sidetracks and infield drilling. This has held production at constant levels for the last two years. Management seems to have a good handle on this field.
4 new wells are scheduled to be drilled at North Irael. Three wells have been successfully drilled at this field to date. The average well has initially produced in excess of 300 bpd.
A 100% interest in an adjoining concession, South Sotchemyu, will have an exploration well drilled in the first half of 2008.
Given the scope of development drilling and the current level of workovers, the Russian forecast seems quite reasonable. Successful drilling at North Irael and South Sotchemyu may not result in an acceleration of development. Under the Russian system, companies can be penalized for not meeting spending requirements. They can also be penalized for overproduction. Therefore, Arawak will not likely exceed forecast volumes in this region.
2008 revenues & EBITDA may increase by 64% and 57% respectively
Assuming that their Kazakhstan production continues to sell for the 4th quarter 2007 average of $66.41 per barrel, revenue from Kazakhstan could be $219 million.
Should my own projection be met, revenue at Kazakhstan could be in the range of $226.3 million-$231.2 million.
A successful acquisition of Saigak can improve total revenues in Kazakhstan by up to 8% in 2008. This production is lighter than Arawak's present Kazakhstan output, and not subject to domestic quotas. Assuming that the 620 bpd average forecast rate sells for $75 US per barrel, this would increase total Kazakhstan sales to a range of $236-$248.2 million.
As for Russia, Arawak is budgeting for average production of 4658 bpd. Assuming that Russian oil prices remain at the 4th quarter 2007 price of $57.13 per barrel, revenue could be $97.1 million.
Total 2008 revenues could be $333.1-$345.3 million. Netbacks from production increases and Saigak premiums may be fully offset by increases in operating costs. I apply EBITDA margins modestly lower than that generated in 2008 (46%) and come up with $153.2-$158.8 million.
Due to the aformentioned miscues, Arawak shares trade at modest valuations
At the end of 2005, Arawak had an enterprise value of $471.6 million US. This enterprise value was supported by 40.41 million barrels of reserves (mostly probable) and average production of 5667 bpd. EBITDA was $29.3 million, which was completely inadequate to cover capex. The firm sold for 16X EV/EBITDA
As of today's' date, Arawak has an enterprise value of $547.2 million. This enterprise value is supported by mostly proven reserves of 45.8 million-47.8 million** barrels, trailing average production of 10,180 bpd and trailing EBITDA of $97.8 million.
In light of current oil prices, there seems to be a very clear disconnect. The enterprise value should have grown by much more than 14%, given all of the positive results generated for the past two years. Investors traditionally assign at least SOME value for production growth estimates.
In the case of Arawak, it seems that investors have largely "given up".
A comparative analysis suggests that Arawak is greatly undervalued
The median international small cap producers I use for comparative purposes include BNK, BVX, CAX, CYR, HOC, ORC.b, POE, PAR, SOR, TGL and WIN. They trade for an average of 10.5X EV/EBITDA. Many of the producers in this market cap tend to have little production to speak of, and also have poorly defined reserves. They trade upon expectations, and not production.
While metrics are not necessarily directly comparable from one producer to the next, it appears that ABG sells for, by far, the greatest discount among peers.
2008 could be the breakout year for long suffering Arawak shareholders
Management has not done shareholders any favours in the past. They now appear somewhat chastened, and will need to earn respect from the investment community.
With 11,500 + barrels of trailing 1st quarter production, forecast EBITDA in excess of forecast capex, and a production growth plan capable of increasing output by 30% for 2008, Arawak now seems a very logical investment.
The firm has grown reserves by a very satisfactory level in 2007, and has the ability to expand reserves further at Besbolek, Alimbai and North Irael. A continuation of development and exploration success comparable to 2007, may result in Russian and Kazakhstan 2P reserves surpassing 50 million barrels.
I think that Arawak energy is a strong buy for value investors at current prices
All that needs to occur, for a shift in investor sentiment, is for management to simply meet expectations. Based upon the capital budget for 2008, I consider it quite possible that Arawak will beat expectations.
Should management deliver on production forecasts, oil prices remain constant and investor sentiment swing, Arawak could be fairly valued in one year at up to 6X 2008 EV/EBITDA. This suggests a fair market value of $4.16 per share, 84% above the current market. I suspect that at least one of the major Canadian brokerage firms is considering coverage introduction.
2008 exit production rates of 15,000 bpd would certainly attract some market attention and start to lay groundwork for a 2009 market cap of $1 billion+. Reasonable exploration success at East Zharkamys III might greatly improve the mid term outlook.
The most recent investor presentation may be found by clicking here
*assumes no closing of Saigak Investments BV and production as per management estimate
**assumes closing of Saigak Investments BV and production as per my estimate.
I estimate that the trailing EV of Spindletop was $37 million at the end of 2007. The company may have generated $4.7 million of EBITDA.
SPND develops & operates 91% of its gas/oil prospects. Production is largely natural gas. Management has historically used existing cash flow & partners to develop assets.
The company generally spends less on development than is generated from operations. A solid cash balance has built up. Management controls 77% of the shares.
2006 was a transformational year
SPND held 6656 acres of highly prospective Barnett shale acreage, but lacked the necessary capital to develop the assets. 4275 acres of these lands are in Parker County, directly adjacent to production.
A potentially lucrative development agreement was finalized late in 2006. This joint venture (JV), with Williams Production Company, requires Williams to pay 100% of the drilling cost on horizontal wells. SPND maintains a 50% carried interest in each well, at no direct cost.
After 90 days of production, SPND also becomes the operator of each well. I assume that successful wells may be tied into the Spindletop owned gathering system, creating additional pipeline revenues.
The initial results from the Williams' joint venture are encouraging
In late 2006, 2 wells were drilled. They were tied in mid February/March 2007. Initial production rates (net to SPND interest) were 1100 mcf/d (550 mcf/d per well).
Through the 3rd quarter of 2007, Williams had drilled 5 more wells, of which four were considered successful. These wells were far more successful, averaging 1043 MCF per well, net to Spindletop.
Several more wells were planned in the 4th quarter of 2007, but details are not available as of today's date.
Spindletop continues to develop its primary gas field
In the past 3 years, SPND drilled 7 vertical Barnett shale wells on operated acreage in Denton Country. The Denton wells initially produced a daily average of 861 mcf per well and roughly 22 bpd of ngl/oil per well.
Production growth may have exceeded 100% in 2007
It is conceivable to envision 2007 year end natural gas production of 5500 mcf/d. Exit rate oil/ngl production could be 110 bpd.
Further carried interest drilling success may greatly enhance 2008 revenues and 2008 EBITDA
Needless to say, no cost development drilling and well operatorship carries very high profit margins. The firm does not hedge natural gas sales and is fully exposed to rising prices.
If natural gas prices remain above $8 per mcf, 2008 revenues may touch $20 million. EBITDA could exceed $10 million.
This would result in a 2008 year end EV/EBITDA ratio of 3.7X.
Spindletop could be a triple in 3 years time
Tight gas producers tend to sell for higher EBITDA multiples than do conventional gas producers.
Based upon a continuation of the Williams joint venture, an 80% development success ratio and natural gas prices of $8 per mcf; SPND could generate more than $40 million of revenue and $20 million of EBITDA by 2011.
My three year return forecast is based upon a 5X EV/EBITDA ratio, which is in line with conventional producers. This suggests a potential share price of $16.5.
Conclusion
Barnett Shale wells are generally slower to deplete than conventional natural gas wells. The benefits of the Williams JV should become evident, as more wells are brought on stream.
Due to the largely cost free nature of the Williams JV; Spindletop will be able to use internal cash flow to speed up development of its Denton County Texas field.
There are smallish, conventional production E&P firms selling for lower forecast EV/EBITDA. However, few peers are debt free, have cash in the bank and own their own pipeline. I have yet to see a development agreement as generous (for the vendor) as is the Williams JV.
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