Oil and gas plays in Africa are no day at the beach, but they are more promising than the press would suggest, says Ashley Kelty, oil and gas equities analyst at Cenkos Securities Plc. Africa has locals with oil patch skills, abundant, accessible reservoirs and less volatile fiscal regimes than investors might think. In a wide-ranging interview with The Energy Report, Kelty riffs on shale in the U.S., basement reservoirs throughout the world and the news out of Africa. The investment opportunities are many.
The Energy Report: You have described market sentiment toward the exploration and production (E&P) sector as "bearish." What would turn that sentiment around?
Ashley Kelty: It would be better to say that, more specifically, sentiment toward oil and gas in the London market is bearish at the moment. However, I would say the opposite for the U.S. market. If you look at the indexes for U.S. independents comprising the Standard & Poor's North American Exploration and Production (E&P) Index, versus the U.K.'s Financial Times and London Stock Exchange (FTSE) Alternative Investment Market (AIM), you would see that they're diverging at a rapid rate. In Q1/14, the U.S. independent sector went up around 28%, whereas in the U.K. it fell 18%. For some investors in the London market, sentiment remains very negative and very bearish against the sector. This is not the case in the U.S., which I think is largely buoyed by success of both majors and independents in onshore unconventional (shale) plays.
To reverse negative sentiment in the U.K., it will come down to macroeconomic factors, particularly the ongoing quantitative easing across Europe and the U.S. Simply, savers are being penalized. People are looking for yield, which has driven them out of equities. It certainly has hampered the resources sector.
In the U.K., I believe what the market is looking for is consolidation through mergers and acquisitions (M&A), with a consequent recycling of capital into new and earlier-stage companies. Unfortunately, a lot of pretty poor offerings have come to market in recent years, which haven't performed particularly well. There haven't been enough success stories in the last few years to convince people that the fundamental resource plays are worthwhile. That's certainly the case for mining and oil and gas.
TER: What are your forecasts for oil prices?
AK: For my models I'm using $105/barrel ($105/bbl) flat for Brent and $100/bbl flat for West Texas Intermediate. I think, to be honest, that we're going to bounce. Certainly in Brent, I think price will move around the $100–110/bbl range for the next few years.
A lot people are talking about whether a U.S. move into export mode will have an impact on global oil prices. I don't believe it will. My feeling is that the key factor will be the levels in production within OPEC. As it stands now, the likes of Nigeria and Venezuela are not in a position to increase production. But Saudi Arabia still has the swing capacity to manage levels of production. It believes the world is comfortable with $100/bbl oil. If the U.S. were to become a major exporter, it would be more likely to impact disruptive production from the likes of Libya and other countries in North Africa. Saudi Arabia would rather choke back production to maintain those levels than have the price decrease, or see oil prices rising materially. It would prefer for oil to stay within a manageable range rather than see large levels of volatility.
TER: Africa appears to be the new frontier for oil and gas development. What do you see going on there?
AK: It has changed over recent years. Five years ago, nobody wanted to look at East Africa. It was seen as just a gassy province, with no way of monetizing it. Then a couple of years ago, everyone got very excited about East Africa and the potential for large-scale liquefied natural gas (LNG) production. But in many respects, the industry has been caught out with the sheer scale of gas reserves found there. We are seeing huge discoveries in Mozambique and Tanzania, and people are comfortable that there is enough to justify large-scale LNG developments. The issue now is the level of scalability. Key issues will be funding these developments and the logistics of building them in remote areas, with little existing infrastructure. These successes have led to most of the acreage being held by the majors, with smaller scraps remaining for the independents.
Over the last couple of years, the industry has focused its attention back on West Africa. It is looking at different plays, such as the Atlantic Transform Margin along the most westerly part of Africa, around Mauritania all the way up to Morocco, looking for the next Jubilee field, as well as investigating Brazil analogs, such as the pre-salt play in Angola, and exploring the southern edges of the Transform Margin all the way down to Namibia.
The key is that Africa is still largely unexplored. Aside from a few areas, the level of well density is still very low, relative to the likes of the Gulf of Mexico or North Sea, so there's enough for both the majors and independents to go after—and to attract investment.
Some African countries are opening up toward foreign investment and becoming more politically stable, and people are looking to invest in that. But African E&P activity is also skewed somewhat, even in established areas, by the moves of U.S. majors and independents, who have been retrenching back toward the U.S. to focus on domestic onshore production. Opportunities have opened up in Nigeria, Ghana, Angola, Egypt and other countries as U.S. companies have focused efforts on the likes of the Permian Basin and Bakken Shale, as they see huge returns there without the political risk.
TER: Why has it taken so long for African oil and gas to develop? Why is growth only now occurring?
AK: Growth actually has been occurring for years and years. When you look at the African continent, the wealth of opportunities, even in specific countries, is huge—and there are both on- and offshore opportunities. In southern Kenya, I saw a company that had a number of blocks that would be equivalent to half the Norwegian North Sea in terms of actual acreage. The scale is far more vast than any other established basin. In that sense there's been so much more to go for. Explorers have been going for the lower-hanging fruit in some of the established basins, but much in Africa is relatively unexplored.
TER: What countries or regions of Africa are the hottest prospects today?
AK: At the moment industry focus has shifted away from East Africa. Most of the perceived quality acreage in East Africa offshore has been acquired by the majors. They're busy drilling that up. The issue there is monetization of the resource, and the scale of the multi-train LNG developments that will be required. Both investors and management are concerned about funding these. They're wondering about the billions that will be required, and whether long-term LNG prices in Asia will be strong enough to justify these developments, particularly as you have Australian LNG projects coming on stream. The Fukushima earthquake and the disruption to Japanese nuclear power have helped LNG prices, as I think they will for a long time. The question is whether large companies are willing to press the button in East Africa without some guarantee those prices will hold up.
The focus is going back to West Africa. Companies are now looking at the pre-salt in Angola and at Ghana, which prospectively looks very good. You could say that about a number of countries. The ongoing unrest in northern Africa—Egypt, Libya, Algeria—has made people somewhat jittery about going for more conventional plays there.
TER: Where do you expect to see growth in Africa five years or more from now?
AK: Growth will come from the development of LNG. Once LNG facilities are built, I think a number of companies would look to monetize their discoveries and resources, which at the moment are arguably stranded. The majors would encourage that development, as it would lower the marginal cost for them.
I think there will also be a movement toward greater onshore exploration and development in Africa, which has been seen as difficult largely due to political stability issues. Now, both E&P companies and investors are more comfortable with looking at onshore exploration as domestic infrastructure and end markets are improving. Plus the fact that vast, underexplored basins could offer better returns, particularly as offshore acreage and the low-lying fruit is disappearing.
TER: The news out of Africa is full of war and insurrection, terrorism, corruption and repressive government. But the continent is also home to some of the fastest growing economies in the world. What's the investment climate there really like?
AK: It's still hard, to be honest. You really have to know where you are operating. But given the supernormal returns oil and gas can offer—particularly given that export of oil/gas can be to a global market—the market is not particularly sensitive to whether you get your gas from Ghana or Egypt or Mauritania. It's more about quality, and whether you can deliver the product. Because you're selling into a global market, and also because petroleum revenue is one of the main sources of foreign income for these countries, oil and gas investment is seen as comparatively stable. Countries don't want to discourage investment from these huge companies.
Companies are also finding that there are locals who actually have the needed skill sets. Given the wider industry problem of a lack of experienced personnel, I think companies are seeing Africa as a great opportunity to train up locals for the future. It also satisfies local content laws, and the investment in that is worthwhile.
Issues of corruption and unrest have certainly hampered onshore development in Africa. I think companies have felt the onshore security risks are too high, whereas offshore it is less of an issue, since local insurgents don't have boats that can take them 30–40 miles out to sea. Plus, governments are very protective of offshore developments. I think insurgents recognize that even if they do initiate a coup, they will need investment from oil and gas companies to generate the revenue that they require. In that sense, I think oil and gas is one of the more attractive sectors to be in, because locals identify it as a primary revenue driver.
It's because of the overall investment and security of supply that African countries, particularly countries such as Mozambique, Tanzania and Kenya, support the oil and gas industries. I think they've recognized that the service sector is a need they can fill pretty quickly. The service sector does not need as much expertise as the upstream element, and there's a far greater opportunity for local content. Recognition of these industries as being primary revenue sources for African nations has made the investment climate easier.
There's also been far less volatility in the fiscal regimes in Africa. In fact, there have been more changes in the fiscal regime in the North Sea in the last 10 years than in most African countries. People still commonly believe that Africa is always chopping and changing. Those nations have now recognized that it doesn't help to keep changing things for the sake of an extra few percent, which in the short term looks good, but in the long term does not.
The investment climate in Africa is particularly attractive for E&P. I think services companies are now seeing an opportunity to grow their businesses on the continent, and are looking at Africa as a place to which they can export their technologies, so they will have the early-mover advantage. If you look at the U.S. onshore, you've got the likes of Schlumberger Ltd. (SLB) , Halliburton Co. (HAL) and so on, all with large positions. But across Africa, Schlumberger will not have the same position. In some countries in Africa, that would allow Halliburton to gain a greater position. I think companies see greater opportunities to build positions in a relatively low-competition market.
TER: The Chinese seem to have been doing their best to lock up Africa's oil and gas resources and make it their own oil patch. How are the companies you cover meeting that competitive challenge?
AK: Perhaps three years ago, the Chinese were very aggressive. The Chinese economy was growing fast, and some of the U.S. majors and independents were retrenching back home. Their exit strategy was largely to sell to the Chinese. The Chinese were acquiring development and production; they weren't generally acquiring exploration acreage. They were also targeting countries that were generally seen by the western powers as being very difficult—politically corrupt, dangerous, unstable—which the Chinese seem to be far more comfortable dealing with as opposed to the western nations. They've managed to build a big position in Africa.
In terms of opportunity, smaller companies and independents—the likes of Ophir Energy Plc (OPHR:LSE) and Tullow Oil Plc (TLW:LSE)—are still exploring, which is something the Chinese haven't been actively doing. After the initial land grab, the level of activity has not been sustained.
In addition, in the last couple of years the level of Chinese M&A has dramatically fallen off. For example, a U.K.-listed company in Chad, Caracal Energy Inc. (CRCL:LSE), is being bought by Glencore International Plc (GLEN:LSE), a large commodity business—not by the Chinese, who were seen by the market as the most likely takeout partner, given the fact that the Chinese had the acreage adjacent to Caracal's.
I also get the feeling, having been on the ground, that the way the Chinese operate does not always sit easily with some African governments. The Chinese do not, on an anecdotal basis, appear to be very keen on local content, and are far less willing to negotiate and work with local governments than some of the Western powers. But that's anecdotal and hearsay.
TER: Can you give us more detail on the companies you cover that are operating in Africa—their prospects for M&A, their prospects for further growth? What are their recent successes?
AK: Ophir Energy focuses largely offshore. It's had some great success in East Africa, partnering with the likes of BG Group Plc ($BRGYY) (BG:LSE) and Statoil ASA (STO; STL:OSE). However, it was taking large working interests and looking to farm down. It stated it was planning on farming out some of its acreage, which has not happened to the extent anticipated. That has upset the market somewhat.
However, today Ophir's interest seems to be more on proving up its positions in both Tanzania and Equatorial Guinea. It's focused on offshore. The company has made bids for other companies that didn't come off. It looked to a deal with Premier Oil Plc (PMO:LSE), but the Premier board rejected that. It was particularly disappointing given that Premier is an established developer and producer, but has a poor record with the drill bit, and generally has only managed to grow its business through acquisition, rather than through organic exploration success.
Tullow has long been a darling of the stock market. It's a very good company, and has expanded into many jurisdictions in Africa that other companies wouldn't touch—and has been very successful doing so. It had a fantastic run of exploration success a number of years ago—15 or 20 successful wells in a row. However, in the last couple of years the company has had a comparatively poor success rate. It's had a few dry holes.
The problem for Tullow is that the market expected continued success. If you look at Tullow on a five-year basis, it has above-average, or above-sector-average, success rates. It also had tax issues in Uganda, which caused a few problems. However, fundamentally, Tullow has among the best understandings of Africa in terms of personnel and culture. Tullow is certainly the go-to guy for operations in Africa.
TER: Many jurisdictions in Africa come with high risks, and high risks can earn high rewards. But some companies you cover operate in politically safer jurisdictions. Is their profit potential less for taking the safer path?
AK: No, not at all. Their profit potential is still fantastic. I think oil and gas can (and does) offer supernormal returns. The issue comes down to an investor base not willing to go for high-risk/high-reward. I think the only reason people are investing in Iraq is because the volumes are so huge as to make a difference. In terms of the actual revenue the company gets relative to the government tax take, it is minuscule.
Operating in a stable environment, such as in the North Sea or onshore U.S., is very attractive. A large amount of the market will follow that. You're looking for profit, and these companies will grow, but the main driver is that you're not looking for discoveries to be transformational. Those companies make accretive discoveries or accretive transactions, but don't need to be transformational to get the market excited. There is certainly an appetite for more traditional, stable environments and production, rather than for huge, elephant-hunting exploration in Africa. Also, for companies operating outside Africa, such as in the U.K. and U.S., it's easier to attract capital. They have an advantage in that they are able to secure comparatively low-cost financing to develop their asset bases, which companies in Africa would not be able to do.
TER: What companies do you cover that operate outside of Africa?
AK: Caza Oil & Gas Inc. ($CAZ:CA; CAZA:LSE), Empyrean Energy Plc (EME:LSE), Hurricane Energy Plc (HUR:LSE)) and Ithaca Energy Inc. ($IAE:CA). Caza and Empyrean are both onshore U.S. Caza is focused on the Bone Spring play in New Mexico, and Empyrean on the Eagle Ford Shale in Texas. Ithaca is a lower-risk developer and producer in the North Sea, and not focusing on exploration. In fact, all these companies are more development and production stories, rather than pure explorers.
Caza is a small-cap E&P. It's been around for a few years. The company recently targeted transformational big gas discoveries along the Gulf Coast in Texas and Louisiana. It had a couple of disappointing exploration wells. Then it reevaluated its strategy and decided to go for organic growth. It's now concentrating on the Bone Spring play in New Mexico, which has multiple stacked intervals and is one of the more exciting unconventional plays onshore U.S. Caza has had 17 successful wells in a row. It has managed to triple production just over the last year.
Caza is still a comparatively small company, with a market cap around £42 million (£42M), but it has grown rapidly. It also has a lot of upside, particularly given that most of the well locations have between four and six stacked productive intervals, with one or, at best, two producing at the moment. No one else on the London market is active in the Bone Spring.
Empyrean has a small, non-operated interest in the Eagle Ford. However, the partner is Marathon Oil Corp. (MRO) . Marathon is committing over $2 billion ($2B) in capex in the Eagle Ford this year alone. It was looking to almost double the well count, to over 200 wells on Empyrean's acreage. Production has been growing rapidly. In the last couple of weeks, Empyrean has effectively put itself up for sale, recognizing the value of its interest in this Marathon-operated field. Empyrean seems to be in the sweet spot of the Eagle Ford, getting a little bit of oil, plenty of condensate and a little bit of dry gas. It's receiving great netbacks. Also, the level of activity that Marathon has planned should be transformational this year. That's got a lot of people interested.
Ithaca is focused on development and production, and has grown massively in the last couple of years. It has a large development called Stella that should come on stream the middle of next year. Stella will more than double the company's production and will lift output from around 15 thousand barrels a day (15 Mbbl/d) to over 30 Mbbl/d. That will move Ithaca up to the next tier in terms of production companies in the U.K.
Given that the company is not concentrating on exploration, the level of cash flow it will generate will be significant. The company is thinking about returning cash to shareholders once Stella is on stream. Now that it's moving into a phase where it may pay a dividend, as well as offer capital growth from its development activities, Ithaca has strongly piqued the attention of investors.
Hurricane is particularly interesting in that it's targeting the basement reservoirs in the West of Shetland Basin. It has two discoveries, each of which is more than 200 million barrels (200 MMbbl) in size, which is particularly significant given that the average size of discoveries in the U.K. over the last four years has only been 25 MMbbl. Hurricane's discoveries are sufficiently big to attract the majors.
The basement play has been largely ignored in the U.K. It is potentially a game changer for companies, particularly West of Shetland. BP's massive Clair Ridge development, sits at the other end of the Rona ridge from where Hurricane is active. BP is looking at the third phase of the Clair development and says the field could have 8 Bbbl of oil in place. Given that BP has produced oil from basement with earlier Clair well tests, the potential offered by productive basement reservoirs could add a significant amount to that. In fact, BP has invested in Hurricane. The U.K. government is very keen to see the basement reservoirs developed, and is making noises about offering tax losses for the basement play, which could certainly improve the economics.
TER: How are basement reservoirs different from shale or other unconventional reservoirs?
AK: The main difference is that a reservoir is essentially an impermeable rock, such as granite, so the oil is not actually held within the rock, but within the fractures. The key to developing basement reservoirs is being able to intersect the fractures within the reservoir.
Hurricane's chief executive, Robert Trice, is arguably a world expert on fractured reservoirs. Prior to setting up Hurricane, he was Royal Dutch Shell Plc's ($RDS.A) (RDS.B) in-house roving expert for fractured reservoirs. Hurricane has identified and built a very extensive model that understands these fracture networks. It recently drilled an appraisal well on its Lancaster discovery West of Shetland to assess the commerciality of its discovery. The initial well produced about 2.5 Mbbl/d from a well that had intersected one to two fracture zones. This time, the company drilled a well with a 1-kilometer horizontal section that intersected nine fracture zones, to see whether this would flow at commercial rates, deemed to be 4 Mbbl/d—and it flowed under natural pressure over 5.3 Mbbl/d. When the company used artificial lift, the well flowed at a capacity-constrained 9.8 Mbbl/d, which was far in excess of the 4 Mbbl/d needed.
TER: The well maintained that level over time?
AK: Yes. Hurricane tested the well over a three-week period; the result was fantastic. A lot of people in the industry were interested. I think the opportunity for the company to attract a farm-in partner is going to be tremendous.
Hurricane is very close to infrastructure too. It also has several potential options for early production—one is via tie-back to a nearby field called Solan, which is operated by Premier Oil. This could deliver production, by 2016, of about 4 Mbbl/d, which would help fund the wider Lancaster development. Other options include the use of a VPU (versatile production unit).
The scale of Hurricane's resource is such that the majors should be interested because of the impact on their reserve replacements. Hurricane's two discoveries are 440–470 MMbbl, depending on whether one of them is purely oil or a mix of oil and condensate, but there's certainly plenty that the company could give up to attract the interest of the majors. At 25 MMbbl, majors aren't interested; at 100–200 MMbbl, they're very interested.
This development doesn't actually require unconventional technology. It doesn't require fracking. It's not high pressure. The only thing different is that it's a different kind of reservoir. Basement reservoirs are very prolific in Vietnam and can be found in Egypt, Yemen and Venezuela. In fact, there are fields onshore U.S. that have been producing since the 1960s from basement, but it's certainly not a play that has been actively targeted.
TER: Ashley, thank you for your time.Oil and gas equities analyst Ashley Kelty has more than 14 years experience in the oil and gas sector. Kelty joined Cenkos Securities Plc from the Lloyds Banking Group (formerly Bank of Scotland) oil and gas team, where he was responsible for the management of a portfolio of debt clients. He both led and assisted in raising debt for numerous oil and gas companies, including Dana Petroleum, Faroe Petroleum, Serica Energy, Valiant Petroleum and PA Resources. He has also worked for Enterprise Oil and Andersen Consulting (now Accenture).
Source: Tom Armistead of The Energy Report
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