The substantial re-rating is partly down to a very positive fourth quarter trading update, but also reflects a significant valuation uplift due to a change in tax status on its Nigerian operations. And despite the re-rating, there is every reason to believe there could be further share price upside to come as more investors become aware of the value in the company.
A valuable resource
To recap, following a complex series of transactions to fund the $850m (£515m) acquisition of OML 30, one of the largest of Shell's onshore Nigerian assets sold in the past couple of years, Heritage Oil ended up with a 30 per cent economic interest and a 30.7 per cent working interest in the investment vehicle controlling OML 30. The balance is held by its Nigerian energy partner, Shoreline Energy.
OML is a vast resource, located onshore in the Delta, less than 50 kilometres east of Warri in Southern Nigeria. True, Nigeria is hardly the most stable country in the world and any investment in the region needs to carry a risk warning. That is one reason why Heritage shares are lowly rated. But there can be no doubt there is potential to generate substantial returns from OML, one of the largest onshore licences in the country, with eight producing fields and associated infrastructure; gross proved and probable reserves of 1,114bn barrels of oil. Analysts calculate that OML has an economic valuation of proved plus probable reserves between $3.1bn and $3.8bn (£1.9bn to £2.3bn).
In order to exploit the full potential of OML, Heritage’s plan is to ramp up output to around 100,000 bopd next year and close to 150,000 bopd in 2016. If all goes to plan, OML could be producing 300,000 bopd by 2020, or six times this year’s exit rate.
The good news is that OML is now making major headway towards these medium-term targets. After a blip in the second quarter last year, when production missed targets due to a manifold in a gas lift compression system failing and a strike by local workers, output recovered strongly and ended the year higher than 50,000 bopd. The net daily production attributable to Heritage averaged 13,300 bopd in the fourth quarter, up from around 8,150 bopd in the first nine months of 2013, which meant the resource delivered total revenues of $465m net to Heritage, including $170m from four liftings in the final quarter.
Moreover, in a trading update at the end of last month, Heritage confirmed that production in the first two months of the current financial year has averaged a net 15,600 bopd to the company, around 17 per cent higher than in the final quarter of last year. There have been three further liftings in the past couple of months and it is expected these will now occur on a monthly basis.
The increase in production has been achieved by the installation of new equipment, working over existing wells and commencing production from the Uzere West field, which had been shut-in for nearly two years. The plan is to ramp up output to around 60,000 bopd in 2014, of which the net production to Heritage will be in the range of 16,000 to 21,000 bopd. If achieved, analysts at investment bank Citi expect OML to produce $529m of revenues this year, pre-tax profits of $349m and EPS of 129.6c. On that basis, the shares are trading on a miserly 3.3 times earnings forecasts of around 79p and that’s after the share price surge since the turn of the year.
The respective forecasts for the 2013 financial year are revenues of $464m, pre-tax profits of $237m and EPS of 78.6c. In other words, if all goes to plan then Heritage Oil is expected to increase net earnings by around two thirds this year alone.
Bumper cashflow generation
Cash generation from OML should be substantial too since the plan is to restore around 60 wells back to production with a focus on horizontal drilling. OML currently has over 200 wells, but only half are in production, mainly because many were vandalised in the period from 2006 to 2009. But pipeline repairs should restore production from a large number of these wells. Drilling is scheduled to commence in the middle of this year.
In turn, this sharp increase in output will generate the bumper cash flow needed to pay down the $500m (£322m) of net borrowings Heritage took on to fund the acquisition of its interest in OML. And this is exactly what is happening as unrestricted cash on Heritage's balance sheet rose from $113m to $190m in the final quarter of last year.
It was the cashflow generation that first attracted me to Heritage when I included the shares in my 2013 Bargain share portfolio when the price was around 200p. To give you some idea of the scale of the potential cashflow generation, analysts at Citi predict that Heritage generated 128c of cashflow per share in 2013, or the equivalent of 77p. The forecast is for a ramp up in cashflow to 146c a share (88p) in 2014, rising to 193c (117p) in 2015. Or put it another way, Heritage is expected to produce total cashflow per share of over 200p this year and next, or the equivalent of three quarters of its share price.
Clearly, tax is an issue, or it was until Heritage announced last week that OML has received ‘Pioneer tax status’ with the Nigerian government for a five year-period. In practise what this means is that Heritage has a five-year tax holiday from the marginal petroleum tax rate of 65.75 per cent on these activities. The net impact of this is a material enhancement in the value of the assets.
Factoring in the tax change, Citi’s core net asset value per share has risen from 165p to 315p. Analysts at the bank also upgraded their earnings estimates significantly. For instance, Citi’s new EPS forecasts of 129c for 2014, and 168c for 2015, represent 200 per cent upgrades on previous estimates. That’s because Heritage is retaining all of the net income from its production share from OML, rather than only a third if the company had to pay the 65.75 per cent petroleum tax on these earnings. As a result, and even after the share price re-rating this year, Heritage shares are still only trading on 2.6 times 2015 EPS estimates of around 100p.
Anomalous valuation
That valuation looks anomalous to me considering that Heritage is expected to more than double EPS this year and next. Citi’s forecasts for 2015 assume revenues of $691m, a near 50 per cent increase on that reported in 2013, and pre-tax profits of $453m, or double the $211m forecast for last year. In other words, with no tax to pay, and fixed costs covered, then net income will rise at a much faster rate than revenues as output ramps up, all of which goes to Heritage. And this is why Citi have almost doubled their core net asset value estimate. Another consequence of this tax change is that the bumper cashflow generated will pay down Heritage’s borrowings far quicker than previously expected. In turn, this opens up the possibility of the company being able to make cash returns to shareholders at a far earlier date than anticipated before.
The upside for the Nigerian government is that there is every incentive for Heritage to ramp up output as quickly as possible in order to benefit from the tax free status of its earnings. As a result, when the five year period ends, the tax take for Nigeria will be significantly higher than it would have been previously. It’s a win-win situation for all parties.
It’s also worth flagging up that Heritage has been increasing its interests in the country, having entered into a joint venture agreement with Bayelsa Oil Company, owned by the Bayelsa State government, to establish an indigenous Nigerian oil company called Petrobay Energy. Petrobay will look to acquire production, development and exploration assets from international oil companies and Heritage has taken a 45 per cent equity interest in the venture. The state of Bayelsa is in Southern Nigeria, the core of the Niger Delta, and contains many of the largest crude oil and natural gas deposits in the country.
The rationale behind this investment is that Heritage will gain access to additional producing fields and other licence opportunities in Nigeria, both onshore and in shallow water. A number of upstream assets in the state of Bayelsa and the larger Niger Delta region have already been identified and Petrobay will engage in competitive auctions to acquire these licences.
Target price
Even factoring in the geopolitical risk, and applying a hefty discount to the earnings and cash flow forecasts given the potential for the ramp up in output not to go according to plan, I still find Heritage an attractive investment.
The technical set-up also suggests further medium-term upside from this point. Assuming the share price can hurdle a resistance level around 266p, dating back to 2011, the shares are unlikely to hit any further resistance until a band between 288p and 300p. Beyond that the 2011 high just shy of 500p is the next target. That may seem a long way off, but a target that high is supported by Citi’s base net asset value estimate of 585p which discounts the 2P reserve production profile and assumes a plateau of 300,000 bopd in 2020.
True, the 14-day relative-strength index (RSI) is showing a reading of 80, so is now overbought. But this can unwind itself quite easily without much damage to the share price. Moreover, with a long-term chart base formation in place, and a break above last February’s highs of 225p signalling a major chart break-out, then Heritage shares are worth accumulating on any price weakness. I am equally happy re-iterating my positive stance at the current price level ahead of full-year results due out at the end of April.
Needless to say, I continue to rate Heritage shares a buy on a bid offer spread of 265p to 266p. My three month target price is 300p, or 13 per cent above the current level.
