Bargain shares update

Heritage ramping up production up

Third quarter results from oil and gas independent upstream exploration and production company Heritage Oil (HOIL: 184p) were strong enough to drive what is a much overdue re-rating in the shares.

To recap, following a complex series of transactions to fund the $850m (£531m) 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 30.7 per cent working interest in the investment vehicle controlling OML 30. The balance is held by its Nigerian energy partner, Shoreline Energy. The good news is that after a blip in the second quarter, when production missed targets due to a manifold in a gas lift compression system failing and a strike by local workers, production has stabilised at 40,000 bopd, almost treble the average output in the first half. In fact, it hit a peak of 46,000 bopd in September. The latest guidance from Heritage is that the exit rate this year will be around 50,000 bopd.

The increase in production from OML 30 is being achieved by the installation of new equipment, working over existing wells and commencing production from the Uzere West field, which has been shut-in for nearly two years. That field is due to start up very shortly and should be producing around 5,000 bopd in a matter of weeks, so the overall exit rate of 50,000 bopd does look realistic to me.

The plan is to ramp up output from OML 30 to between 60,000 and 65,000 bopd next year, of which the net production to Heritage will be in the range 16,000 to 21,000 bopd. On the basis that the oil price averaged just below $111 a barrel in the third quarter, it’s fairly easy to see that the $850m acquisition could be producing well over half a billion dollars of revenues next year for the company.

In fact, subject to review post this week’s trading update, analysts at Northland Capital expect Heritage to report revenues of $512m, pre-tax profits of $302m and EPS of 67.5¢ in 2014. On that basis, the shares, at 183.5p, are trading on a little over four times next year’s earnings forecasts. Analysts are still working their way through their updated 2013 numbers, but as a ball park figure, I would anticipate adjusted pre-tax profits of $198m and EPS of 35.2¢. In other words, Heritage offers the potential to ramp up profits by over half next year.

Cash generation from OML 30 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. However, pipeline repairs should restore production from a large number of these wells. Drilling is scheduled to commence in the middle of next year.

Valuable resource

Geographically, OML is 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 which is one reason why Heritage shares are lowly rated. However, there can be no doubting the 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. On this basis, analysts estimate that OML has an economic valuation of proved plus probable reserves between $3.1bn and $3.8bn (£1.92bn to £2.36bn).

So to exploit the full potential of OML, the plan is to ramp up output to around 100,000 bopd in 2015 and close to 150,000 bopd the following year. If all goes to plan, OML could be producing 300,000 bopd by 2020, or six times this year’s exit rate.

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 purchase of the interest in OML. And it was the cash-flow generation that first attracted me to Heritage in the first place when I included the shares in my 2013 Bargain Share Portfolio. This year alone Heritage has generated cash of nearly $360m from OML, and output has barely scratched the surface.

Furthermore, Heritage is increasing its interests in the country, having just announced 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, which contains many of the largest crude oil and natural gas deposits in the country.

The rationale behind the investment is that through Petrobay, 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.

It's worth noting that Heritage also has ongoing exploration work programmes in Tanzania and Papua New Guinea as well as having interests in Pakistan, Libya and the Democratic Republic of Congo, all of which could provide decent newsflow next year.

Attractive valuation

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.

Analysts at Canaccord Genuity do too. They calculate that Heritage has an unrisked net present value (NPV) of around £1bn on all its assets, using a 12.5 per cent discount rate on future cash flows and factoring in a 2015 Brent Oil price of $102 a barrel and 2 per cent growth in the oil price thereafter. That does not seem unreasonable to me. And even if you apply a 20 per cent discount to the NPV calculation, this still implies a risked valuation of around 291p a share. Being ultra conservative and applying a huge 15 per cent discount rate to Heritage's future cash flows, the NPV still comes out at around 263p a share. So, not only are Heritage's shares lowly rated on an earnings basis, they are also trading on a huge discount to sum-of-the-parts valuations using what I consider to be conservative valuation metrics.

The technical set-up also suggests upside from here. The 14-day relative-strength index (RSI) is in neutral territory, showing a reading of 55, and the share price appears to have found strong support around the 170p level, offering the possibility that the downtrend from the October high of 197p could be coming to an end. A breach of that high would be very bullish indeed. To add substance to the case, it would appear that the moving average convergence/divergence (MACD) is on the verge of giving a buy signal.

Needless to say, with Heritage's operating cash flow forecast to ramp up sharply, and the earnings multiple set to drop rapidly, I still contend that an investment in the shares has potential to hit pay dirt. Buy.

How Simon Thompson's 2013 Bargain Shares Portfolio has performed

Finally, and in response to recent newsflow, I am currently working my way through a large number of updates on the following recommendations: Eurovestech (EVT), Bezant Resources (BZT), Amino Technologies (AMO), Eros (NYSE: EROS), PV Crystalox Solar (PVCS), Crystal Amber (CRS), API (API), Mountview Estates (MTVW), Daejan (DJAN), Bovis Homes (BVS), Town Centre Securities (TCSC), Raven Russia (RUS) and WH Ireland (WHI).

MORE FROM SIMON THOMPSON ONLINE...

Since the start of last week I have published articles on the following nine companies:

■ Macau Property opportunities ('Hot property plays', 12 Nov 2013)

■ First Property ('Hot property plays', 12 Nov 2013)

■ Inland ('Bargain shares updates', 12 Nov 2013)

■ Terrace Hill ('Bargain shares updates', 12 Nov 2013)

■ LMS Capital ('LMS worth capitalising on', 18 Nov 2013)

■ Trifast ('A bolt-on purchase', 18 Nov 2013)

■ Global Energy Development (Awaiting pay dirt, 19 Nov 2013)

■ Entertainment One ('Blue sky territory', 20 November 2013)

■ Marwyn Value Investors ('Blue sky territory', 20 November 2013)