This North Sea energy company is making waves

Of the UK-listed mid-cap energy companies, Serica Energy (SQZ) is an inexpensive option. The North Sea-focused group sits on a forward enterprise value/Ebitda ratio of less than one times. By contrast, Energean (ENOG) trades on three times and Diversified Energy (DEC) – not a particularly pricey stock by any other measure – trades on almost five times. This is partly explained by its significant debt load, which boosts the enterprise value significantly. 

Serica sits between the two companies in terms of returns to shareholders, with a dividend yield of around 12 per cent. Diversified's yield is over 20 per cent (although there is pressure to get this down) while Energean's is around 10 per cent. 

Serica's metrics look so attractive because its share price has fallen by 60 per cent from an August 2022 high of 450p. Even a cash-and-shares deal that doubled production has not been enough to bring shareholders back. The group could be due a rebound, however. 

We last put forward Serica as a buy idea in January 2022 in order to hedge against soaring household energy prices. The shares shot up in the months that followed, driven by Russia’s invasion of Ukraine, but since then the government’s windfall tax, combined with weaker energy prices, has knocked its valuation.

Serica’s relatively low enterprise value (EV)/Ebitda ratio is driven by its high cash profits and small pile of debt. Ebitdax (‘x’ being exploration costs) for 2023 is forecast at £401mn. This is a sizeable drop from 2022 due to lower oil and gas prices, but still represents a cash profit margin of 63 per cent. Broker Stifel thinks this margin will climb to 70 per cent in the current year, implying Ebitdax of £612mn. 

Peel Hunt is less optimistic about this year’s performance. It recently slashed its 2024 Ebitdax estimate from £715mn to £480mn on the back of lower gas prices (70p per therm against a previous estimate of 100p per therm) and lower production estimates – 43,900 barrels of oil equivalent per day (boepd) against an old estimate of 45,900 boepd. The upcoming departure of chief executive Mitch Flegg, who has run the company since 2017, may also be weighing on investors' minds.

Peel Hunt analysts Werner Riding and Matthew Cooper remain bullish, however. “Despite lowering our numbers, it is important to state that we believe the business remains in a very strong financial position and is funded for all planned work programmes and shareholder distributions."

Canny M&A 

We’ve covered at length how Serica ended up with significant producing assets in the North Sea. The short version is a smart 2017 deal with BP (BP.) in which just £13mn was paid up front for the Bruce, Keith and Rhum fields, collectively known as BKR. The rest of the payment came from a profit-sharing mechanism that ended just as prices sky-rocketed, pushing cash profits from £28mn in 2020 to £415mn in 2021. 

This figure jumped again in 2022, reflecting a wider sector trend. The difference with Serica, though, is that profits should hit that level again this year thanks to an acquisition completed in 2023.

The Tailwind deal was covered with shares – 100mn new shares, to be precise, taking the count to around 380mn – and £58.7mn of cash, drawn from a sizeable cash pile. The deal increased Serica's production from an average of 26,000 boepd to a forecast 40,000-45,000 for 2023. The thinking behind the deal was the same as that behind the BKR acquisition: add mature production. 

The broad idea is that mature fields that aren’t large-scale enough for the majors to take an interest in or to hold onto for the long term will still have reserves large enough to provide positive cash flow for at least a few years. 

BP brought the Bruce field into production in 1993, tying back the Keith field in 2000 and then adding the Rhum satellite field in 2005. Serica now adds new wells to the existing fields, known as infill wells, or refreshes existing wells, known as interventions, in order to boost output. Even without the Tailwind acquisition, the company has added reserves in the past five years on a net basis, while producing the equivalent of 30mn barrels of oil. 

Chief executive Mitch Flegg said last year that the company had lifted production by 300-400 per cent from a well “effectively abandoned or forgotten” by the previous owner of the Rhum field. “This is not new infrastructure, this is getting more oil and gas out of the infrastructure,” he said, adding that this meant good returns and lower cumulative emissions as little new equipment is needed. 

The company did receive two development permits under the government’s most recent North Sea licensing round, but these are for reopening a field that closed in 2020 rather than looking for new oil. 

Much of the appeal of Serica lies in its low operating costs, although these have climbed a third from $16 (£12.70) per boe in 2022 to around $20 per boe now, according to Peel Hunt forecasts. They are expected to stay around that level in the medium term, however, and margins are already ahead of peers'. Gross profit per barrel (or netback) is around $40/boe for 2023, which Stifel forecasts will rise to $49/boe this year.  

Use of cash 

The North Sea investment environment changed significantly when the government brought in its windfall tax in 2022. Harbour Energy (HBR) made the clearest u-turn by limiting its UK North Sea activity, and it has since arranged a merger with Wintershall DEA, which has significant capacity in Norway. 

For Serica, the impact has been a rise in its tax bills and a less certain borrowing environment. Flegg said last year that, had it not been for the higher tax rate, the company would have been looking more at whole-field development rather than the infill approach. The post-windfall tax, quick payback approach is working for the balance sheet, however. 

Chris Wheaton, an analyst at Stifel, sees net cash rising from £81.4mn at the end of 2023 to £449mn two years later. This is more of a rebound than a turnaround, given the use of £58.7mn in the Tailwind buyout and a cash outflow in the second half of last year (as per Wheaton’s forecast). But it does leave management with some firepower, even alongside its work to get more barrels out of existing wells. 

This is likely to mean flat production out to 2028, says Wheaton, at around 46,000 boepd. This is assuming Serica goes ahead with capital investments at the ‘pre-approval’ stage, which include more infill wells and other initiatives such as the Bruce enhanced reservoir production plan. There is also an exploration prospect called Skerryvore. 

The extra cash may well come in handy. Wheaton thinks capex will climb by 50 per cent this year to £180mn before dropping to £105mn in 2025. Peel Hunt said the 2024 plans would mean most of the company’s non-Tailwind wells were in tip-top shape: “We understand that by the end of this year’s programme up to 74 per cent of all BKR wells will have been worked over, with five potential Bruce wells remaining at [the end of 2024].” 

In its most recent annual report, covering 2022, Serica management explained why this maintenance work had such an impact on financial performance.

“The initial well (Bruce M1) was re-entered for the first time since 1998. After a successful scale removal and water shutoff, a significant reperforation and new perforation campaign was executed and the well returned to production,” the report said. “Production rates from the well increased from around 400 boepd before intervention to over 1,800 boepd in July 2022.”

Similar work at another well saw production go from 450 boepd to 2,400 boepd. 

Transition time

The oil and gas industry has enjoyed a resurgence in government support in recent years, after a long period of investors pulling away. Clearly North Sea players have not had all their wishes granted – the windfall tax still being in place is the key example of this – but forecasts around oil and gas use have been revised as global trade flows have changed. 

The pendulum could swing the other way, of course, if electric vehicle penetration picks up ahead of current forecasts, or the predicted rise in global gas demand does not play out. Serica’s portfolio offers balance between energy scenarios with 55 per cent gas and 45 per cent oil production. The reserves life is slightly less than a decade, so further deals will be needed to keep the company going. But its short- and medium-term prospects are good, and at this yield and valuation we would buy.