Wednesday, June 6, 2007

Harvest Natural Resources (HNR)

HNR is an oil & gas company. Its primary asset is the right to drill and sell oil and gas from fields in Venezuela.

The big picture: HNR appears to trade at a substantial discount to its intrinsic value. Current share price compares to estimated intrinsic value of $20-$25 per share. The big risk is political risk, the risk that HNR is subject to continuing expropriation through renegotiated or broken contracts with Venezuela. Given that the original contract been broken by VZ in 2006, and renegotiated in late 2006, has enough risk been removed to justify investment?

Total reserves 3P (proved, probable and possible) are worth about $23 per share. Cash on hand, net of debt, is about $3.00 per share. Thus for $7.00 per share (excluding net cash) you get reserves worth $23 per share, if HNR starts operating again.

A great Warren Buffet quote comes to mind:

I prefer businesses domiciled in the U.S. Susie and I each have one share of a stock I bought in 1955. It looked very safe at the time. It was a marvelous stock. There’s just one problem. Its property is located in Havana and Castro seized it. We can’t get title to it. It just sits there. We’ve got huge claims against the government. And it’s never going to be worth anything. I keep it round to remind me of what can happen. The rules in other countries can change overnight.

Having been warned by the master, how do we estimate intrinsic value? Two methods to start: (1) enterprise value per barrel of oil and (2) enterprise value compared to discounted value of income from reserves (ev/PV10).

Enterprise Value Per Barrel of Oil
Currently, at a $10 share price, that's equity market value of 376mn (37.55mn shares @ 10 per share) plus 98mn of debt less 213mn of cash. 376+98-213=261mn.

Reserves net to Harvest after Petrodelta agreement takes effect are:

Proved: 45mn
Possible: 74mn

Thus, you pay $5.80 per proved barrel, or $1.74 for 3P (proved, probable and possible).Leading oil & gas companies without political risk trade around $18 per proved barrel.

Since per barrel comparisons can be tricky, because different companies have different prices for oil sales price, lifting costs, etc., we should also look at ...

Discounted Value of Reserves
HNR provides an estimate of after-royalty, but before VZ tax, income, discounted at 10%. Proved $616mn Probable 317 Possible 792

Total $1,725 Subtracting a VZ tax of 50% would leave discounted net income for reserves of:

Proved $308mn, or $8.20 per share
Probable $159mn, or $4.22 per share
Possible $792mn, or $10.55 per share
For a total of $863mn, or $22.96 per share.

Out enterprise value is $261mn, or about $7.00 per share. Thus at $7 per share, HNR trades at a 70% discount to total reserves value.

Reimbursement -- Source of Additional Value?
Once the new agreement is finalized, HNR's subsidiary Petrodelta will receive reimbursement for oil and gas sales to PDVSA, to obtain the same economic result as if the conversion had been completed on April 1, 2006. Since April 1, 2006 through March 31, 2007, HNR delivered 6.7mn barrels of oil. The estimated price for reimbursement over this period is $47 per barrel.So, 6.7 x 47 = $315mn dollars.HNR also delivered 14.8bcf of gas, priced at $1.54 per mcf, for total sales of 22.79mn dollars.

So total sales are 315+23=$338mn.The 33% royalty must be deducted, so net sales are $226mn. During this period, costs have been about $46mn, most of which has already been reimbursed. Thus, during this period, the profit before tax for Petrodelta is $226mn-$46mn, or $180mn. Taxes are 50%, so net after tax profit is $90mn. HNR has an effective 32% interest, so its share of net income for this period will be about $29mn, or $0.77 per HNR share.

In theory, the value of this income should already be included in the discounted value of the reserves, which is as of April 1, 2006. Thus, to add the value of the interim net income would I think be double-counting, relative to the discounted value of the reserves. The dividend payment will no doubt be welcome, and might be a catalyst to recognizing overall value, but this should be a secondary factor to the value of obtaining final approval of the National Assembly and Chavez.

I expect Petrodelta will dividend less than 100% of net income for this period. Petrodelta will need more cash on hand to fund (1) cost of new rigs (2) increased operating expenses as operations expand and (3) initial capitalization of Petrodelta.

Proving Additional Reserves?
The estimates of recoverable reserves could increase after HNR resumes active drilling and development of the new fields obtained in the renegotiation. HNR has had a good record in the Monagas fields. In 1992 when HNR entered Monagas, proved reserves were 18mn barrels and HNR produced 124mn barrels in the following years.

No value has been included for the China WAB-21 parcel, but that's alright because it is the subject of a terratorial dispute between China and Vietnam. Thus no value will be realized until that dispute is first finished.

Bottom Line
HNR looks like a bargain. The political risk has been reduced, but not eliminated, with the renegotiation. Petrodelta has begun to secure rigs to drill, and PDVSA has appparently agreed to reimburse Petrodelta a portion of the costs if the agreement is not approved by the National Assembly. That appears to be a meaningful signal that approval is expected. A reasonable upside case is $25. A bad downside scenario would be probably produce the cash value of $3 per share. Weighing the odds, HNR seems like a good investment, the words of the master notwithstanding.


Anonymous said...

Now that, Mr. Value Vista, was a nice post. Precise, detailed, and clear. Keep it up. I will certainly read anything you post from now on, and i rarely read anything.

Anonymous said...

Excellent information! Through and concise. I'll "hit" your sight often for any news that you can dig up. Thank you valuevista.

Kistler said...

Is a PV 10% discount assumption fair for a company like this?

valuevista said...

The 10% rate is used to provide a standard rate for all oil & gas companies. You can obviously use a higher rate, but I do not believe the choice of using 10% or 15% will be the critical factor is deciding whether HNR is attractive given the risk.

Kistler said...

Thanks. It's been a nice call for you so far. Your case was compelling until I refelcted on your last point about the discount rate. It made me realize that we are really talking about in HNR is a political gamble, which we have no way of calculating. It's an asymetric bet like betting on the super bowel. Your modelling helps to understand the potential upside but not fair value in the value sense. Too risky for me.

valuevista said...

Kistler --

I agree that the chief risk in HNR is political. As I wrote in the original post:

The big risk is political risk, the risk that HNR is subject to continuing expropriation through renegotiated or broken contracts with Venezuela.

Since the original post, I think the risk has been significantly reduced with the National Assembly vote and the comments of the oil minister about upcoming dividend payments. In fact, HNR may be a better risk/reward deal now than prior to the announcement of National Assembly action.

In any event, I think we are being paid for the political risk. I wouldn't put 100% of my net worth into such a proposition, but I'd be happy to put 10% into HNR and then 10% each into 9 other similarly structured, and uncorrelated, deals.

As a group, I think they will do well.

jason said...

Have you done a DCF valuation on HNR? I'm working on one now, but there's so many variables that are unknown.

Anonymous said...

If you take the $275M (per mgmt) that Petrodelta is supposed to be reimbursed, adjust it for taxes and HNRs 32% net interest, assume a $48.50 barrel of oil and $1.54 per thousand cubic feet of natural gas, then you're looking at an average of $8.8M of earnings per quarter, or just over $35M per year. Right?

Since, in reality, Mr. Chavez could expropriate anytime if he wanted to, it seems like the market may base HNRs valuation more on earnings power than asset value. So the $35M in earnings is probably more meaningful than the $23 PV10 of reserves. I hope the market values it more on the PV10 of reserves, b/c if HNR can come close to their historical recovery rates their PV10 is drastically understated -- as is the $35M earnings assumption.

The $35M in earnings assumption is obviously low b/c that should pick up significantly once they start drilling again and start on the 3 new fields (presumably in the 4th quarter). What do you see as normalized, post-conversion, annual earnings for HNR?