AFRICA OIL CORP AOI.
May 13, 2018 - 6:18pm EST by
Alejo Velez
2018 2019
Price: 1.27 EPS N/A 0
Shares Out. (in M): 470 P/E N/A 0
Market Cap (in $M): 466 P/FCF N/A 0
Net Debt (in $M): 0 EBIT 0 0
TEV ($): 9 TEV/EBIT 0 0

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Description

Africa Oil Corp (AOI CN)

Summary:

Africa Oil Corp (AOI CN) is a Canadian E&P with assets in Kenya and Ethiopia. The company holds a 25% interest in the South Lokichar basin of Kenya, where Tullow Oil is the operator. The company also holds equity interests in three E&P companies which themselves hold oil and gas assets at different stages of development: Africa Energy (34.63% interest), Eco oil and gas (18.9% interest), Impact Oil & Gas (25% interest) Africa Oil shares trade on the TSX and Nasdaq Stockholm and both Africa Energy and Eco Oil and Gas are publicly listed companies.

There are 470.1 million shares outstanding, 9.5 million options, 3.9 million PSUs and 2.5 million RSUs for a total of 486.4 million fully diluted shares. At the current share price of C$1.27, market cap is $466 million. As of March 2018, the company had $378.9 million in cash and $408.7 million of working capital (classified as Intangible Exploration assets in the balance sheet). There are $27 million of accounts payable offset by $56 million of receivables but no long-term debt in the balance sheet. The current enterprise value is $9 million.

I believe Africa Oil presents an attractive asymmetric payoff profile for investors today. Downside is limited by cash and receivables in the balance sheet and the three equity stakes (95% of today’s market cap). Upside is provided by the working interest in South Lokichar, nearing final investment decision and with first oil expected in 2022. The pre-development resources in South Lokichar, discounted at 15% and assuming a long-term oil price of $60/bbl are worth C$0.56/share. In my base case, there’s at least 39% upside to the current share price.

Additional upside should come from any significant event happening at any of the investees, all of which have attractive assets at different stages of development which have become attractive in their own right given their characteristics but more importantly, given the lack of exploration and development activity the world has suffered outside of North America over the past four years, particularly offshore.

Major risks come from oil prices, which could postpone Africa Oil’s main project FID and prevent Tullow, the operator, from finding the required resources to proceed. Lower oil prices would also impact the investees ability to monetize or continue the development of their current pipeline.

Capital allocation by management is another risk. The Lundin Group were until 2010 a major shareholder with more than 20% of the shares. They have since been diluted and their position no longer requires disclosure. Their stake is likely between 4.5%-5.2% today. In principle, this should prevent them from influencing management decisions, however, Keith Hill, Africa Oil CEO, sits at several other Lundin Group company boards and has been involved with the family for over 20 years. The Lundin Group is a major shareholder in Africa Energy and now has a seat at the board in Eco and Impact, thanks to Africa Oil’s stakes. Insiders in each of the company have meaningful shareholdings which should help align their interest with minority shareholders, however, I think it is highly unlikely for Africa Oil to ever distribute the cash it holds in the balance sheet even if South Lokichar was never sanctioned. Effectively, their recent strategy of investing in a “portfolio” of E&Ps shows that they would rather attempt other ways of “creating value” than liquidating the company. In the current oil environment, this could work in investors favour, but there could be a scenario where it does not. I feel comfortably partnering with the Lundin Group, and more so in the oil environment mentioned, but I don’t expect Africa Oil or any of the other investees to be paradigms of corporate governance, so investors most feel comfortable with that.

 

Timeline:

-    March 1993: Africa Oil was incorporated under the name “Canmex Minerals Corporation”

-  July 1999: issued and outstanding common shares (100,000,000) were consolidated on a one-for-five basis and authorized capital was increased, post-consolidation to 100,000,000 common shares.

-    August 2007: Company changed its name to “Africa Oil Corp”

-   2007-2010: AOC assembled a highly prospective portfolio of exploration assets in Kenya, Ethiopia and Somalia.

-   June 2009: Shareholders of AOC approved a resolution to increase the share capital of the company to an unlimited number of common shares.

-   September 2010: AOC and Tullow entered into the Tullow Farmout Agreement, which assigned a 50% interest and operatorship of Blocks 10A, 10BB and South Omo (Now relinquished) to Tullow and granted Tullow an option to acquire a 50% interest in Blocks 12A and 13T. AOC received $9.5 million from Tullow. Tullow exercised these options in September 2010 paying $1.55 million to AOC.

-   June 2013: shareholders approved a resolution authorizing an alteration of the Company’s articles to include advance notice provisions for the nomination of directors.

-    February 2015: AOC completed a private placement, issuing 57,020,270 common shares at a price of SEK 18.5 (C$ 2.74) per common share. Net proceeds were $120.5 million.

-   May 2015: AOC completed a private placement with Stampede Natural Resources, issuing 52,623,377 common shares at a price of C$2.31, for gross proceeds of $100 million.

-   August 2015: AOC completed a (gross) $50 million private placement by issuing 31,169,048 common shares at a price of C$2.1

-   November 2015: AOC entered into a definitive farmout agreement with Maersk. Maersk agreed to acquire 50% of AOCs interests in Blocks 10BB, 13T and 10BA in Kenya and the Rift Basin and South Omo blocks in Ethiopia in consideration for reimbursement of a portion of AOC past costs and a future carry on certain exploration and development costs.Maersk paid AOC $350 million as reimbursement of past costs incurred by AOC prior to the agreed March 31, 2015 effective date. Maersk also reimbursed AOC for its acquired working interest share of costs incurred between the effective date and the closing date. As of the effective date, Maersk would carry up to $75 million of AOCs share of development expenditures upon confirmation of resources and $15 million of AOCs share of exploration expenditures. Additionally, upon FID, Maersk would also carry up to $405 million of AOCs working interest share of development expenditures for the Lokichar Development Project, with the total carry amount being contingent upon the project meeting certain resource growth thresholds and the timing of first oil. This agreement was closed early in 2016, when they received $439.4 million from Maersk ($350 million consideration plus $89.4 million for Maersk’s share of costs incurred between the effective date and closing, including $15 million of carry related to exploration expenditures). During November 2015, Oil prices averaged $46.1/bbl (Brent)

-  July 2016: the Government of Kenya agreed to a three-year extension to the Second Additional Exploration Period in Blocks 10BB and 13T (South Lokichar) expiring on 18th September 2020.

-   May 2017: AOC and Maersk agreed payment terms related to the $75 million advance development carry. AOC will receive equal quarterly payments of $18.75 million at the end of each calendar quarter during 2018.

-    November 2017: AOC acquired 19.77% of Eco (Atlantic) Oil and Gas for total consideration of C$14 million ($10.9 million) Keith Hill, AOC’s President & CEO joined the Eco board of directors in December 2017. The agreement between the two companies entitles AOC to bid jointly on any new assets or ventures proposed to be acquired by Eco on the same terms as Eco and for an interest at least equal to AOCs percentage holding of the common shares in Eco. AOC also has a right of first offer on the farmout of exploration properties currently held by Eco.

-   October 2017: the Joint Venture Partners and the Government of Kenya signed a JDA to progress the development of the export pipeline, which allows FEED studies and environmental and social impact assessments to commence, as well as studies on pipeline financing and ownership.

-    February 2018: AOC purchased 59,681,539 ordinary shares and 29,840,769 share purchase warrants of Impact Oil and Gas Ltd, a private UK company, for approximately $15 million. Additionally, AOC entered into a share purchase agreement with Helios Natural Resources to acquire 70,118,381 shares and 15,529,731 warrants currently held by Helios in the capital of Impact. The investments gave AOC a 25.2% equity interest in Impact.

-   May 2018: AOC subscribed 144,956,250 common shares of Africa Energy Corp at a price of C$0.16, increasing their equity interest from 28.54% to 34.63%. Total consideration was $18 million.

Since changing its name to Africa Oil in 2007 to-date, the company has raised over $1bn in equity.

 

South Lokichar:

As of December 2017, the company had interests in:

Source: Africa Oil 2017 Annual Report

The South Lokichar basin is the main asset and consists of Blocks 10BB and 13T. In its most recent annual results conference call, Tullow Oil, the operator, has guided towards an FID of the project in 2019 with the aim of achieving first oil in 2021 or 2022 and 100kbpd of plateau production. The initial stage of development of the field includes plans for the construction of an oil export pipeline to Lamu, 850km from the Lokichar basin, on the east coast of Kenya. Without the pipeline, the basin is landlocked and the only other transportation mean would be by truck, making the project uneconomical.

In their latest corporate presentation, Tullow estimates South Lokichar may hold up to 4 billion barrels of oil in place, of which 560 million are classified as 2C resources with upside potential of an additional 670 million barrels, for total discovered resources of 1.2 billion barrels.

Source: 2018-05 (Tullow Oil) Overview presentation

The development plan for the basin includes a Foundation Stage targeting 210MMboe with initial production of 60-80kbpd. The Foundation Stage CAPEX requirements add up to $2.9bn, of which $1.8bn corresponds to Upstream development of the Ngamia and Amosing fields and $1.1bn to the Pipeline.

Source: 2018-04 (Africa Oil) AGM presentation

AOC incurred $59.3 million in exploration costs in Kenya and $1.4 million in Ethiopia during 2017 offset by a $75 million advance development carry settlement from Maersk (see timeline below). Operating cash burn was reduced to $0.9 million in 2017 from $4.4 million in 2016.

According to management, South Lokichar’s estimated breakeven is $27/bbl Brent. The main issue with the project is the Kenya’s lack of big oil project developments and the missing infrastructure, which has to be developed from scratch and faces the typical bottlenecks: political vagaries, social factors, financing and terms. This was considered frontier exploration back in 2012, when the basin was first discovered.

The Kenyan government holds a buy-in option of 22.5% on the block 13T and 20% on block 10BB, which can be exercised within six months from the date a development plan is sanctioned. The PSCs for both blocks are in place for 25 years once a development plan is adopted.

Even today, Africa Oil has the best balance sheet of all the partners in the field. Tullow has recently raised capital in order to reduce leverage and Maersk sold its energy business to Total in a transaction announced in August 2017. Management believes it should be easier to finance the construction of the pipeline than the upstream infrastructure, and mentioned that both GE and Schlumberger were offering attractive terms for some of the required upstream assets needed.

Low-case production of the field is 80kbpd in phase 1 of the project, which, assuming a 2019 FID, would come around 2022. The base case production scenario calls for 120kbpd in phase 2 of the project, with an optimistic case of 150kbpd.

Operating costs in the field are estimated by the company at $5/bbl excluding pipeline. Tariff costs would be between $11-13/bbl, however, the PSCs allow a portion of these OPEX costs to be recovered once in production.  

An Early Oil Production Scheme (EOPS) is due to commence in the first half of 2018. Estimates of daily production for this plan are 2,000 bpd.

AOC management has mentioned that they expect to be left with $100-200 million in cash post first-oil, thanks to the Maersk carry and the possibility of financing part (potentially 40%) of the upstream development work.

All in all, while there’s a probability the project does not go ahead, I think there are several indications that it eventually may, and perhaps faster than the market seems to be expecting.  

-    Maersk farm-in back in 2015 valued blocks 13T and 10BB at approx. $3.4bn at a time when oil prices were below $50/bbl.

-   Total’s press release announcing the acquisition of Maersk Oil highlighted how the deal complemented “Total’s leading East Africa position via Maersk Oil’s Kenya assets” (https://www.total.com/en/media/news/press-releases/total-acquires-maersk-oil-for-7-45-billion-dollars-in-share-and-debt-transaction)

-    Total and Tullow’s expertise in African project completions could help facilitate the necessary conditions for the project to move forward. In fact, upon Total’s acquisition of Maersk Oil, Manoah Esipisu, State House Spokeperson of the Kenyan government, said: “Kenya is optimistic that the entry of Total into the Kenya Joint Venture will strengthen the financial resources and technical competence to the Joint Venture and this will go a long way in accelerating the development of the resources in these Blocks” (https://www.standardmedia.co.ke/business/article/2001266996/total-to-buy-shares-in-turkana-oil-blocks)

-    In late November 2017, it was reported that the National Oil Corporation of Kenya plans to raise $1bn by listing its shares in the Nairobi Stock Exchange and the London Stock Exchange by early 2019, in order to raise money to exercise their buy-in rights in blocks 13T and 10BB. (https://uk.reuters.com/article/uk-kenya-oil/kenya-plans-1-billion-dual-listing-of-national-oil-corp-by-early-2019-idUKKBN1DT20Y)

-    In late April 2018, it was reported that Wood Group had been awarded the FEED work for the Turkana (Lokichar) – Lamu pipeline that will be used to export the oil once commercial production starts by 2022 (https://www.standardmedia.co.ke/business/article/2001278220/uk-firm-to-design-crude-oil-pipeline)

-  Tullow’s (operator) comments in its most recent FY17 conference call: “The overall development plan, as you're aware, is the export pipeline to Lamu. We've proposed to the government – the drivers here – the governments are very keen to move forward with this development. They're very keen to get to FID, why? Because they want to get First Oil and they want to move this project forward. So that was one consideration.

Another one is really around the low cost environment we're in. The sooner we can get this project to FID and like contracts, over the border in Uganda, we're starting to see some of the pricing and we're starting to see the cost base there, because we will lock in these low cost in Uganda, because we'll FID that project this year. And we're taking those licenses across to Kenya realizing the quicker we can get this underway, the more likelihood we'll lock in a very low cost CapEx for the project.

And then, the other thing I believe is that momentum is what these projects are all about. You got to build momentum, drive momentum and move them forward”

-   Lastly, the cost decline for CAPEX requirements both for the upstream and downstream projects has made these more attractive for any potential partner and for the government of Kenya it’s now more attainable than before.

 

Equity Interests:

As described by AOC, the equity investments provide participation in 14 exploration blocks and represent a new approach, by which they put the cash they estimate won’t be needed for the South Lokichar development to work while the project is sanctioned.

-   Eco (Atlantic) Oil & Gas (18.9% interest – current valuation $13 million): TSX/AIM listed E&P with assets in Namibia, where it has several high potential prospective blocks, and Guyana, where it holds acreage adjacent to Exxon’s Liza discovery. The company description reads: “In Guyana, Eco Guyana holds a 40% working interest alongside Tullow Oil (60%) in the 1,800 km2 Orinduik Block in the shallow water of the prospective Suriname Guyana basin. The Orinduik Block is adjacent and updip to the deep-water Liza Field and Snoek, Payara, Pacora and Turbot 1 Discoveries, recently discovered by ExxonMobil and Hess, which is estimated to contain as much as 3.2 billion barrels of oil equivalent, making it one of a handful of billion-barrel discoveries in the last half-decade.

In Namibia, the Company holds interests in four offshore petroleum licences totalling approximately 25,000 km2 with over 2.3 billion barrels of prospective P50 resources in the Walvis and Lüderitz Basins.  These four licences, Cooper, Guy, Sharon and Tamar are being developed alongside partners, which include Tullow Oil, AziNam and NAMCOR.  Drilling activity in Namibia is set to gather pace in 2018 and 2019, with a few wells confirmed to be spud on Tullow PEL 037 and Chariot Central Blocks. The Company has applied for drilling permits on its Cooper (Operator) and Guy blocks.”

In September 2017, they signed an Option Agreement with Total by which they received a $1million fee giving Total the right to farm-in to the Orinduik block at their discretion for an additional $12.5 million in exchange for a 25% working Interest in the block. The exercise of the option must be made within 120 days of completion of processing of the 3D seismic survey completed in early September 2017. Post the exercise of the option, Eco would remain a partner in the block with 15% working interest. In April 19th 2018, Eco published a press release mentioning that they were still processing the data together with Tullow and that Total was also in possession of the data for their own analysis in order to expedite the farm-in agreement. Management told me they expect to have enough cash to cover the 2 exploratory well costs in Guyana and 1 well in Namibia and still have aprox. $10 million left, which would prevent them from having to raise capital in the short term. Potential resources in Guyana could be greater than 900 MMbbl, but there are no reserves yet.

As of the end of February, the company had $14.7 million in cash and equivalents. There are 155 million common shares, 6.8 million options issued to directors, officers and consultants, 0.4 million RSUs and 2.2 million warrants outstanding, for a total diluted count of 170 million shares.

Insiders at Eco own 25.8 million shares, ca. 15% of the fully diluted share count.  The management team is heavily compensated in shares and options, which creates a significant incentive to deliver strong returns. However, the CEO, CFO, COO, VP and Finance Director all receive compensation in the form of consulting fees to third party entities related to themselves, rather than a salary. This mitigates their downside risk.

With Africa Oil now being the largest shareholder, the Lundin Group have one person on the board in the form of Keith Hill, AOC’s CEO who also sits in five other Lundin Group boards, including AOC and Africa Energy.

-   Africa Energy Corp (34.63% interest – current valuation $32.3 million): TSXV listed E&P with an inventory of exploration prospects, including Total’s operated South Africa Block and Tullow’s operated Namibia Block, with wells planned for 2018.

The short pitch: the company was spun-off of Africa Oil as Horn Petroleum in June 2012, which held assets in Puntland, Somalia. They exited Somalia in 2014. Following Tullow Oil’s layoffs, some of their exploration team joined the Africa Oil shell in Johannesburg. In March 2015 they raised capital and listed in the TSXV. They’ve done four capital raisings in total, raising approx. $60 million.

In December 2015 they acquired: 25% of Block 2B offshore South Africa for $1 million from Afren Plc, which was in bankruptcy and under Administration; 34.5% of Block 2B via the acquisition of Thombo Petroleum Ltd for $2 million and 14.8 million Africa Energy shares; a farm-in agreement with Crown Energy AB to acquire 30.5% of Block 2B in exchange for $0.3 million of net back costs and the commitment to fund Crown’s costs for their remaining 10% working interest in the block. In total, $5 million gave them exposure to 90% of the block. They are currently looking for a partner for this asset ideally before the end of 2018. Best Estimate Prospective Resources for Block 2B are 800 MMbbl

In November 2016, they acquired a 10% working interest in the PEL 37 offshore Namibia for a total $6.5 million consideration and will be carried through the current exploration period by one of the joint venture partners (Tullow, ONGC, Pancontinental and Paragon). Best Estimate Prospective Resources are 915 MMbbl.

In November 2017, they acquired a 4.9% working interest in Block 11B/12B offshore South Africa. Total is the operator with a 45% interest, Qatar Petroleum holds 25% and CNRL 20%. The total cost to Africa Energy was $7.35 million. They have also agreed to fund up to $7.55 million of Total’s and CNRI’s costs for a proposed exploration well to be drilled in December 2018.

In May 2018, they raised $45 million via a private placement in which Africa Oil participated, increasing the stake from 28% to the current 34.6%. There are 681.2 million shares outstanding following the placement. As of year-end 2017, there were 16.1 million outstanding options. The Lundin Family owns 11.8% of the outstanding shares. The board, management and employees owned 11% of the company prior to the recent private placement and have all subscribed shares in it. They should currently hold a similar position post the event. Ahsley Heppenstal, Chairman, sits in the board of six other Lundin Group companies and was the CEO of Lundin Petroleum until September 2015.  

-    Impact Oil & Gas Ltd (25.2% interest – private company – valued at $25.7 million): Impact  Oil and Gas acquired its first asset, the Tugela South Exploration  Right, offshore South Africa in 2011 and has subsequently expanded its asset base across the offshore margins of South and West Africa. It has since partnered with ExxonMobil and Statoil (South Africa), CNOOC (AGC – between Senegal and Guinea Bissau) and Total (Namibia and South Africa).  It is currently seeking a partner in its Gabonese assets. The company’s current portfolio covers a combined area of over 90,000 km² (gross).

AOC has a right to two seats on the board. Keith Hill is currently sitting on the board after the completion of the investment.

AOC has now exposure to 14 exploration blocks, of which six have high potential, strong partners/operators and have plans for 2018 and 2019 drilling campaigns.

Source: 2018-04 (Africa Oil) AGM presentation

 

Valuation:

You need to keep in mind that AOC does not have any reserves booked yet. There’s no external assessment of what their assets in Kenya and Ethiopia are worth.

Under normal circumstances and for many reasons I would entirely avoid an investment in a company like this: 1) to begin with, I’m not a geologist or a petroleum engineer, so presentations are of limited information to me with all their maps and forecasts of future production; 2) even though I’m not a geologist or petroleum engineer, I do understand that resources are not reserves, and getting from one classification to the next usually takes several million dollars, so I don’t like the constant risk of dilution as a shareholder nor the balance sheet risk that some E&Ps have incurred in by taking debt to finance development activity; 3) while I like insider ownership in principle and believe it serves as a good indicator of alignment with shareholders, in the case of E&Ps, a lot of it tends to come as a result of share options, RSUs or PSUs, hence the alignment is not complete and insiders’ downside is much lower than an outsider’s; I don’t think I can accurately price options, which early stage E&Ps essentially are and therefore I’d rather avoid them, except in the case where I feel I can be “approximately right”.

So why is Africa Oil a worthy investment?

First, I feel you don’t need to be a geologist in this case. The value of the South Lokichar has been validated through several farmouts, beginning with Tullow’s buy-in in 2010 and most recently in early 2016 with Maersk Oil’s acquisition of 50% of AOCs working interest for a total consideration of $845 million, valuing the asset at c. $3.4bn. Total’s recent acquisition of Maersk Oil is a continuation of Maersk’s commitment to the development of the asset and more recently, the announcement of the National Oil Corporation of Kenya’s intention of an IPO in early 2019 to raise enough capital to exercise their buy-in rights shows the government’s willingness to take the project to fruition.

Second, I think the company’s current balance sheet largely mitigates the risk of absolute capital loss. With $379 million in cash, $29 million of net receivables and $408 in working capital (Maersk pending carry which is contingent on FID and resource estimates, classified as Intangible exploration assets in the balance sheet) vs. $466 million of market cap and no long-term debt, the market is clearly not assigning much value to the South Lokichar asset. In a worst case scenario, where no development plan is approved over the next couple of years, a wind down of the company and a distribution of the cash to shareholders could take place. The cash plus the receivables represent 95% of the market cap today. On the other hand, an FID would trigger Maerk’s carry payments, mitigating AOC need to raise capital for CAPEX funding. Under current CAPEX estimates of $1.3bn, AOC share is $325 million, giving them excess cash balances of $54 million after first oil assuming all goes according to plan. Management has mentioned that ca. $100-200 million of cash may be left in the balance sheet after first oil, so there seems to be a floor on the downside that is not too far from the current share price of C$1.27.

The above analysis excludes the equity investments. Their Africa Energy and Eco stakes are worth $45.3 million at current prices. Their stake in Impact is valued at $25.7 million in the balance sheet. In total, taking into account the equity investments, the current enterprise value is close to $0. Buying Africa Oil shares today therefore give you an interesting asymmetric payoff: you don’t stand to lose much in case South Lokichar does not go ahead as planned or if it is delayed for longer than the partners in the JV expect; you stand to win, perhaps a lot, if anything goes well either for Africa Oil or for any of their investees.

For Africa Oil, should there be an FID announcement by Tullow or an announcement by the Kenyan government indicating the construction of a pipeline from Tarkana to Lamu, it would trigger an immediate revaluation of the NAV, by de-risking the asset through the booking of reserves. The sell-side has an average NAV estimate for AOC of C$1.82/share, 49% above the current price of C$1.22/share.

 

The pre-development resources in South Lokichar, discounted at 15% and assuming a long-term oil price of $60/bbl are worth C$0.56/share. In my base case, there’s at least 39% upside to the current share price.

The investees all have several of what seem viable prospects and all speak of significant value creation for shareholders through further exploration success or farmouts of what they already have in the pipeline. In the case of Impact, a potential IPO seems to be the preferred route management would take to realize the value of their assets. A rising oil price increases the chances of that happening.

Third, while I’m not happy with the dilution brought upon shareholders by option and unit grants, I understand that in this case it helps mitigate the cash burn for each company. This is an important consideration given the stage of development all the companies involved here are in. Additionally, while there are potential conflicts of interest arising from cross shareholdings and cross board representation, I still like to get involved with the Lundin Family when it comes to investing in Natural Resources. For what it’s worth, I think the below slide from a 2013 Africa Oil corporate presentation, gives an indication of what the Lundin Group has managed to achieve in oil and gas investments for the benefit of shareholders. I believe they bring valuable experience to the table and I like the fact that they have a very long-term approach to natural resources investing. For reference, the Lundins have never diluted their stake in Lundin Petroleum and had never taken any money out since September 2001 until 2018, when the company declared their first dividend ever. The Lundin Group involvement should bring discipline to the capital allocation process in Africa Oil but also in Africa Energy, Eco and Impact.

Source: 2013-11 (Africa Oil) Corporate presentation

 

The most obvious risk to an investment in Africa Oil today is the oil price. The recent strength, which appears to be reflecting a supply crunch accelerated by OPEC production cuts and strong underlying demand worldwide, increases the chances of South Lokichar being sanctioned in line with the operator plans and also improves the chances of aligning the different stakeholders involved in the pipeline construction. Additionally, given Tullow’s still stretched balance sheet, a strong oil price environment would help them find the necessary resources to proceed with an FID. A return to a lower oil price environment would have the opposite effect, as evidenced by the delays the oil price downturn has had on the project already since 2014.

To mitigate cash burn, which currently runs at ca $6 million a year, AOC management have mentioned they are contemplating the option of buying production in order to generate free cash flow and gain exposure to an oil price recovery. This is both an upside and downside risk, dependent of course on the price paid for any acquisition. In their latest presentation, AOC says there are “several Africa based production deals being evaluated”. The recent oil price rally is not helpful in closing a deal under favourable terms. However, if a deal is reached under decent conditions, the ability to generate sufficient cash for expenses and CAPEX further reduces the risk of an investment in Africa Oil.

Finally, there’s the risk of AOC being diluted in their equity stakes, should the investees require additional capital in the short term. Also, you need to keep in mind potential conflicts of interest between the different Lundin Group investments and how they can impact Africa Oil in this case. In a way, this risk is mitigated by the company having taken the approach of diversifying their pipeline exposure indirectly, therefore benefiting regardless of conflicts of interest taking place between AOC, Africa Energy, ECO and Impact.

 

 

 

 

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise do not hold a material investment in the issuer's securities.

Catalyst

Catalyst: An FID announcement, positive developments towards the construction of a pipeline connecting South Lokichar with Lamu, material news from any of the investees involving discoveries, farmouts, takeovers, etc. Finally, a takeover of Africa Oil itself would lock-in gains for investors in the company today.  

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    Description

    Africa Oil Corp (AOI CN)

    Summary:

    Africa Oil Corp (AOI CN) is a Canadian E&P with assets in Kenya and Ethiopia. The company holds a 25% interest in the South Lokichar basin of Kenya, where Tullow Oil is the operator. The company also holds equity interests in three E&P companies which themselves hold oil and gas assets at different stages of development: Africa Energy (34.63% interest), Eco oil and gas (18.9% interest), Impact Oil & Gas (25% interest) Africa Oil shares trade on the TSX and Nasdaq Stockholm and both Africa Energy and Eco Oil and Gas are publicly listed companies.

    There are 470.1 million shares outstanding, 9.5 million options, 3.9 million PSUs and 2.5 million RSUs for a total of 486.4 million fully diluted shares. At the current share price of C$1.27, market cap is $466 million. As of March 2018, the company had $378.9 million in cash and $408.7 million of working capital (classified as Intangible Exploration assets in the balance sheet). There are $27 million of accounts payable offset by $56 million of receivables but no long-term debt in the balance sheet. The current enterprise value is $9 million.

    I believe Africa Oil presents an attractive asymmetric payoff profile for investors today. Downside is limited by cash and receivables in the balance sheet and the three equity stakes (95% of today’s market cap). Upside is provided by the working interest in South Lokichar, nearing final investment decision and with first oil expected in 2022. The pre-development resources in South Lokichar, discounted at 15% and assuming a long-term oil price of $60/bbl are worth C$0.56/share. In my base case, there’s at least 39% upside to the current share price.

    Additional upside should come from any significant event happening at any of the investees, all of which have attractive assets at different stages of development which have become attractive in their own right given their characteristics but more importantly, given the lack of exploration and development activity the world has suffered outside of North America over the past four years, particularly offshore.

    Major risks come from oil prices, which could postpone Africa Oil’s main project FID and prevent Tullow, the operator, from finding the required resources to proceed. Lower oil prices would also impact the investees ability to monetize or continue the development of their current pipeline.

    Capital allocation by management is another risk. The Lundin Group were until 2010 a major shareholder with more than 20% of the shares. They have since been diluted and their position no longer requires disclosure. Their stake is likely between 4.5%-5.2% today. In principle, this should prevent them from influencing management decisions, however, Keith Hill, Africa Oil CEO, sits at several other Lundin Group company boards and has been involved with the family for over 20 years. The Lundin Group is a major shareholder in Africa Energy and now has a seat at the board in Eco and Impact, thanks to Africa Oil’s stakes. Insiders in each of the company have meaningful shareholdings which should help align their interest with minority shareholders, however, I think it is highly unlikely for Africa Oil to ever distribute the cash it holds in the balance sheet even if South Lokichar was never sanctioned. Effectively, their recent strategy of investing in a “portfolio” of E&Ps shows that they would rather attempt other ways of “creating value” than liquidating the company. In the current oil environment, this could work in investors favour, but there could be a scenario where it does not. I feel comfortably partnering with the Lundin Group, and more so in the oil environment mentioned, but I don’t expect Africa Oil or any of the other investees to be paradigms of corporate governance, so investors most feel comfortable with that.

     

    Timeline:

    -    March 1993: Africa Oil was incorporated under the name “Canmex Minerals Corporation”

    -  July 1999: issued and outstanding common shares (100,000,000) were consolidated on a one-for-five basis and authorized capital was increased, post-consolidation to 100,000,000 common shares.

    -    August 2007: Company changed its name to “Africa Oil Corp”

    -   2007-2010: AOC assembled a highly prospective portfolio of exploration assets in Kenya, Ethiopia and Somalia.

    -   June 2009: Shareholders of AOC approved a resolution to increase the share capital of the company to an unlimited number of common shares.

    -   September 2010: AOC and Tullow entered into the Tullow Farmout Agreement, which assigned a 50% interest and operatorship of Blocks 10A, 10BB and South Omo (Now relinquished) to Tullow and granted Tullow an option to acquire a 50% interest in Blocks 12A and 13T. AOC received $9.5 million from Tullow. Tullow exercised these options in September 2010 paying $1.55 million to AOC.

    -   June 2013: shareholders approved a resolution authorizing an alteration of the Company’s articles to include advance notice provisions for the nomination of directors.

    -    February 2015: AOC completed a private placement, issuing 57,020,270 common shares at a price of SEK 18.5 (C$ 2.74) per common share. Net proceeds were $120.5 million.

    -   May 2015: AOC completed a private placement with Stampede Natural Resources, issuing 52,623,377 common shares at a price of C$2.31, for gross proceeds of $100 million.

    -   August 2015: AOC completed a (gross) $50 million private placement by issuing 31,169,048 common shares at a price of C$2.1

    -   November 2015: AOC entered into a definitive farmout agreement with Maersk. Maersk agreed to acquire 50% of AOCs interests in Blocks 10BB, 13T and 10BA in Kenya and the Rift Basin and South Omo blocks in Ethiopia in consideration for reimbursement of a portion of AOC past costs and a future carry on certain exploration and development costs.Maersk paid AOC $350 million as reimbursement of past costs incurred by AOC prior to the agreed March 31, 2015 effective date. Maersk also reimbursed AOC for its acquired working interest share of costs incurred between the effective date and the closing date. As of the effective date, Maersk would carry up to $75 million of AOCs share of development expenditures upon confirmation of resources and $15 million of AOCs share of exploration expenditures. Additionally, upon FID, Maersk would also carry up to $405 million of AOCs working interest share of development expenditures for the Lokichar Development Project, with the total carry amount being contingent upon the project meeting certain resource growth thresholds and the timing of first oil. This agreement was closed early in 2016, when they received $439.4 million from Maersk ($350 million consideration plus $89.4 million for Maersk’s share of costs incurred between the effective date and closing, including $15 million of carry related to exploration expenditures). During November 2015, Oil prices averaged $46.1/bbl (Brent)

    -  July 2016: the Government of Kenya agreed to a three-year extension to the Second Additional Exploration Period in Blocks 10BB and 13T (South Lokichar) expiring on 18th September 2020.

    -   May 2017: AOC and Maersk agreed payment terms related to the $75 million advance development carry. AOC will receive equal quarterly payments of $18.75 million at the end of each calendar quarter during 2018.

    -    November 2017: AOC acquired 19.77% of Eco (Atlantic) Oil and Gas for total consideration of C$14 million ($10.9 million) Keith Hill, AOC’s President & CEO joined the Eco board of directors in December 2017. The agreement between the two companies entitles AOC to bid jointly on any new assets or ventures proposed to be acquired by Eco on the same terms as Eco and for an interest at least equal to AOCs percentage holding of the common shares in Eco. AOC also has a right of first offer on the farmout of exploration properties currently held by Eco.

    -   October 2017: the Joint Venture Partners and the Government of Kenya signed a JDA to progress the development of the export pipeline, which allows FEED studies and environmental and social impact assessments to commence, as well as studies on pipeline financing and ownership.

    -    February 2018: AOC purchased 59,681,539 ordinary shares and 29,840,769 share purchase warrants of Impact Oil and Gas Ltd, a private UK company, for approximately $15 million. Additionally, AOC entered into a share purchase agreement with Helios Natural Resources to acquire 70,118,381 shares and 15,529,731 warrants currently held by Helios in the capital of Impact. The investments gave AOC a 25.2% equity interest in Impact.

    -   May 2018: AOC subscribed 144,956,250 common shares of Africa Energy Corp at a price of C$0.16, increasing their equity interest from 28.54% to 34.63%. Total consideration was $18 million.

    Since changing its name to Africa Oil in 2007 to-date, the company has raised over $1bn in equity.

     

    South Lokichar:

    As of December 2017, the company had interests in:

    Source: Africa Oil 2017 Annual Report

    The South Lokichar basin is the main asset and consists of Blocks 10BB and 13T. In its most recent annual results conference call, Tullow Oil, the operator, has guided towards an FID of the project in 2019 with the aim of achieving first oil in 2021 or 2022 and 100kbpd of plateau production. The initial stage of development of the field includes plans for the construction of an oil export pipeline to Lamu, 850km from the Lokichar basin, on the east coast of Kenya. Without the pipeline, the basin is landlocked and the only other transportation mean would be by truck, making the project uneconomical.

    In their latest corporate presentation, Tullow estimates South Lokichar may hold up to 4 billion barrels of oil in place, of which 560 million are classified as 2C resources with upside potential of an additional 670 million barrels, for total discovered resources of 1.2 billion barrels.

    Source: 2018-05 (Tullow Oil) Overview presentation

    The development plan for the basin includes a Foundation Stage targeting 210MMboe with initial production of 60-80kbpd. The Foundation Stage CAPEX requirements add up to $2.9bn, of which $1.8bn corresponds to Upstream development of the Ngamia and Amosing fields and $1.1bn to the Pipeline.

    Source: 2018-04 (Africa Oil) AGM presentation

    AOC incurred $59.3 million in exploration costs in Kenya and $1.4 million in Ethiopia during 2017 offset by a $75 million advance development carry settlement from Maersk (see timeline below). Operating cash burn was reduced to $0.9 million in 2017 from $4.4 million in 2016.

    According to management, South Lokichar’s estimated breakeven is $27/bbl Brent. The main issue with the project is the Kenya’s lack of big oil project developments and the missing infrastructure, which has to be developed from scratch and faces the typical bottlenecks: political vagaries, social factors, financing and terms. This was considered frontier exploration back in 2012, when the basin was first discovered.

    The Kenyan government holds a buy-in option of 22.5% on the block 13T and 20% on block 10BB, which can be exercised within six months from the date a development plan is sanctioned. The PSCs for both blocks are in place for 25 years once a development plan is adopted.

    Even today, Africa Oil has the best balance sheet of all the partners in the field. Tullow has recently raised capital in order to reduce leverage and Maersk sold its energy business to Total in a transaction announced in August 2017. Management believes it should be easier to finance the construction of the pipeline than the upstream infrastructure, and mentioned that both GE and Schlumberger were offering attractive terms for some of the required upstream assets needed.

    Low-case production of the field is 80kbpd in phase 1 of the project, which, assuming a 2019 FID, would come around 2022. The base case production scenario calls for 120kbpd in phase 2 of the project, with an optimistic case of 150kbpd.

    Operating costs in the field are estimated by the company at $5/bbl excluding pipeline. Tariff costs would be between $11-13/bbl, however, the PSCs allow a portion of these OPEX costs to be recovered once in production.  

    An Early Oil Production Scheme (EOPS) is due to commence in the first half of 2018. Estimates of daily production for this plan are 2,000 bpd.

    AOC management has mentioned that they expect to be left with $100-200 million in cash post first-oil, thanks to the Maersk carry and the possibility of financing part (potentially 40%) of the upstream development work.

    All in all, while there’s a probability the project does not go ahead, I think there are several indications that it eventually may, and perhaps faster than the market seems to be expecting.  

    -    Maersk farm-in back in 2015 valued blocks 13T and 10BB at approx. $3.4bn at a time when oil prices were below $50/bbl.

    -   Total’s press release announcing the acquisition of Maersk Oil highlighted how the deal complemented “Total’s leading East Africa position via Maersk Oil’s Kenya assets” (https://www.total.com/en/media/news/press-releases/total-acquires-maersk-oil-for-7-45-billion-dollars-in-share-and-debt-transaction)

    -    Total and Tullow’s expertise in African project completions could help facilitate the necessary conditions for the project to move forward. In fact, upon Total’s acquisition of Maersk Oil, Manoah Esipisu, State House Spokeperson of the Kenyan government, said: “Kenya is optimistic that the entry of Total into the Kenya Joint Venture will strengthen the financial resources and technical competence to the Joint Venture and this will go a long way in accelerating the development of the resources in these Blocks” (https://www.standardmedia.co.ke/business/article/2001266996/total-to-buy-shares-in-turkana-oil-blocks)

    -    In late November 2017, it was reported that the National Oil Corporation of Kenya plans to raise $1bn by listing its shares in the Nairobi Stock Exchange and the London Stock Exchange by early 2019, in order to raise money to exercise their buy-in rights in blocks 13T and 10BB. (https://uk.reuters.com/article/uk-kenya-oil/kenya-plans-1-billion-dual-listing-of-national-oil-corp-by-early-2019-idUKKBN1DT20Y)

    -    In late April 2018, it was reported that Wood Group had been awarded the FEED work for the Turkana (Lokichar) – Lamu pipeline that will be used to export the oil once commercial production starts by 2022 (https://www.standardmedia.co.ke/business/article/2001278220/uk-firm-to-design-crude-oil-pipeline)

    -  Tullow’s (operator) comments in its most recent FY17 conference call: “The overall development plan, as you're aware, is the export pipeline to Lamu. We've proposed to the government – the drivers here – the governments are very keen to move forward with this development. They're very keen to get to FID, why? Because they want to get First Oil and they want to move this project forward. So that was one consideration.

    Another one is really around the low cost environment we're in. The sooner we can get this project to FID and like contracts, over the border in Uganda, we're starting to see some of the pricing and we're starting to see the cost base there, because we will lock in these low cost in Uganda, because we'll FID that project this year. And we're taking those licenses across to Kenya realizing the quicker we can get this underway, the more likelihood we'll lock in a very low cost CapEx for the project.

    And then, the other thing I believe is that momentum is what these projects are all about. You got to build momentum, drive momentum and move them forward”

    -   Lastly, the cost decline for CAPEX requirements both for the upstream and downstream projects has made these more attractive for any potential partner and for the government of Kenya it’s now more attainable than before.

     

    Equity Interests:

    As described by AOC, the equity investments provide participation in 14 exploration blocks and represent a new approach, by which they put the cash they estimate won’t be needed for the South Lokichar development to work while the project is sanctioned.

    -   Eco (Atlantic) Oil & Gas (18.9% interest – current valuation $13 million): TSX/AIM listed E&P with assets in Namibia, where it has several high potential prospective blocks, and Guyana, where it holds acreage adjacent to Exxon’s Liza discovery. The company description reads: “In Guyana, Eco Guyana holds a 40% working interest alongside Tullow Oil (60%) in the 1,800 km2 Orinduik Block in the shallow water of the prospective Suriname Guyana basin. The Orinduik Block is adjacent and updip to the deep-water Liza Field and Snoek, Payara, Pacora and Turbot 1 Discoveries, recently discovered by ExxonMobil and Hess, which is estimated to contain as much as 3.2 billion barrels of oil equivalent, making it one of a handful of billion-barrel discoveries in the last half-decade.

    In Namibia, the Company holds interests in four offshore petroleum licences totalling approximately 25,000 km2 with over 2.3 billion barrels of prospective P50 resources in the Walvis and Lüderitz Basins.  These four licences, Cooper, Guy, Sharon and Tamar are being developed alongside partners, which include Tullow Oil, AziNam and NAMCOR.  Drilling activity in Namibia is set to gather pace in 2018 and 2019, with a few wells confirmed to be spud on Tullow PEL 037 and Chariot Central Blocks. The Company has applied for drilling permits on its Cooper (Operator) and Guy blocks.”

    In September 2017, they signed an Option Agreement with Total by which they received a $1million fee giving Total the right to farm-in to the Orinduik block at their discretion for an additional $12.5 million in exchange for a 25% working Interest in the block. The exercise of the option must be made within 120 days of completion of processing of the 3D seismic survey completed in early September 2017. Post the exercise of the option, Eco would remain a partner in the block with 15% working interest. In April 19th 2018, Eco published a press release mentioning that they were still processing the data together with Tullow and that Total was also in possession of the data for their own analysis in order to expedite the farm-in agreement. Management told me they expect to have enough cash to cover the 2 exploratory well costs in Guyana and 1 well in Namibia and still have aprox. $10 million left, which would prevent them from having to raise capital in the short term. Potential resources in Guyana could be greater than 900 MMbbl, but there are no reserves yet.

    As of the end of February, the company had $14.7 million in cash and equivalents. There are 155 million common shares, 6.8 million options issued to directors, officers and consultants, 0.4 million RSUs and 2.2 million warrants outstanding, for a total diluted count of 170 million shares.

    Insiders at Eco own 25.8 million shares, ca. 15% of the fully diluted share count.  The management team is heavily compensated in shares and options, which creates a significant incentive to deliver strong returns. However, the CEO, CFO, COO, VP and Finance Director all receive compensation in the form of consulting fees to third party entities related to themselves, rather than a salary. This mitigates their downside risk.

    With Africa Oil now being the largest shareholder, the Lundin Group have one person on the board in the form of Keith Hill, AOC’s CEO who also sits in five other Lundin Group boards, including AOC and Africa Energy.

    -   Africa Energy Corp (34.63% interest – current valuation $32.3 million): TSXV listed E&P with an inventory of exploration prospects, including Total’s operated South Africa Block and Tullow’s operated Namibia Block, with wells planned for 2018.

    The short pitch: the company was spun-off of Africa Oil as Horn Petroleum in June 2012, which held assets in Puntland, Somalia. They exited Somalia in 2014. Following Tullow Oil’s layoffs, some of their exploration team joined the Africa Oil shell in Johannesburg. In March 2015 they raised capital and listed in the TSXV. They’ve done four capital raisings in total, raising approx. $60 million.

    In December 2015 they acquired: 25% of Block 2B offshore South Africa for $1 million from Afren Plc, which was in bankruptcy and under Administration; 34.5% of Block 2B via the acquisition of Thombo Petroleum Ltd for $2 million and 14.8 million Africa Energy shares; a farm-in agreement with Crown Energy AB to acquire 30.5% of Block 2B in exchange for $0.3 million of net back costs and the commitment to fund Crown’s costs for their remaining 10% working interest in the block. In total, $5 million gave them exposure to 90% of the block. They are currently looking for a partner for this asset ideally before the end of 2018. Best Estimate Prospective Resources for Block 2B are 800 MMbbl

    In November 2016, they acquired a 10% working interest in the PEL 37 offshore Namibia for a total $6.5 million consideration and will be carried through the current exploration period by one of the joint venture partners (Tullow, ONGC, Pancontinental and Paragon). Best Estimate Prospective Resources are 915 MMbbl.

    In November 2017, they acquired a 4.9% working interest in Block 11B/12B offshore South Africa. Total is the operator with a 45% interest, Qatar Petroleum holds 25% and CNRL 20%. The total cost to Africa Energy was $7.35 million. They have also agreed to fund up to $7.55 million of Total’s and CNRI’s costs for a proposed exploration well to be drilled in December 2018.

    In May 2018, they raised $45 million via a private placement in which Africa Oil participated, increasing the stake from 28% to the current 34.6%. There are 681.2 million shares outstanding following the placement. As of year-end 2017, there were 16.1 million outstanding options. The Lundin Family owns 11.8% of the outstanding shares. The board, management and employees owned 11% of the company prior to the recent private placement and have all subscribed shares in it. They should currently hold a similar position post the event. Ahsley Heppenstal, Chairman, sits in the board of six other Lundin Group companies and was the CEO of Lundin Petroleum until September 2015.  

    -    Impact Oil & Gas Ltd (25.2% interest – private company – valued at $25.7 million): Impact  Oil and Gas acquired its first asset, the Tugela South Exploration  Right, offshore South Africa in 2011 and has subsequently expanded its asset base across the offshore margins of South and West Africa. It has since partnered with ExxonMobil and Statoil (South Africa), CNOOC (AGC – between Senegal and Guinea Bissau) and Total (Namibia and South Africa).  It is currently seeking a partner in its Gabonese assets. The company’s current portfolio covers a combined area of over 90,000 km² (gross).

    AOC has a right to two seats on the board. Keith Hill is currently sitting on the board after the completion of the investment.

    AOC has now exposure to 14 exploration blocks, of which six have high potential, strong partners/operators and have plans for 2018 and 2019 drilling campaigns.