Description

Arawak Energy (ABG $2.26 US):  Capable of exceeding modest investor expectations.

 

All estimates and prices are in US dollars.  Current share price is converted from Canadian to US currency at the rate of .9918.

 

Fully diluted shares outstanding (includes proposed 

 

Total liabilities –short term cash and equivalents:                                   $105.2 million.

 

Enterprise Value:                                                                                      $547.2 million

 

EBITDA for 2007:                                                                                    $97.8 million.

 

2007 EV/EBITDA ratio:                                                                           5.6X

 

2005 average production:                                                                           5,667 bpd

2006 average production:                                                                           7,905 bpd 

2007 average production:                                                                        10,180 bpd

 

2008 forecast production:                                                       12,645*bpd-13,265 bpd**

2008 forecast EBITDA:                                                        $153.2 million-$158.8 million 

2008 forecast EV/EBITDA:                                                                       3.5X-3.6X                                           

 

Thesis

 

Investors seeking a rapidly growing oil producer in Kazakhstan and Russia at an inexpensive valuation should consider a purchase of Arawak Energy.  Due to rising oil prices and rapidly increased production, the firm has been transformed from a capital intensive explorer, to a positive cash flow generating producer. 

 

Currently, the shares are selling for a significant discount to peers, based upon 24 months of modest under execution. 

 

I forecast that in 2008, production and financial targets will be met or exceeded.  Recognition that current growth plans may look to be about fully funded from operations could remove concerns about further dilution, or leveraging of the balance sheet.

 

Arawak should carry a valuation comparable to the median smaller mid cap international developer. A return to investor favour could occur as soon as the release of 1^st quarter results. This could be on or about May 14^th, 2008.

 

Company description

 

The Vitol Group, a major oil trading firm based in Switzerland, holds 67.3 million common shares. 

 

Kazakhstan is where Arawak generates the bulk of revenues.

 

Arawak produces oil from 3 fields in Kazakhstan in which it holds a 100% interest.  Oil produced is medium grade crude that sells for a healthy discount to Brent.  80% of produced oil can be sold to export markets, with the remainder being sold to domestic markets. 

 

At year end 2007, there were 72 producing wells in three fields; Akzhar, Besbolek and Karataikys.  A new exploration concession, Alimbai, demonstrated productivity from 2 reworked Soviet era wells, and 1 recently drilled exploration well was also successful.

 

In 2007, average production from these fields averaged 5898 bpd.

 

Russia is Arawak’s secondary source of oil production.

 

Arawak owns a 50% interest in two producing fields, Sotchemyu-Talyu and North Irael.  The remaining 50% interest is held by Lundin Petroleum.  These two fields generated (net to Arawak) average production of 4282 bpd in 2007. Oil produced is a relatively low grade light crude.  Roughly 45% of crude oil is exported, and the remainder sold to domestic markets.

 

At year end, there were 70 producing wells in Russia.

 

Arawak has a modest concession in Azerbaijan.

 

The firm has an effective 29.736% interest in exploration properties and 10 productive oil and natural gas wells in Azerbaijan.  This profit sharing agreement (PSA) is operated by a third party, whose controlling interest is China National Petroleum.   Oil production averaged 20 bpd in 2007.

 

Natural gas sales were converted to oil equivalents by Arawak. For accounting purposes, this added 130 bpd.  However, as Azerbaijan natural gas sells for about $1.25 per mcf ($7.5 per barrel equivalent), this represents purely a theoretical exercise.

 

In the past, detractors have criticized Arawak for lack of reserve growth and poorly defined reserves.

 

As a result of these expenditures, Arawak has been able to increase proven and probable reserves, in the past 24 months by 5.46 million barrels.  The firm had also produced 6.6 million barrels of oil.  

 

Arawak has also booked large natural gas and associated oil reserves in Azerbaijan.  However, many investors and analysts have largely ignored these reserves.  This reserve base is poorly defined.  Furthermore, most of this Azerbaijan reserve is natural gas, difficult to produce and sells for little more than breakeven.  No development or exploration drilling is planned in Azerbaijan until late 2008 at the earliest.

 

Given the funding requirements, the geological complexity of the region, and the lack of proper modern seismic over much of the concession, it seems that investors are actually penalizing Arawak for continuing to hold and fund the Azerbaijan PSA.   I completely exclude any valuation for Azerbaijan reserves.

 

At year end 2007, proven reserves in Kazakhstan and Russia were 32.2 million barrels, up from 22.2 million in the prior year, mostly producing.  Probable reserves fell to 13.6 million barrels at year end 2007, as compared to 22.1 million barrels at year end 2006.   

 

The decline in probable reserves was entirely due to a conversion to proven, with development drilling.

 

My confidence level attached to the proven reserve estimate in Russia and Kazakhstan is high.

 

Most of the proven reserves in Kazakhstan estimated by Arawak are contained in shallow, highly porous fields.  They are easy to access through infill drilling, and well covered with modern seismic.  In Russia, while the reserves are deeper, they are equally well defined, and the firm has proven to be capable of extracting the oil with modern reservoir management.

 

A significant amount of the $132.1 million in capex was for infrastructure in key fields, not drilling.  Much of this development cost has been completed.    Stripping out these expenses indicate that F&D costs become 1^st quartile.

 

Overly optimistic production forecasts by management have been the other sore point.

 

In the last 3 years, Arawak increased net oil production by 79.6%.

 

While this would normally be a cause for celebration, executive has continually confounded analysts on a quarter to quarter basis.  Management has used such terms as  “peak” oil production for any given period, or “productive capability” in conferences and press releases.  These terms have been repeated over the past 2 years, to the point whereby investors have been led to believe a high water mark on any given day represents the net average production for a quarter.  Consequently, production rates have failed to meet the rosy estimates in every quarter since 2006. 

 

Annual information forms (AIF), supplied by Arawak have also proven to be erroneous.

 

For 2006, executive estimated that annual production would average 8,780 bpd.  At year end, production averaged 7,905 bpd, a miss of 11%.

 

For 2007, management provided original guidance for average production of 11,024 bpd, and averaged just 10,180 bpd, a miss of 7.7%.  

 

In fairness, more than 30 of the 54 wells drilled in 2007 were defined as exploration wells. These will always carry a lower success rate than development wells.  Nevertheless, management should have taken this into account, when outlining a production estimate. 

 

Investors now seem cautious to accept production forecasts at face value.

 

For 2008, Arawak predicts average production 13,700 bpd.  Based upon the prior two years failure to hit targets, retail and institutional investors may be penalizing this forecast by about 7.7%-11%, to be safe.

 

A long delayed acquisition of a small oil field interest in Kazakhstan may close in the 2^nd quarter of 2008.

 

Vitol, the majority shareholder of Arawak, had agreed sell a 40% gross interest in the Saigak producing block in Kazakhstan.  The cost was originally set at 8.353 million shares of Arawak + additional shares for working capital adjustment. 

 

At the time that the deal was announced (June 6th 2007), Saigak was reported to be producing 3500 bpd gross.  At present, the gross production is 2500 bpd.  This implies an annual depletion rate of 38%. 

 

Based upon the original estimate of proven and probable reserves – annual production, Saigak would add about 2 million barrels of reserves for Arawak.  The acquisition cost, at the current share price, works out to be $9.8 per barrel of 2P reserves.  Alternatively, based upon a 620 bpd forecast 2008 average, the cost is about $31,665 per flowing barrel. 

 

A 20,000 bpd pipeline is planned to link the Akzhar field to a main pipeline.

 

At an estimated $25 million capital cost, this pipeline has the potential to reduce transport costs at Akzhar by $3-$4 per barrel. If completed by mid 2009, it could save about $6.5-$8.8 million per year in costs.  The excess capacity might create a further source of revenue, if utilized by neighbouring producers. 

 

For the first time in years, it appears that management may be accurate with 2008 forecasts.

 

For 2008, the emphasis will be more focused upon development drilling.  Only 38% of the proposed 2008 drilling program will be for exploration.  This should add greater certainty to the 2008 estimate. 

 

Kazakhstan:  average production of 9040 bpd is projected by Arawak. 

 

2008 Akzhar production is estimated by management to be 5389 bpd.  Production from 36 wells in the field was about 4700 bpd at year end, and had risen to 4725 by March 2008.  Management was planning to drill a further 8 wells in the first quarter of 2008.  It takes about 6-8 weeks to bring an Akzhar well on stream.  A further 11 wells are planned for 2008.  

 

Based upon the timing of the drilling, and assuming that 2007 development and exploration success rates are matched, this estimate seems entirely reasonable. The number of productive wells might increase by 35% in 2008.

 

2008 Besbolek production is estimated by management to be 3273 bpd. Production at year end was 3000 bpd, and averaged 3150 bpd in March.  Management intends to drill 15 more wells at this field in 2008. 

 

As the total number of wells at Besbolek might increase by 50% in 2008, production forecasts might be conservative by 200-300 bpd.

 

The 2008 Alimbai concession is estimated by management to produce 216 bpd. There are already 3 producing wells now reported at Alimbai, producing an average of 195 bpd in March.  One of these wells was simply a reworking of an old Soviet era well and has modest production.  Assuming a 70% success ratio, the proposed 3 well program + present production, suggests that 320 bpd is a more realistic target.

 

2008 Karataikyz production is estimated by management to be 202 bpd for March, down from 216 bpd.  As no drilling is planned at this small field, I assume that normal depletion will bring this average down to about 170 bpd for 2008.

 

2008 exploration plans for East Zharkamys III, a major new concession, indicates that 5 exploration wells will be drilled in late 2008.  No success rate has been built into this program at present.

 

Judging by 2007 results at Akzhar, Besbolek and recent success at Alimbai, it appears that overall production forecasts might be conservative by 300-500 bpd.  Any success at East Zharkamys would be incremental to this forecast.

 

In aggregate, I forecast Kazakhstan production of 9340-9540 bpd over 2008.  If Saigak comes on line, it will be backdated to January. This would result increase overall production to 9960 bpd-10,160 bpd.

 

Russia:   oil production estimates for 2008 are forecast to be 4657 bpd.

 

Average production for 2007 was 4282 bpd.  March average production was 4410 bpd. Arawak intends to try and maintain constant production at Sotchemyu-Talyu with workovers, sidetracks and infield drilling.  This has held production at constant levels for the last two years.  Management seems to have a good handle on this field.

 

4 new wells are scheduled to be drilled at North Irael.  Three wells have been successfully drilled at this field to date. The average well has initially produced in excess of 300 bpd. 

 

A 100% interest in an adjoining concession, South Sotchemyu, will have an exploration well drilled in the first half of 2008.

 

Given the scope of development drilling and the current level of workovers, the Russian forecast seems quite reasonable.  Successful drilling at North Irael and South Sotchemyu may not result in an acceleration of development.  Under the Russian system, companies can be penalized for not meeting spending requirements. They can also be penalized for overproduction.  Therefore, Arawak will not likely exceed forecast volumes in this region.

 

2008 revenues & EBITDA may increase by 64% and 57% respectively.

 

Assuming that their Kazakhstan production continues to sell for the 4^th quarter 2007 average of $66.41 per barrel, revenue from Kazakhstan could be $219 million.

 

Should my own projection be met, revenue at Kazakhstan could be in the range of $226.3 million-$231.2 million.

 

A successful acquisition of Saigak can improve total revenues in Kazakhstan by up to 8% in 2008.  This production is lighter than Arawak’s present Kazakhstan output, and not subject to domestic quotas.  Assuming that the 620 bpd average forecast rate sells for $75 US per barrel, this would increase total Kazakhstan sales to a range of $236-$248.2 million.

 

As for Russia, Arawak is budgeting for average production of 4658 bpd.  Assuming that Russian oil prices remain at the 4^th quarter 2007 price of $57.13 per barrel, revenue could be $97.1 million.

 

Total 2008 revenues could be $333.1-$345.3 million.  Netbacks from production increases and Saigak premiums may be fully offset by increases in operating costs. I apply EBITDA margins modestly lower than that generated in 2008 (46%) and come up with $153.2-$158.8 million.

 

 

At the end of 2005, Arawak had an enterprise value of $471.6 million US.  This enterprise value was supported by 40.41 million barrels of reserves (mostly probable) and average production of 5667 bpd.  EBITDA was $29.3 million, which was completely inadequate to cover capex.  The firm sold for 16X EV/EBITDA

 

As of today’s’ date, Arawak has an enterprise value of $547.2 million. This enterprise value is supported by mostly proven reserves of 45.8 million-47.8 million** barrels, trailing average production of 10,180 bpd and trailing EBITDA of $97.8 million. 

 

In light of current oil prices, there seems to be a very clear disconnect.    The enterprise value should have grown by much more than 14%, given all of the positive results generated for the past two years.  Investors traditionally assign at least SOME value for production growth estimates.

 

In the case of Arawak, it seems that investors have largely “given up”.

 

A comparative analysis suggests that Arawak is greatly undervalued.

 

The median international small cap producers I use for comparative purposes include BNK, BVX, CAX, CYR, HOC, ORC.b, POE, PAR, SOR, TGL and WIN.  They trade for an average of 10.5X EV/EBITDA.  Many of the producers in this market cap tend to have little production to speak of, and also have poorly defined reserves.  Most trade upon expectations, and not production.

 

While metrics are not necessarily directly comparable from one producer to the next, it appears that ABG sells for, by far, the greatest discount among peers.

 

 

With 11,500 + barrels of trailing 1^st quarter production, forecast EBITDA in excess of forecast capex, and a production growth plan capable of increasing output by 30% for 2008, Arawak now seems a very logical investment. 

 

The firm has grown reserves by a very satisfactory level in 2007, and has the ability to expand reserves further at Besbolek, Alimbai and North Irael.   A continuation of development and exploration success comparable to 2007, may push Russian and Kazakhstan 2P reserves to more than 50 million barrels.

 

I view Arawak energy as a strong buy for value investors, at current prices.

 

Should management deliver on production forecasts, oil prices remain constant and investor sentiment swing, Arawak could be fairly valued in one year at up to 6X 2008 exit EV/EBITDA. This suggests a fair market value of $4.16 per share, 84% above the current market.  I suspect that at least one of the major Canadian brokerage firms is considering coverage introduction.

 

2008 exit production rates of 15,000 bpd would certainly attract some market attention.  Reasonable exploration success at East Zharkamys III could greatly improve the mid term outlook, and may render this outlook as conservative.

 

The most recent investor presentation may be found by linking here

 

http://www.arawakenergy.com/docs/Arawak%20Presentation%20April%2001%202008.pdf

 

*assumes no closing of Saigak Investments BV

**assumes closing of Saigak Investments BV

 

 

Catalyst

64% forecast revenue growth and 57% EBITDA growth are forecast in 2008. Production has the potential to meet or exceed forecasts, which will reconfirm the growth story. A modestly accretive acquisition will support increased capex for 2009-2009.

Coverage by a major Canadian brokerage firm seems to be forthcoming, and won't be a "sell" recommendation.