Description

I believe BPZ Resources (“BPZ”) has seriously misled the investment community.  Furthermore, it is my opinion that management has made a material misstatement in their 10-K that I believe is directly tied to the dramatic increase in the Company’s stock price.  Combine that with an outrageous valuation and I think BPZ Resources is a highly compelling short.  Just a few years ago, BPZ was a cash-strapped microcap company that listed on the bulletin board through a reverse merger with a shell company.  As I will explain below, I believe BPZ has overstated the value of their oil reserves in an attempt to raise equity from the public and to raise debt from the International Finance Corporation (IFC), which is a member of the World Bank. 

BPZ Resources is an exploration and production company headquartered in Houston and currently listed on the American Stock Exchange under the ticker BZP.  The Company has rights to explore acreage in Peru and Ecuador.  The Company’s primary asset is its right to explore Block Z-1 off the coast of Peru.  This was a site that was abandoned by larger oil companies in the 1970s and 1980s.  To be clear, I am not challenging the existence of meaningful resource potential in these fields.  I simply believe the Company has issued an implausible estimate of the value of these reserves and in turn, the market has awarded this tiny company with a valuation that is several times higher than its peers and a stock price that is significantly beyond any reasonable estimate of value. 

DISCLAIMER:  We currently hold a short position in this security.  We may change our position at any time without posting an update.  The views expressed here are merely the opinion of the author.  Please do your own research.

Quick History

In September 2004, BPZ became a public company through a reverse merger with a company called Navidec.  The Company’s intent was to exploit gas reserves in the Block Z-1 by building a gas-to-power plant in Peru (without which, the gas would have little or no commercial value), which would be financed in part by the IFC of the World Bank.  The Company’s Chairman, Fernando Zuniga was formerly a project officer for the Energy Division of the World Bank, a relationship which I suspect was helpful in securing the financing.  His son, Manuel Zuniga, is BPZ’s CEO. 

In October 2005, the Company announced an increase in its cost estimates for drilling and power plant construction and also stated it planned on selling power out of its future plant in late 2006.  As of June 2008, the Company has not completed that plant and has no near-term prospects of selling power.

In March 2007, the Company announced that one of its wells found oil.  I will discuss the tests and actual production history down below, but by the end of 2007, the Company had drilled several more successful wells and produced 41,000 barrels of oil.  

In March 2008, the Company released two reserve reports (which I will also discuss below in more depth).  These reports pertain to the Company’s main Corvina field.  The Company has also recently started to tout the potential of its Albacora field which they think can be of similar size. I believe the “blockbuster” Corvina reserve reports and comments by management have significantly contributed to driving the Company’s value to a market cap of over $2 billion (compared with around $200 million just 18 months ago).

The December 31, 2007 Reserve Report Referenced in the 10-K

With the filing of the 2007 10-K, BPZ released proved reserve estimates under SEC guidelines for the first time.  The report was prepared by Netherland, Sewell & Associates with the assistance of management.  The following are excerpts from the 10-K:

Royalties under the [Block Z-1] contract vary from 5% to 20% based on production volumes. Royalties start at 5% if and when production is less than 5,000 barrels of oil equivalent per day (boepd) and are capped at 20% if and when production surpasses 100,000 boepd.

As of December 31, 2007, we owned a 100% working interest in the Corvina Field, subject to Peruvian government royalties of 5% to 20% net revenue interest depending on the level of production. Our estimate of proved reserves have [sic] been prepared under the assumption that our license contract will allow production for the expected 30-year term for oil and 40-year term for gas, as more fully discussed under “Description of Block Z-1” above.  Based on forecast production volumes, the average royalty over the term of the license contract associated with proved reserves is expected to be 5.0%

The reported proved reserve number in the 10-K is 11.9 million barrels of oil (all in the Corvina field).  If management believes production will be less than 5,000 barrels per day (5% royalty = <5,000 barrels per day of production), then maximum annual production must be 1.825 million barrels, which would tell us that the most ambitious estimate of harvesting those reserves is 6.5 years (11.9 / 1.825).  Based on peers, this strikes me as a reasonable estimate of time to extract the resource.  However, when we look at the detail on the reserve report as disclosed later on in the 10-K, we can tell that a much more aggressive time frame was used in calculating a PV-10 (for investors not familiar with energy companies, PV-10 is simply the present value of the Company’s proved reserves after accounting for all costs – it is a helpful measure in determining the asset value of an E&P company).    Here is the disclosure given on standardized measure (after-tax PV-10), in millions:

The most striking aspect here is that the undiscounted cash flow of $651 million became $557 million after discounting the cash flows at 10% per year.  Given earlier comments that the proved reserve estimates were prepared under the assumption that daily production would be no more than 5,000 barrels per day, this calculation simply makes no sense.  Discounting $651 million of cash flows equally over 6.5 years at a 10% rate would equal around $460 million.  This report must have been prepared under the assumption that these reserves would be fully extracted within 3 years (for the PV haircut to be so small), which not only contradicts earlier comments in the 10-K, but it is not even remotely realistic, in my judgment.

Why is this so important?  Because I believe the value of this entire company is based on the reserve estimates and management credibility at this point.  If management may have gone so far as to include a clear and material misstatement in the 10-K which could be in violation of Sarbanes-Oxley Section 302, it is possible that they are being misleading elsewhere.  For example, I believe the production cost estimates are also unrealistic.  An average of BPZ’s peers have production costs of 17% of revenues in their PV-10 vs. 13% for BPZ and development costs of 16% for the peers vs. only 8% for BPZ.  I have included this in the chart down below.  It is particularly worth noting that the peers have already spent considerably more capital than BPZ, so if anything, I would expect BPZ’s future costs to be much higher and certainly not lower than the peer group.  As a result, I personally find the entire reserve report to be suspect.

The February 29, 2008 Reserve Report

In a February 29^th report, the Company took it up a notch.  Under guidelines set forth by the Petroleum Resources Management System (and not allowable in an SEC document), the Company increased its reserve estimates even further.  Since the value per barrel remained about the same after accounting for the commodity price increase from December to February, it appears that the aggressive assumptions on costs and timing remained in this report.

Production Levels – Something Isn’t Right

In March 2007, the Company tested well 21XD for 3,150 barrels of oil per day (bopd).  In April, the Company noted this number had increased to 5,900 bopd and also mentioned that another well, 16X, found some gas but no oil.  In September, the Company announced well 14D was testing at 1,700 bopd and later in the month increased this number to 2,400 bopd.

On November 14^th, the Company announced production had officially begun on November 1^st at Corvina after the successful well tests conducted earlier in the year.  The Company announced production of 10,000 barrels during the 2 week period.  The Company claims 21XD was producing at 2,500 bopd (lower than the 5,900 bopd test) and 14D was producing at 1,900 bopd (lower than the 2,400 test bopd).  However, 10,000 barrels per day over 14 days is 714 bopd.  Management claims the wells were flowing too much gas and they had to shut them for several days.  In any case, the wells are producing materially below levels initially indicated.  From November 14^th to December 31^st 2007, the wells produced 31,000 barrels or around 670 bopd between the two wells.  Management claims this was once again due to the need to shut the wells at times and some vacation time for Christmas.

In January 2008, the Company produced 45,000 barrels of oil or around 1,450 bopd.  On January 31, one of the Company’s tankers caught fire and sank, killing one person and injuring several others.  This was an unfortunate tragedy and an environmental concern. The Company was not allowed to resume shipping oil until June 2008. 

On April 1, 2008 the Company guided to 6,000 barrels of production per day when it resumed production.  On June 9, 2008, the Company announced it will miss its production targets and get to 6,000 barrels later than expected.  The current forecast calls for 6,000 barrels by Q3 and 8,000 barrels by Q4.  Keep in mind that wells typically decline by 25-50% in their first year, so even if the Company hits these seemingly aggressive targets at first, it will have to add several new wells to increase production to offset likely declines in the wells.

Thoughts on Value

So, what does this mean for the value of the Company?  Let’s start with the balance sheet for some perspective.  As of March 31, 2008, the Company had $182 million of assets and $126 million of equity.  Its current enterprise value is $2.1 billion or 14.5x its non-cash assets.  Offshore peers (ATPG, SGY, MMR, BDE, WTI, EPL and CPE) trade at 1.4x non-cash assets.  Put another way, the peers have assets, net of cash on average of $1.5 billion and enterprise values on average of only $2.2 billion vs. $144 million of assets, net of cash for BPZ vs. an enterprise value of $2.1 billion.

Perhaps, BPZ’s valuation is explained by its strong cash flow estimates.  No.  It trades at over 20x 2008 EBITDA vs. less than 4x for its peers. 

Then, it must be the significant reserve value.  This is trickier because we now have to rely on the suspect reports from the Company.  First, let’s take it at face value.  The Company is claiming $1.1 billion of pre-tax proved PV-10 (oil and gas) which will amount to about $850 million after-tax.  This is based on just proved reserves using February 29^th, 2008 commodity prices (the date of the latest report) and a methodology not allowable by the SEC.  Let’s compare that to the peers which used lower commodity prices in their SEC reports at December 31, 2007.  I will not upwardly revise the peers’ commodity price assumption to match BPZ’s (for conservatism).  On this basis, BPZ trades at 2.5x after-tax proved PV-10 vs. 1.2x for the peers.

But, as I stated earlier, there is considerable evidence to believe the BPZ reserve estimates are wildly optimistic.  Let’s dig into the detail filed with their 2007 10-K and compare it to the peer group to appreciate the magnitude of the aggressiveness. (Note: the dollar value of the BPZ assumptions was listed earlier in the standardized measure calculation if you want to derive my calculations).

As shown above, BPZ is more aggressive than the peers on every measure.  Most importantly, as I mentioned earlier, their 14.5% discount factor (which implies an average 3 year life vs. 6 years for the peers) is ridiculous given the limited capital invested to date, the poor production history, the production forecasts, the capital budgets, the technical capabilities, the low levels of proved developed reserves, barge capacity limitations and the general lack of availability of the necessary equipment.  If that wasn’t enough, keep in mind that the peers have already invested billions of dollars and are producing at high levels of cash flow today.  In my view, the fact that the production and development costs are lower than the peers is highly suspect when considering the minimal investment in these assets to date.  Furthermore, developed proved reserves are only 25% of total proved reserves vs. an average of 62% for the peers which also indicates BPZ’s future costs and discount factor should be higher.

So, what is a reasonable estimate?  In my opinion, if we use the average of the peers (which may be generous) for the statistics above and apply it to BPZ, it should give us a reasonable place to start.  This math would result in $395 million (starting with the $1.020 billion of revenue and applying the cost and PV assumptions of the group).  The peers trade at 1.2x this value, which would imply a $6 per share value for BPZ. 

One might say that I am being overly harsh because the Company has subsequently increased proved reserves and we haven’t even really addressed probable reserves or the Albacora field which they will explore next.  Or maybe the fact that oil prices have increased since February can account for the value.  Keep in mind that the peers have significant probable reserves and other fields to explore and the reserve reports for the peers have been done at prices from December 31, 2007.  Despite this, the stock market values this group on average at only a 20% premium to proved reserves. 

What would BPZ look like based on un-risked proved and probable reserves at higher commodity prices using my adjusted reserve value from above?  At the $395 million after-tax PV-10, the value per barrel is $33.  Let’s increase that by $10 for the increase in oil prices to $43 per proved barrel.  Based on the Company’s own February 29, 2008 report, the proved + probable value per barrel is 25% less than the proved value to account for the longer time and higher cost of extracting a probable barrel.  This means that we should discount our $43 per barrel number down to $32 when applying it to proved + probable reserves.  The proved + probable reserves are 37.8 million which equals $1.2 billion at $32 per barrel or $16 per share (which I would call a best case).  Call me a skeptic, but even this valuation would be very aggressive as the market would normally heavily discount probable reserves.  With regards to Albacora, it is unclear what value to ascribe to that.  Normally, the market would (and should) discount it heavily.  The latest report on that field was from 2006 and showed 19 million of proved and possible reserves (based on non-SEC guidelines).  We will likely see a significant upward revision to that number from BPZ.  But, discounting for time and uncertainty, I do not think this should be of significant value compared to the market cap of the Company today.

Other Considerations

Why push the envelope on the reserve reports?   The Company has had a high incentive to put out aggressive numbers.  Coming into 2008, the Company had $8 million of cash and a capital budget of $215 million.  In March, right after releasing the reserve report, the Company raised $40 million in a public equity offering.  Currently, the Company is negotiating with the IFC for $320 million of loan commitments (an extremely large single commitment for the IFC).  BPZ is not bashful about making the association of their oil discoveries and the financing on their web site:

Also, per the March 31, 2008 10-Q, it is clear that the reserve base matters for the critical financing discussions with the IFC:

What do analysts say?  They have nothing but great things to say.  In fact, they are so enamored with the “blow-out” reserve reports, that they hail how well this team has delivered.  They have overlooked the continued production disappointments and have readily accepted the production guidance for 2008. 

Earn-out share grants.  Oddly, the Company has paid out 18 million shares to a group including the CEO and Chairman of the Company based on hitting two goals.  Why it is that they would be entitled to an earn-out related to a reverse merger into a shell company is beyond me, but those shares are worth $486 million today.  The first 9 million shares were triggered by showing there were reserves present in the fields which they accomplished with a non-SEC Albacora report in 2004.  The second 9 million shares were issued based on 2,000 bopd of production which they needed to hit by the end of 2007.  They say they hit that on November 30, 2007 although as I explained earlier, the actually production numbers make that impossible to verify.  The CFO and COO (who were not involved in the earn-out) got 225,000 shares each for hitting that “goal” as well because I suppose it was in the best interest of shareholders to incentivize senior management to hit an arbitrary milestone that would cause 9 million shares of dilution.

Political Risk.  While rule of law currently prevails in Peru, we cannot forget that this is a country and a region with considerable political risk.  Normally, this would result in a heavy discount to the valuation.

Sinking Ship.  In its very limited production history, the Company has already been involved in a tragic sinking of an oil tanker.  I don’t have much more to say here, but I don’t think it reflects particularly highly on this company or their management.

Sarbanes-Oxley.  As I mentioned earlier, it appears to me that there is a clear and material misstatement in the 10-K (based on the proved reserves being prepared under a royalty using 5,000 bopd or lower but the PV-10 prepared under something closer to a 10,000 bopd assumption) that I believe one can reasonably associate with the dramatic rise in the stock price.  The Company also issued equity and insiders sold stock after this report was released.  Furthermore, they are currently negotiating with the IFC to lend them a significant amount of money secured by the value of these reserves.  To the best of my knowledge, this could present a serious problem.

Catalyst