Description

Dragon Oil (DGO) is a mid-size, growing E&P company based in Dubai, incorporated in Ireland, and traded in London, with its main producing assets in Turkmenistan (arguably, the most important single risk but one that has not to date led to major issues). The key to the long thesis is DGO’s balance sheet and capex plans – the cash on the balance sheet at 9/30/08 is $820mm, or an astonishing 68% of the current market cap, with no debt. Depending on oil prices, DGO should be able to invest in expanding its operations without severely impairing this position – we currently assume $500mm in 2009 capex vs $340mm of CFFO, at $49/bbl realized prices. Assuming the forward curve is correct, DGO should return to generating FCF in 2010, a year in which we assume only 10% production growth (vs 25% in 2009).

In addition to its attractive cash-bolstered valuation, there is an upside option which we give no credit for, namely the commercialization of its 3.4Tcf natural gas resource. The company is currently investing on the assumption that this will be a successful venture but the timeline is somewhat fluid, making ignoring it the conservative choice for valuation analysis at this stage.

DGO’s output is governed by a production sharing agreement (PSA) which was signed with a state agency of the Government of Turkmenistan in May 2000. The PSA has a 25-year term which expires in May 2025 with an exclusive right on the part of Dragon Oil to negotiate an extension for a further period of not less than 10 years.

Per the 2007 annual: a report from an independent energy consultant [Gaffney Cline] certified the remaining recoverable proven and probable oil reserves of 659 million barrels of oil and condensate at 30th June 2007 in the Cheleken Contract Area. On 31st December 2007, the remaining recoverable proven and probable reserves stood at 651m barrels (after adjustment of production in 2H 2007), of which the Group’s entitlement under the PSA as at that date was 324m barrels of oil and condensate. In addition, the independent energy consultant estimated contingent gross gas resources of approximately 3.4 trillion cubic feet in the contract area. Dragon Oil is on course to complete the recertification of the reserves in Turkmenistan later in 2008 and the fully-revised field development plan will be finalized by the middle of 2009.

A reassuring feature of DGO is that it is 52%-owned by ENOC, which is one of the main Dubai state-owned enterprises. In fact, DGO has its head office in Dubai, which it rents from ENOC. Furthermore, the Group avails itself of services from ENOC, including internal audit, general administration and engineering services. DGO is one of two upstream equity positions owned by ENOC (Dubai itself is not rich in oil or gas reserves, unlike its neighbors).

Exports of crude oil are undertaken through two routes – Neka in northern Iran and Baku in Azerbaijan. In 2007, 8.7m barrels were sold, of which 83% (2006: 89%) were routed through a swap arrangement with a subsidiary of the National Iranian Oil Company. The company currently assessing alternative routes including the Baku-Tbilisi-Ceyhan pipeline and Makhachkala in Russia.

Valuation -

Share Price (GBP)		1.64	2P Reserves at YE07		325	*attributable under PSA
GBP-USD FX Rate		1.4411	EV/boe Oil (ex gas)		1.19
Share Price (USD)		2.36
Q3-YTD Production		21,476
Shares Out		510.771	EV/bpd	17,942
Market Cap (USD)		1,205.3	Projected FY09:
P/E			7.8
Net Cash	820.0	EV/EBITDA	1.1
EV	385.3
Cash as % of Equity		68%

(Note, we have assumed crude oil prices approximating the Brent forward curve, ~$49/bbl average for 2009.)

For comparison, a basket of London-listed E&Ps trades closer to 5x 09 EBITDA.

Growth –

Management in 2007 committed to growth in average daily crude production of 25% for the subsequent three years, and achieved this level last year and this year. In fact, the Q3 production rate of 42,320 bpd, YTD up 32% [average 1H08 production of 38,482 bpd (up 36% YoY; 20,850 bpd attributable to the company)] suggests that DGO is ahead of plan. Note, DGO’s entitlement under its PSA decreased due to the full recovery of capex in 2007.

•  DGO had an expectation of spending at least $300mm in infrastructure in 2H08 + 2009 (excluding drilling costs); $330mm for development (development/appraisal wells, workovers) and $40mm for “field/other"
•  Targeting 10 wells in 2009
•    Projects include:

o   New trunkline - November 2009 completion target @ a cost of $170 million

o   Increased CPF processing capacity to 100,000 bfpd - December 2009 completion target @ a cost of $37 million

Natural Gas Option –

Per the company, “Dragon Oil is committed to the commercial utilization of the gas resources within the Cheleken Contract Area“. As mentioned, the company has substantial gas resources (3.4 Tcf). The commercialization plan being pursued includes separation of LPGs to be exported with crude; dry gas to be exported 70km to government facility – which will entail the construction of a gas treatment plant; the FEED study is underway and should take ~6 months.

Turkmenistan Risk -

DGO comments re Turkmenistan:

·         “Strict adherence to the PSA terms resulting in a spirit of full cooperation with the Turkmeni authorities.”

·         “Steady increase in the number of Turkmen staff employed with approximately 90% of field based manpower now originating from Turkmenistan.”

·         "I am pleased to announce that the CEO and I recently had a very constructive meeting with the  Vice  Prime Minister of Turkmenistan and the Director of the Agency for the Use of Hydrocarbon Resources to discuss the Company's strategic development programme. Dragon Oil and the Government of Turkmenistan continue to enjoy a strong relationship and we look forward to building further on that relationship in the years ahead."   [from 10/22 interim release]

The recent history of Turkmenistan – regarded by some, under the prior regime, as the most closed country outside of North Korea – is perhaps not the most inspiring in terms of confidence in business practices. However, there does appear to be a slow integration unfolding with the rest of the world (beyond Russia, that is). An illustration is the conference attended by US Energy Secretary Bodman last year – his speech is contained in this link: http://www.energy.gov/news/5715.htm

DGO has sold off with the rest of the energy complex. However, if investors are looking to buy into energy today, a growing company with a fortress-like balance sheet like DGO should be considered.

Catalyst

Production and drilling updates; natural gas commercialization progress