Description

Genel Energy (Genel) is a high-risk arbitration idea that should be sized accordingly. However, I believe the risk-reward is asymmetric. The thesis revolves around a legal arbitration with the Kurdistan government where the potential outcomes look very appealing and the timeline could be relatively short, offering potentially an interesting CAGR. The scenarios are numerous and varied though, as the situation is somewhat unique and unpredictable, making it difficult to quantify or model with any degree of certainty.

The company is listed on the London Stock Exchange, with its primary operations focused on oil production in the Iraqi Kurdistan. Genel was a significant player until 2014 oil price crisis, which saw its market capitalization drop from USD$3 billion to USD$75 million, or 11 pence per share. Now it is essentially an arguably undervalued asset with no debt. Currently, its market cap stands at £210 million, which translates to approximately US$260 million. The company holds USD$363 million in cash against USD$248 million in debt, resulting in a net cash position of USD$115 million. Moreover, it's owed USD$107 million by the Kurdistan Regional Government. Considering the net cash and outstanding receivables, the company effectively has a net cash position of USD$222 million against a market cap of USD$260 million. This implies an enterprise value of USD$38 million.

Furthermore, Genel had strong cash generation in 2022, generating USD$235 million in free cash flow from 3,000 barrels produced, and paid out USD$50 million in dividends.  Looking back at 2021, even amidst lower oil prices, Genel maintained a similar production level of 31,000 barrels. Despite challenging market conditions, the company generated USD$239 million, with USD$86 million in free cash flow and USD$44 million in dividends paid out.

With a current enterprise value of USD$38 million and the potential balance sheet improvement upon receiving outstanding government payments, I would argue this idea already presents significant upside potential on a standalone basis. However, there are a three relevant catalists that make this a timely idea in my opinion:

The arbitrage:

The Kurds are the largest ethnic group globally without its own sovereign state. Instead, they span across regions in Iraq, Syria, Turkey, and Iran. Notably, the semi-autonomous Kurdistan region in northern Iraq, governed by the KRG, has achieved a degree of sovereignty amid geopolitical tensions, particularly after the Iraq War and subsequent American intervention. Geopolitically, this region is highly strategic, given its history and the involvement of various stakeholders, including the Kurds as allies of the United States in combating threats like ISIS. However, this alliance often leaves the Kurds vulnerable to shifting geopolitical dynamics.

Currently, Iraq stands as a significant oil producer, producing over three million barrels daily. Notably, production from Kurdistan, which once reached nearly 500,000 barrels, has been disconnected. In this context, seve), publicly traded companies, such as ShaMaran Petroleum Corp (SNM.V) , DNO ASA (DNO.OL), and Genel, operate in the region.

The events of 2014, marked by the oil price crash, prompted the Kurds to take independent measures. They initiated pipeline projects from Kirkuk, where these companies operate, to the port of Ceyhan in Turkey. Instead of utilizing Iraq's State Organization for the Marketing of Oil (SOMO) for export, they arranged their own crude shipments. These transactions often involved discounts ranging from 10% to 20% off international prices, facilitated through banking channels in the United Arab Emirates. This arrangement enabled Kurdistan to secure immediate funds without passing through Baghdad's central authority.

It so happens that Erdogan, upon assuming power, had a son-in-law with various entities in offshore tax havens. This person established a company in Turkey aimed at constructing pipelines and exporting oil. Conveniently, when Erdogan was in good terms with Barzani, the Kurdish president, Erdogan granted exclusive export rights to his son-in-law's company. Consequently, Erdogan and his son-in-law profited from the price differentials in transportation, while the Kurds maintained relations with the Baghdad government.

This arrangement led to an international dispute arbitrated in Paris, which took nine years to resolve, culminating in Iran's victory over Turkey regarding Kurdish oil exports. Turkey faced substantial penalties, with additional claims against Baghdad for unpaid taxes. Consequently, Turkey received notification of the penalties and promptly ceased operations, disconnecting the pipelines to avoid further legal complications.

This sudden cessation of Kurdish oil exports, accounting for nearly half a million barrels, significantly impacted global markets. Such a volume is substantial in a finely balanced market. Moreover, the halt in exports affects stakeholders in Turkey, Kurdistan, and Iraq. Since March 2023, exports have remained halted, impacting regional dynamics and global oil markets significantly.

This situation involves substantial sums of money, and efforts are underway to reach an agreement. Essentially, Baghdad seeks to bring Kurdistan back into compliance and restore oil exports according to its terms. There was an agreement dating back to 1973, whereby Turkey pledged not to directly engage with Kurdish oil. However, this agreement was breached. Kurdistan, too, has been complicit in this disregard for some time, along with publicly traded companies that followed suit.

However, Baghdad has not contested the validity of contracts with these international companies in Kurdistan. Instead, they aim to renegotiate these contracts to ensure control over cash flows before redistribution. Consequently, Kurdish companies have seen significant declines in their stock prices. Genel Energy, for instance, dropped from £2 to around 75 pence, reflecting a two-thirds decrease in its valuation. Presently, they're only selling oil domestically, fetching prices between USD$30 and USD$35 per barrel.

Genel has initiated a rigorous cost-cutting program, halting production and relinquishing licenses for fields like Taq Taq and Tawke. These fields, once yielding around 120,000 barrels per day, have seen a significant reduction in output, currently around 67,000 barrels. Genel has downsized its workforce by two-thirds and completely abandoned fields like Sarta. They've very much cut all non-essential expenses, reduced costs across the board, and initiated local sales. Since March, they've reported no cash burn, even with a significantly reduced production level of around 16,000 barrels per day, selling at USD$30 to USD$35 per barrel. This illustrates how efficient operations can be in Kurdistan.

General owns two gas fields, primarily Bina Bawi and Miran, where Genel conducted explorations initially yielding oil but later discovered significant gas reserves. Genel invested substantially in expansions and stake acquisitions, including a 21% stake purchase in OMV, an Austrian company, for USD$240 million, valuing pre-existing production at approximately USD$2 billion, considering gas findings. The majority of reserves in Bina Bawi are gas, with oil equivalents totaling around 1.5 billion barrels. These are significant assets that Genel aimed to develop and produce.

However, in August 2021, the Kurdistan government announced plans to revoke Genel's licenses in the region, alleging a lack of a serious and realistic development plan from Genel. Genel, naturally, took action. In December 2021, they announced their intention to pursue international arbitration against the Kurdistan government. Despite efforts to reach an amicable resolution, legal recourse became necessary.

A hearing is about to begin at the London Court of International Arbitration, scheduled to last two weeks. This marks a pivotal moment in the dispute between Genel and the Kurdistan government. It's crucial to note that, unlike in other disputes, Kurdistan isn't alleging anything against Genel. There's no counterclaim asserting that Genel owes them money, acted improperly, or failed to meet investment plans. They're simply stating that Genel opted to discontinue operations, indicating a rather straightforward case.

Genel asserts that the termination of the Production Sharing Contract (PSC) by the Kurdish government was wrongful and entailed significant damages. Genel invested USD$1.4 billion in acquiring stakes in that block, as well as in capital expenditures and developing those fields. The claim amounts to USD$1.4 billion plus interest, opportunity costs, and other related expenses. Remarkably, Kurdistan isn't seeking any damages from Genel. They anticipate the arbitration award to be finalized by the end of the year.

This detail is significant. Mentioning "the end of the year" indicates a conservative estimate. In the presentation, which consists of just a few slides, we learn more about the arbitration process. The hearing, scheduled for two weeks starting on February 19th, is confidential. This confidentiality extends to the timing of any announcements. It's unlikely that there will be press releases, updates, or responses to public inquiries until the final award is rendered. The timing of the award is uncertain, but it's anticipated to occur in 2024. However, this arbitration process isn't typical; it's conducted through the London Court of International Arbitration, a private venue known for swift and efficient proceedings. Therefore, even though the expectation is for the award in 2024, it's likely a cautious estimate.

Look at the previous case resolved in the International London Court of International Arbitration involving the Kurdistan Regional Government. It was an arbitration case with a company called Dana Gas, which also had a consortium with Crescent Petroleum, a Saudi company. In this consortium, there were also national companies like OMV from Austria, MOL from Hungary, among others. While this case isn't about asset theft, it involved various disputes. Dana Gas claimed they were paid below-market prices for oil, weren't compensated for condensate, and weren't allowed to perform farm-outs as other companies joined the consortium. Kurdistan, in turn, countered with several claims, making it a complex case. However, Dana Gas emerged victorious, receiving awards against Kurdistan.

In the Dana Gas case against the Kurdistan Region of Iraq, there was an initial oral hearing from April 20th to 24th, 2015. This indicates the rapid pace at which matters are resolved in the London Court of International Arbitration, which issued a partial final award on June 30th, 2015, just two months and one week after the oral hearing. This award, totaling USD$1.98 billion. The second partial final award was issued on November 27th, 2015, again within a short period after the oral hearing on September 21st. This award amounted to USD$1.98 billion. The third award was issued on January 30th, 2017, after the oral hearing between September 12th and 16th, 2016. Although this process took about four and a half months, it's essential to note the complexity of the case, as evidenced by the numerous claims and counterclaims.

Considering the swift resolution of these cases, the potential for a quick resolution of the arbitration against the Kurdistan Regional Government could serve as a significant catalyst for Genel's stock price. And while there's no defined timeline for issuing an award, there's a crucial element to consider: parties appearing before this tribunal commit to accepting the final decision and refrain from further claims. This is highly positive. Furthermore, given that Genel isn't presenting any counterclaims and the defense from the other side appears weak, it's reasonable to expect a favorable outcome. The fact that they've spent USD$1.4 billion on capex and had a contract dating back to 2014 strengthens their case.

Some may argue that even if they win a USD$2 billion award, chasing Kurdistan for payment might be futile. However, there's a secondary market where these awards can be bought and sold, often at significant discounts, offering potential additional cash flow for Genel. Looking at the Dana Gas case, it's worth noting that Kurdistan paid USD$1 billion in cash, with a portion earmarked for reinvestment in the country, while the remaining debt was converted into tax benefits. Genel could potentially sell its stake in Tawke to its partner, DNO, which holds 75% of the license, at a considerable profit margin. Currently, with production at full capacity, Genel's flowing barrel is trading at around 8,000, significantly undervalued compared to similar companies. Selling its license in Tawke, which produces 30,000 barrels per day, could fetch around 50-60 million, given the favorable tax benefits and negotiating power with Kurdistan. This exit strategy might seem disappointing for Genel but could translate into a two to three-bagger for investors if they receive a substantial award and sell their stake in Tawke.

The reopening of the pipeline:

If Turkey doesn't reopen the pipeline, the oil won't flow. Similarly, if Kurdistan and Iraq don't reach an agreement, everyone loses because every day Kurdistan doesn't export oil results in significant losses. Therefore, there's a mutual interest in resolving the pipeline issue and ensuring oil flows smoothly. So sooner or later, a solution will be reached regarding the pipeline issue and the distribution between Kurdistan, Turkey, and Baghdad. In parallel to this, Iraq is looking to modernize its contract types, moving from service contracts to the classic Production Sharing Agreements (PSAs). This transition aims to make the sector more attractive for investment, decentralize decision-making, and create a more favorable legal framework, especially in Kurdistan.

When the oil starts flowing again, there will likely be a surge in activity, not only in Kurdistan but also in the broader Iraqi industry, thanks to the improved legal framework and security. While Kurdistan may not export to Turkey at the steep discounts seen before, the international companies like Genel may face tougher negotiations. However, they'll be selling at global market prices, which should offset any potential loss in percentage or revenue.

The outstanding A/R with the government:

As mentioned at the beginning, General is owed USD$107 million by the Kurdistan Regional Government, a common practice in the region where payments are often delayed but eventually fulfilled.

Catalyst

Resolution of the Arbitration: The swift resolution of Genel Energy's arbitration case with the Kurdistan government could lead to a favorable outcome for the company, potentially resulting in a significant financial award. Instead of paying the award in cash, Kurdistan might return the two licenses, providing a way to settle the arbitration without a hefty cash payment.

Reopening of Pipelines: Any developments indicating the reopening of pipelines for oil exports from Kurdistan would positively impact Genel's revenue and stock price.

Resolution of Kurdistan's debt to the company: Once paid, this could significantly boost the company's stock price.