Description

I think Harvest Natural Resources represents an attractive speculative long investment at the current price level. HNR has been written up several times in the past, most recently by reaux1318 3 years ago who did an excellent job of writing up the company and updating the story via the message board.

HNR is an oil company that owns two assets that are both potentially worth more than the current EV. But this stock also has a chance of going to zero due to a tight liquidity situation and questions on HNR’s ability to timely monetize its assets.

A lot of you are probably familiar with HNR as it has been trading at large discount to its potential value for many years due to sovereign risk from its Venezuela asset. What’s different this time is that management seems intent on trying to sell its Venezuela stake. This is coupled with the added risk that HNR’s current balance sheet does not give them a lot of time to figure things out.

Company Overview

HNR owns interests in:

Venezuela – This is the company’s most valuable asset. Harvest owns a 32% equity interest in the JV Petrodelta, operated by PDVSA, Venezuela’s state owned oil company. Petrodelta operates six fields with 9B BBL+ of gross oil in place. Petrodelta is currently producing about 37,000 BOPD and is cash flow positive despite running a massive drilling CAPEX program to increase production. There are several indications that under normal circumstances this asset should be worth a lot ($500M+):

o    1P and reserves net to harvest are 38 MMBOE, 2P reserves are 100MMBOE, 3P 200M+

o    HNR’s stake of Petrodelta’s 2012 operating income and net income was $95M and $54M

o    1P PV-10 is $562M, 2-P PV-10 is $1,146M, 3-P PV-10 $1.9B

o    Book value of Venezuela asset is $418M on HNR’s financials. 32% of Petrodelta’s book value is $243M

o    Failed sale of asset to Indonesia’s state-owned oil company Pertamina for $725M ($525M post tax)

However, this is an asset in Venezuela, and if HNR can never get any money out, HNR’s Petrodelta stake is worth $0.

Gabon – HNR owns a 66.67% interest in Dussafu, an off-shore exploration project with a 680,000 acre PSC. Gabon has a book value of $81M, with the company’s drilling program discovering oil prospects with combined 45MMBBL of 2P contingent reserves. Future exploration has potential to make this asset a sizeable resource (Panaro energy, the 33% owner of the Dussafu project has stated that it thinks the gross unrisked prospective resources could be as high as 500-600MMbbl).  This asset is potentially worth $200M-$400M, but there are two key issues that need to be overcome. First, is the resource size large enough to cover the CAPEX necessary to bring the asset to production? And secondly, how will HNR fund that CAPEX?

Indonesia – HNR owns a 71.5% interest in a 747,862 acre PSC. HNR has spent $62M in the last three years drilling two wells that turned out to be duds. The potential resource size here is huge – 700MMBBL+, which if successful would be a home run. HNR recently became the operator of this asset and is planning to drill another well (probably in 2014 if they make it), but I value this as a zero.

Oman – HNR spent $28M the last three years drilling 3 dry holes. Project is now abandoned and worth $0.

China - Written off. $0

Asset Value $M      Low        Reasonable Low         High     Notes

Venezuela              0                 300                     525      Reasonable Low - book value, high- Pertamina bid

Gabon                    0                 100                     400     Reasonable Low - rushed sale, high - self-development 

Indonesia               0                   0                       100

Cash after burn       0                   0                        20

Debt                    -80                -80                      -80

Total                   -80                320                      965

Per Share              0                   $8                    $21.20

So to sum up the above, Venezuela is potentially worth $300M-$400M and Gabon $100-400M, but all the assets also have a chance of being worth nothing.

Petrodelta Detail:

HNR owns 80% of Harvest Vinccler and has operated in Venezuela since 1992 (Oil & Gas Technology Consultants (Netherlands) owns the remaining 20%). In 2005, the government of Venezuela nationalized the oil industry, where PDVSA was given a controlling interest in all operating companies. In march of 2006, Harvest signed a MOU to convert the existing operating agreement to the Petrodelta JV. The key terms of the arrangement where that PDVSA would own 60% of Petrodelta and Harvest Vinccler would have a 40% interest, and Petrodelta will operate the fields for 20 years. While this nationalization was clearly a negative with Harvest Vinccler losing 60% of the equity of its operating company, the new arrangement did extend Harvest’s term and gave the JV access to three new fields.

During the conversion process, Petrodelta’s oil production dropped from a high of about 30,000 BOPD in 2004 to about 12,000 BOPD by 2007. Since the new agreement was signed, Petrodelta has since brought oil production up to 37,000 BOPD, with production likely to increase in the future due to the new JV’s active four (maybe five) rig drilling program. I think this production drop helps illustrate why Venezuela should have an incentive to not nationalize Petrodelta again, as a 60% ownership of a JV producing 40,000 BOPD would produce more government revenue than a 100% ownership of a JV producing 20,000 BOPD.

In 2011, Venezuela introduced a new windfall profits tax. While this illustrates another risk of operating in Venezuela, the tax makes Petrodelta’s value relatively insensitive to oil price changes, but also eliminates the equity upside to oil price spikes. The royalty is  20 percent for sales of oil between $55-80 per barrel, 80 percent between $80-100, 90 percent between $100-110, and 95 percent over $110. Taxes are Petrodelta’s largest operating expense.

In June 21, 2012, HNR signed an agreement to sell its Petrodelta stake for $725M to Pertamina. On February 19, 2013, Pertamina’s sole shareholder, the Government of Indonesia, decided to not approve the transaction. It is unclear exactly why Pertamina didn’t complete the deal, but it is likely that it didn’t agree with some of Venezuela's demands. HNR’s stock dropped 40% the next day to $5.45.

On March 19th, HNR filed that its auditor had declared the company a going concern risk, and declared the company had material internal control weaknesses. The company also announced that its 10-K would be delayed due to accounting restatements that needed to be made.  The stock dropped a further 32% to $3.70 on this news. The errors related to the incorrect capitalization of certain lease maintenance costs and certain internal selling, general and administrative costs. In addition there were errors in the presentation of certain cash flow items as well as asset impairments. The accounting restatements turned out to be largely a non-issue from an economic standpoint.

HNR has received $84M in dividends from Petrodelta since 2008. However a dividend of $9.8M was declared in November 2010 but this dividend, or any other dividends, have not been paid out since.

Petrodelta is truly a world class asset. It has a lot of oil and low operating costs. There is substantial upside to reserves and resources through more drilling and achieving higher recovery factors than modeled in reserve reports. HNR’s stake in Petrodelta would probably easily be worth $1B if it was in the U.S. The problem has never been around the asset, just that the asset is in Venezuela.  

PDVSA has been using Petrodelta as a source of cash for social programs, as well as selling oil cheaply to other nations as a geopolitical tool. This has led to PDVSA being in poor financial shape and dividends not being paid out to Harvest. It has also led to operational problems such as delays in paying suppliesr causing drilling inefficiencies and slowing production growth. A buyer of Petrodelta with deep pockets could solve a lot of the problems by putting some capital into the business. This would allow suppliers to be paid, drilling to increase, and production to grow rapidly, thereby solving some of PDVA’s/Venezuela's cash flow issues through higher royalties and taxes. The issue is that no company is going to want to put cash into Petrodelta unless they feel like they can be assured that at some point they will be able to earn a return on that cash through future Petrodelta dividends. With HNR not having the desire or ability to put more cash into Petrodelta it seems like Venezuela should be open to approving a sale as it is in their best interest.

Venezuela is in bad shape right now. Things will change at some point, if only because they have to. With the Chavez dead, Venezuela might start acting more rationally in order to save PDVSA and its country’s finances. Venezuela needs to increase its oil production to solve its financial problems, and will need foreign investment to do so. And to get foreign investment, it will need to show some that it respects contracts and will pay out dividends to foreign investors.  On the other and, it is probably tempting for Venezuela to view taking the other 40% of Petrodelta it doesn’t own  for free as a way to  quickly solve its financial problems. I don’t think this would  help their financial problems, and I don’t think this will happen, but it is a risk.

Gabon Detail:

HNR’s Dussafu prospect is in a highly prospective off-shore region of Gabon surrounded by other producing oil fields. A  total of 24 wells have been drilled on the block to date, of which 5 have been discoveries (4 oil and 1 gas) with oil shows present in most other wells.

-Walt Whitman – 4 MMBBL

-GMC-1X – 5 MMBOE (gas)

-Moubenga – 3 MMBBL

-Ruche – 11 MMBBL

-Tortue – 22 MMBBL

Total 2P contingent reserves - 45MMBBL

30 miles to the northwest of Dussafu is the Etame block, operated by 28% owner Vaalco Energy ($400M market cap), which is currently producing 17,000 gross BOPD from four fields, connected to an FPSO facility. A similar development strategy may make sense for Dussafu.

With the latest Tortue discovery, it is looking increasingly likely that Dussafu will be developed. Since Petrodelta is unlikely to be a near term source of cash through a sale or through dividends turning back on, Gabon looks like a good source of cash through farm-outs to buy HNR some more time. Gabon is probably worth $200M if HNR tried to sell it today vs. an NPV of $400M if it finds the money to develop the fields itself.  

How Much Time Does HNR Have?

HNR’s ultimate deadline is October 2014, when its $80M debt comes due. But without any corporate actions, it is likely to run out of cash about a year before then, in the fall of 2013. Harvest had $73M of cash and $40M of current liabilities at 12/31/2013. G&A is running $20-$25M/yr, interest will be $9M, and they might need to spend $20M in 2013 on exploration.

HNR’s management is aware of the crisis they are in are and seem prepared to do what is necessary to raise cash. Debt is not an option at this point, as they raised $80M in the fall of 2013 before the Pertamina transaction failed at 11%+ interest. And at these price levels, obviously equity issuance doesn’t seem to be a great idea. HNR was in a similar situation in 2011 when they sold their Utah properties for $215M. While the Utah properties were further developed than Gabon, they had much lower upside. The Utah sale price was likely low compared to the value that HNR could have realized through development, as is likely the case for any Gabon sale/farmout, but at this point, a sale at any decent price would likely be welcomed by shareholders.

HNR is going to put Petrodelta back on the sale block. The $725M Pertamina bid established a value for the asset, but is probably more of a ceiling of potential bids at this point. While I think HNR can ultimately sell the asset to someone, the bids may only net $300-$400M to HNR shareholders with the deal not closing quickly enough to fix the liquidity situation. HNR is also unlikely to receive Petrodelta dividends soon enough to sole the liquidity situation. The upside to a Petrodelta sale this time around is that with the Gabon success, it is more likely that a deal for all of HNR is possible, which could mean several dollars of increased value to HNR shareholders through tax savings.

So that leaves Gabon and Indonesia to save the day. HNR has stated that they will try to farm out Gabon and Indonesia by late summer. CEO James Edmiston stated on the recent conference call regarding farm outs: “I expect to be receiving bids sometime in the July timeframe and have them consummated late August, September.” I am not expecting anything to materialize from Indonesia unless they show some drilling success first, but I think  selling something like half of HNR’s Gabon stake for ~$100M is possible to timely complete. This would give HNR time to realize something closer to full value on its remaining assets.

Thoughts on Management

I view CEO James Edmiston and generally honest and competent. The company has had some exploration failures over the years like Indonesia and Oman, but also some successes like Utah and Gabon. If you ignore the liquidity situation, the company has likely increased intrinsic value with its pursuits outside of Venezuela with the Utah and Gabon successes outweighing the other exploration expenses and G&A. I don’t have the knowledge to say how much of the success vs. failure was derived by skill or luck though. The Utah transaction and the failed Petrodelta transaction show that the company is willing to take reasonable bids for asset sales. I also think it is important for Edmiston to remain CEO to help negotiate the sale of Petrodelta as he has a long history there

Worst Case/Conclusion

So worst case HNR is a zero, but I think that is unlikely. Let’s say that HNR needs to raise $80M to buy the time to realize the value of its assets. If it can only raise equity at $2.25/share, it will bring the share count to 75M shares. If Harvest can eventually realize $600M, then that is still $7.90/share. If it can only get $200M, then HNR would be worth $2.65, down 15% from today. If HNR cannot raise cash and declares BK, there may still be residual equity value by suing Venezuela and getting restitution through arbitration. Let’s say that process takes 5 years and HNR gets book value of $300M, while spending $10M/yr on G&A and litigation. Discounted at 15% would result in an enterprise value today of $115M. HNR could also potentially spin out Gabon/Indonesia.

So I think the realistic downside is fairly low, let’s say $2.50/share, while the upside is tremendous at $8/share+. I think HNR should probably be trading in the $5 range at this point and is worth a small allocation for those willing to face the risk of a total loss of investment.

Catalyst