Description

Harvest Natural Resources, Inc. (HNR) - Long Idea

Investment Thesis

Harvest Natural Resources is an undervalued E&P stock with tremendous downside protection.  It offers a compelling opportunity to get exposure to a recovery in oil prices with little risk.  But we don't need oil prices to recover for the investment to generate an excellent return. 

Harvest has 3 assets.  First, it has a producing oil asset.  It is in Venezuela.  That is the biggest risk to value, but as we discuss below, the stock is cheap valuing Venezuela at zero.  And the probability that Venezuela is worth zero is very remote.  HNR's Venezuelan asset is its minority interest in Petrodelta, also discussed below.  Petrodelta is self funding, and its cashflow in excess of capital requirements have been distributed as dividends historically.  In 2008, Harvest received net dividends of about $75 million (net to its 32% interest in Petrodelta) or $2.28/share, which is roughly four times the current enterprise value of HNR.  Second, HNR has a series of non producing exploration opportunities.  Third, it has cash.  There is $3.47/share of cash on the balance sheet.  There is no debt.  The stock is $4.00.  At $40 WTI, we value Venezuela at $4.75/share, and the other assets at $2.25/share.  At $30 WTI, HNR would operate at breakeven cash from operations.  HNR has no commodity hedge in place, due to its cash position.  Importantly, it doesn't need to access the credit markets to fund its non-Venezuelan operations.      

Venezuela

HNR's main asset is Petrodelta.  From 1992-2007, Harvest Natural Resources' subsidiary, Harvest Vinccler, had been providing operational services to Petroleos de Venezuela, S.A. (PDVSA) under an operating service agreement.  However, Chavez nationalized the Venezuelan oil industry in 2006.  As a result of the change in Venezuelan law, Harvest Vinccler transferred all of its tangible assets and contracts, permits and rights related to the Uracoa, Tucupita, and Bombal fields to Petrodelta and converted its operating service agreement into a minority interest in Petrodelta.  Petrodelta was a PDVSA affiliate.  As compensation for this transfer, Venezuela extended the life of HNR's drilling contracts and also contributed additional 3P reserves (the Isleno, El Salto, and Temblador fields) to Petrodelta.  Petrodelta is 40% owned by HNR Finance and 60% owned by Corporacion Venezolana del Petroleo (CVP), which is an affiliate of PDVSA.  HNR Finance is 80% owned by Harvest Natural Resources and 20% owned by its partner, Oil & Gas Consultants.  Therefore, Harvest Natural Resources has a 32% net interest in Petrodelta. 

Venezuela country risk is not insubstantial.  And anything can happen.  But we find it somewhat instructive that in the recent past, nationalization resulted in reasonable compensation for HNR assets.  A wipeout is unlikely.  And the margin of safety is high.

This margin of safety results from the company's production sharing contracts and exploration acreage offshore the People's Republic of China, offshore the Republic of Gabon, and onshore Sulawesi in the Republic of Indonesia.

Financials

With $30 WTI, (~ $24 oil for Petrodelta), we conservatively estimate that the company would operate at breakeven cash from operations.  This includes all G&A, which is conservative.  Fixed costs are very low.  Oil is easy to extract, and labor is cheap.  The company has no material hedges in place.

We estimate the current cash balance is $114 million.   Analysts are forecasting capex of $45 million in 2009.  We estimate that the majority of the capex is committed, and not optional, since it has $29 million in commitments remaining for the Gulf Coast, Indonesia, and Gabon exploration projects.  As stated above, Petrodelta is self funding.   

With oil prices at $45 per barrel, the company should be able to generate $14 million in cash from operations in 2009.  As a point of reference, in 2008 the company generated $60 million in cash from operations with oil at $100 per barrel, and lower daily crude production than forecast in 2009.  

Valuation

Excluding the company's assets in Venezuela, the company has net assets of $5.75 per share, comprised of cash of $3.47 per share (the company has no debt), Fusion worth $0.82 per share, and an international exploration portfolio worth approximately $1.43 per share.   We estimate that the company's assets in Venezuela are worth an additional $4.75 per share, currently.  The table below summarizes out our sum of the parts analysis:

Notes:

• (1) Acquired 47%-55% in the Budong, Indonesia PSC by committing to fund the first phase of the exploration program for $17.2-$20.0 million. Through September 30, 2008 Harvest incurred $5.7 million of this amount.
• (2) Acquired a 67% interest in the Gabon (West Africa) PSC for $6.0 million.
• (3) The exploratory well on the first Gulf Coast prospect, the Harvest Hunter #1, was spud September 10, 2008.
• (4) Fusion is a technical firm specializing in geophysics, geosciences, and engineering. In October 2008, HNR approved the purchase of an additional 4% interest in Fusion for $2 million.
• (5) EV / Boe multiples are discounted to reflect Venezuela risk.

Investment Risks

The first and most obvious risk is Venezuelan country risk.  Another related risk is that Venezuela, a founding member of OPEC, has recently agreed to cut output.  As a result, Harvest provided an operations update, announcing that gross oil production for Petrodelta is expected to average 18,000 Bopd, based on the government allocation of the OPEC quota.  This is down from previous analyst estimates of 20,000-30,000 Bopd (ramping to 30,000 by the end of 2009).  The venture remains self funding at the new, lower rates. 

Upside may be limited due to the the amended Windfall Profits Tax, which established a special 50% tax to the Venezuelan government when the average price of the VEB exceeds $70 per barrel. In a similar manner, the percentage is increased from 50% to 60% when the average price of the VEB exceeds $100 per barrel. The amended Windfall Profits Tax is reported as a reduction in the price per barrel received by Petrodelta from PDVSA and, consequently, is deductible for Venezuelan tax purposes. Petrodelta reduced oil sales revenue for the three and nine months ended September 30, 2008 by $34.1 million and $56.2 million, respectively, for the amended Windfall Profits Tax.

Catalyst

Recovery in oil prices.

Successful projects in Indonesia, Gabon, or Gulf Coast.

Increased production in Venezuala (reversal of OPEC output cuts).