Description

Summary

Harbour Energy (HBR) is the largest independent London-listed o&g company. The thesis on HBR is simple and timely: 

On July, 5th its shareholders will vote on HBR’s most transformational M&A deal so far, the acquisition of virtually all of Wintershall Dea’s non-Russian upstream assets. If the deal gets accepted (which it very likely will: normally ~70% of shareholders attend HBR’s meetings, and >35% of the total vote has already been secured), HBR will at the stroke of a pen: Triple its 2p resources (from 0.4 bnboe at YE2023 to 1.5 bnboe), increase its annual production by ~170% to >500 kboepd, decrease its unit operating cost by >25%, and increase its FCF by >130% - but maybe most importantly: It will shift 2p resources from >90% UK Continental Shelve (UKCS) to >75% outside of the UK. 

Even if I value all the production of NewCo coming from the UK at zero, I arrive at an upside of >50% for the next ~12-18 months. Including the (for reasons explained in a minute) already discounted production form the UK, the upside becomes > 100% in the same time frame.

The discount exists due to panic about the future of the UK’s o&g producers.  At the moment, everyone – from the financial media to industry analysts– is too distracted by threats of the UK’s Labour Party which is likely to win the upcoming General election (also to happen next week). They announced they will introduce additional taxes and remove investment allowances on o&g production coming from the UKCS. Especially the removal of the investment allowance will have devastating consequences for the o&g industry in the UK to the point that analysts warn this will kill o&g production from UKCS altogether. What is overlooked in this panic is that all these taxes only apply to production from the UKCS. Meaning: The fact that NewCo will make the dramatic shift in production footprint to outside the UK is basically never mentioned.

Details

HBR is a has been written up once by unlatchmergers in November 2018. The company is public since April 2021 and was built through a series of mergers and reverse mergers – please see his/her writeup for details.

Also, this picture from one of their presentations illustrates this quite nicely – and it also shows that the acquisition of Wintershall-Dea (WD) if approved will be the biggest in its history:

…and will place Harbour solidly onto the global scene along much better known names like Marathon, Hess and Aker:

HBR has a market cap of 3.9bn and will buy WD’s assets for 11.5bn USD in a deal that both the financial press and rating agencies have called “transformational”. But the question is: Aren’t they getting ahead of themselves with such a big deal? Short answer: no. Longer answer: The deal has been structured in an extremely smart way which likely will lead to HBR receiving an investment grade credit profile (up from the current BB rating). The slide below gives a good overview but a few extra infos are important:  

• HBR will assume 4.9bn USD of WD’s bonds – at an interest rate of just 1.8% and a maturity of 4.5 years, so at a very cheap rate which is even below the interest rate of many national banks. Indeed, management has declared this as one of the most important sources of synergies because of the reduced costs of finance.

• HBR will pay 2.15bnUSD in cash which they will partly be able to finance from the “interim cash flows” from WD. Meaning: If the deal is voted for by shareholders, it will become effective June 30 2023, i.e.: HBR will receive all cash flow earned by WD since then plus will be able to take some cash form the target, too. All in all, this will amount to 600mUSD from WD’s cash flows from the 2nd half of 2023 alone plus some 200mUSD cash WD brings along. Since the deal is not to close before E2024, further cash flows will come along from both HBR and WD, and it’s likely that little will remain of this deabt at E2024. But just to be on the safe side, HBR has arranged for a bridge facility of 1.5bnUSD to cover the gap.

• Finally, HBR will issue 921m shares at 360p/share to WD’s owners, BASF and LetterOne, a ~13% premium to the current share price, and a premium of >40% vs HBR’s share price during 2023 when the deal was negotiated. This will bring the total share count to about 1.7bn shares.

As written in the introduction already, securing shareholder approval is likely. Afterwards what remains to be done, is getting regulatory and governmental approvals / consents. Given that 2023 was a record year for o&g M&A with more than 300bn USD of deals announced (more than double that of 2022), I don’t think this much smaller deal will be much of an issue.  

Why are these assets on the market? 

The deal is made possible, because of a “failed marriage” of two parties. WD is owned by German chemical company BASF and by LetterOne, a company owned by two Russian oligarchs, who have been sanctioned due to their links with Russia. BASF wants to leave the energy sector, but LetterOne doesn’t. Include the complications of having Russian oligarchs involved, and you could in a way call this a fire sale.

Also, and importantly, LetterOne itself is not sanctioned itself. Nevertheless, HBR management took steps to ensure Harbour was distanced from any potential negative impact related to the situation. This includes several things, but in particular: LetterOne will receive no voting rights and no board representation (vs. BASF receiving two board seats). In exchange, LetterOne will receive a 13% premium on any dividend paid on the ordinary shares. 

Why does the overall situation/discount exist? 

You all remember Ben Franklin’s famous quote on death and taxes being both unavoidable. In this case, though, they might well be the same: After Russia’s attack on Ukraine, o&g prices skyrocketed and so did inflation and cost-of-living expenses. To counteract this, in May, 2022 UK’s Tory government introduced a “temporary” windfall tax on o&g profits form the UKCS, the “Energy Profit Levy” (EPL), with the aim to use the proceeds to help reduce the impact of inflation. Initially the tax was set at 25%, but then it got increased to 35% in January 2023, bringing the total tax rate for o&g production to 75%. This “temporary” tax is set to expire in March 2028, unless prices drop significantly.
But it gets worse: Coming week, the UK will have its General Election, which UK’s Labour party is set to win. The party has already announced it wants to increase overall taxes on North Sea oil and gas companies further to 78%, the same as Norway, but in addition: they want to take away the investment allowance where 29% of taxes are claimed back if reinvested (very different from Norway which counts as “investment friendly” for o&g). So, a headline tax of 78%, with investments not deductible. Unsurprisingly, this caused the cancellation of a number of large projects in the UKCS with many analysts warning that this will significantly reduce production coming from the UK (and some even declaring this to be “the death of North Sea Oil”). Also, price targets for UK based producers got cut. Here is an excerpt from a recent interview with Chris Wheaton, an o&g analyst at Stifels: “… the higher levies would create a “multi-billion pound paradox” where the overall tax take is lower because projects are cancelled and production will fall, and [we] cut price targets for […] Harbour Energy (HBR) […] as a result.”

The funny thing about this interview? Chris Wheaton is also the analyst covering HBR, and has been outright enthusiastic about the upcoming deal with WD, yet does not mention a single word on its implications for production footprint in his recent interview. Here is him during the M&A call on December 21st (while the interview excerpt is from June!): “…I think I'll allow you to wreck my Christmas holiday just for this deal, which is I think brilliant, so well done for getting it done before Christmas as well. […] I think this is exactly what you should have been doing as you will have seen from a lot of the research I've been writing.”

Even the FT, which covers UK-based companies in more depth, is mainly focused on the implications of the further tax hikes, and several longer articles that discuss this issue have been published in the last few months. The HBR-WD deal, though, has only been discussed in two articles on Dec 21st and 22nd just after the deal has been announced. Both these excerpts show, that while people do understand the great implications of the WD acquisition for HBR, they are frozen in panic and therefore rather focus the debate on the tax implications for the sector in general.

Yet another plus: An extremely savvy and shareholder friendly CEO

HBR is run by Linda Cook who has been the CEO of Harbour since 2021. Previously, she was Chairman of Chrysaor, and has had tenures in majors and supermajors before joining Harbour Energy in several operational roles, but also in strategic roles. She retired from Shell in 2010, when she was a member of the board of directors and the Executive Committee. At Shell, she held positions including Chief Executive Officer of Shell Gas and Power (London); Chief Executive Officer of Shell Canada Limited (Calgary); Executive Vice President Strategy and Finance for Global Exploration and Production (The Hague). Rumor even has it that in 2009, she was close to the nomination as CEO of Shell.

This combination of a strategic view and deep operational expertise has been very beneficial for shareholders. Indeed, since becoming public in 2021, HBR has not only managed to reduce its net debt from >2.1bn USD (which largely was caused by its MA activity) to 0.2bn USD at the end of 2023 – it has done so while maintaining its dividend and a buyback program for its shares which in combination have returned >1bn USD to shareholders. (As a little fun fact on the side: The last 200m USD buyback program completed in September bought ~66m shares at an average price of ca. 240p - a discount of 33% over the price of the shares being given for WD.) 

For this merger, management is intent to repeat the same, and even plans to increase its dividends:

Valuation 

Because most of WD’s production is coming from Norway (see slide below), and because of a similar high statutory tax rate, the best peers for the valuation of NewCo are similarly sized Aker BP and VAR Energy.

Below are key KPIs for the set of companies. 

• Note that Net Debt is YE2023 with exception of NewCo where I took YE2024, the time when the deal is set to be completed.

• Also note, that for FCF I used company methodologies to calculate them. That is: Operating CF minus CAPEX for Aker and Var, and Op. CF minus CAPEX minus interest and lease liabilities for HBR and WD, i.e. HBR’s calculation is somewhat more conservative. In addition, HBR and WD will significantly reduce hedging starting in 2025, with the potential to increase FCF even further.

Norway’s assets are in general less mature than the UK’s and so are cheaper to operate. Add in the taxation differences discussed above, and it clear that we cannot simply compare NewCo’s EV/kboepd multiple to that of Aker and Var. 

Instead, we only apply an EV/kboepd of 48 (i.e. mid-way between Aker and VAR) to the production coming from WD’s asset, but value the rest of the production at zero!, we arrive at an EV for NewCo of ~15.4 bn USD, which translates into a share price of ~6 USD, an upside of >55%. Note that this is conservative since it assumes that all production of WD is coming from Norway with its high o&g taxes.

If we apply HBR’s current EV/kboepd multiple to its UK production alone, and add this to the above, we arrive at a share price of ~8USD, an upside of > 100%.

Loose ends

I’ve mainly focused on the WD deal due to its timeliness. In addition to its upstream assets though, HBR also owns 60% of “Viking CCS”, one of the UK’s largest infrastructure for Carbon Capture and Storage (CCS). While no money will come from this before at least a few years’ time, management already now is intended on using this in negotiations with the government. Here is an excerpt from the last earnings call: 

Analyst: “…Could you remind us of if there is indeed such a thing, a connection between the 2 sides of the industry, oil and gas and energy transition or CCS in terms of the U.K. fiscal framework as it is or in terms of how discussions with the government on such things?”

Linda Cook:  “…we do make this point in our engagements with the U.K. government, is that companies like ourselves need cash flow and a supportive general investment climate if we're going to participate in these kinds of projects. So there is a link sort of, at least in that regard, to how companies like ourselves look at investing in CCS in the U.K.”

 Given the bargaining power that comes from the CCS assets towards an incoming Labour Government which is keen on using CCS for achieving its ambitious CO2 reduction goals, I wouldn’t be surprised if the current debate on taxing o&g is too pessimistic which would add further upside potential to the estimates made above. 

Risks

• O&g price volatility

• Vote on WD deal fails

• No regulatory approval for WD deal

• Approvals go through but HBR messes up integrating WD (unlikely given HBR’s and management’s significant M&A and operational experience)

Links to Sources that might be harder to find:

Interview Stifel analyst: https://www.investorschronicle.co.uk/news/2024/06/17/companies-roundup-north-sea-stocks-rio-tinto/

Financials of WD (in particular p. 73, 91, 120 for FCF): https://www.harbourenergy.com/media/gldlxz1p/18-circular.pdf

For the most recent overview of the HBR-WD transaction, got to the “investor presentation” (not “presentation”) under this link: https://www.harbourenergy.com/investors/acquisition-of-wintershall-dea-asset-portfolio/acquisition-documentation/

Catalyst

• Shareholders vote for WD deal (on July 5th), then completion of regulatory approvals (until e2024)

• Significant improvement of all key financial metrics (after approval)

• Increase of dividend rate (after approval)