Description

Hartshead Resources NL (ticker: HHR AU Equity, “HHR”) is an owner and operator of multiple gas fields in the UK Continental Shelf (“UKCS”).

It will stand to benefit from the investment incentives that have been created by the UK windfall tax regime, apart from the apparent energy price and security concerns related to the war in Ukraine.

There is a convincing 2.5x upside from current prices in the near term based on a precedent transaction, with further developmental catalysts on a longer horizon that can lead to higher multiples.

HHR has an ADV of $97k over the last 3 months.

Background

• HHR is the 100% owner and operator of License P2607 which comprises five blocks in quadrants 48 and 49 on the United Kingdom Continental Shelf (“UKCS”), in the Southern Gas Basin which it won in the UK 32nd Offshore Licensing Round, effective 1 December 2020.

• These resources were left behind when ConocoPhillips decided to decommission key infrastructure on exiting the Southern Gas Basin. Production from the associated fields ceased in 2018 and the licences returned to the UK government.

• HHR then reverse-listed into Ansila Energy NL, an ASX listed E&P company in February 2021 to raise A$8 million of new equity and was renamed Hartshead Resources NL shortly afterwards. 

• On 23 June 2022 HHR announced the publication of a Competent Persons Report with Phase 1 2P gas reserves of 52.4mmboe.

• During August 2022 HHR raised another A$11 million at a price of A$2.7c, to progress Phase 1 development and support working capital.

• HHR is currently running a farm-out/partnering process which it expects to conclude during Q1 2023.

• HHR management, and in particular Chris Lewis at the helm, look solid and very competent.

The Energy Profit Levy and the Super-Deduction

• The Energy Profit Levy (“EPL”) was introduced on 26 May 2022, as a 25% add-on tax on ring fence profits of UKCS oil and gas sector, raising the headline tax rate from 40% to 65%, sunsetting on 31 December 2025.

• On the 17th of November 2022, during the Autumn Budget Statement it was confirmed that the rate would increase from 25% to 35% and that the period would extend to 31 March 2028.

• Much less media attention was given to the “super-deduction” investment allowance that was enacted concurrently, which allows for 91.40% of the intended effect of the Energy Profit Levy to be extinguished. 

• So, if one were to fully utilise this super-deduction, the EPL can be reduced from 35% to 3%, resulting in a 43% headline tax. Which brings it arbitrarily close to the pre-Energy Profit Levy headline tax of 40%.

• The office for Budget Responsibility (“OBR”) has estimated the tax revenue impact of the Energy Profit Levy as follows:

Source: OBR

• Subject to the OBR price assumptions (which look reasonable), the table above sums to  about ~£32bn of EPL revenues over the next 6 years.

• The OBR said the following in making these forecasts (emphasis mine):

“The EPL also includes a new investment allowance, which will encourage some companies to bring forward or increase planned investment. But that incentive is weighed against greater instability in the tax regime and the fact that these temporary high tax rates will remain in place until 2028 – factors that are likely to discourage some investment decisions. Our forecast assumes that these positive and negative effects offset each other leaving investment unchanged, but this is highly uncertain.“

Variant View

• The mid to small cap EPL payors will look to rationally offset as much of the EPL as possible via the investment allowance.

• The best way is to initially drill/expand into existing assets at hand, but if/when exhausted to then search for third party owned UK assets to engage upon.

• An interesting consequence will be that EPL payors would likely want to farm into third party owned assets by providing fully carried interest (i.e. CAPEX fully funded) as a way of transferring some of the super-deduction investment allowance benefit towards reducing the outright purchase price of the assets so acquired (which price itself is not tax-deductible), maximising tax efficiency.

• It is casually noted that it would logically make sense to invest into negative NPV projects as a tax mitigation strategy, however unlikely it may sound.

• The total pool of cash that might be chasing UK North Sea assets/capex is huge (~£32bn, see OBR numbers above) and too large for the immediately available opportunity set, which means that large cap EPL payors (Shell, BP, Harbour Energy etc.) will struggle in the mitigation.

• We think all the above should benefit HHR.

Valuation

• HHR 2P reserves stand at 52.4mmboe, which means that EV/2P is $1.10.

• Cornerstone Resources Group (“Cornerstone”) transaction:

  • Cornerstone acquired assets during the 32nd Licensing Round.

  • 85% of its 2P reserves were farmed out to Petrogas North Sea Ltd leaving Cornerstone with a 15% fully carried interest

  • Upon inspection of the CPR report for this private transaction it can be derived that Petrogas acquired their net share of 2P reserves at an EV/2P of $3.61, by way of paying cash amount upfront and transfer of the 15% fully carried interest

  • Further economics that concern prospects or 2C resources are ignored for valuation purposes.

• If we apply this deal metric to HHR we get an implied value of A$ 10c share for an upside of 2.5x.

• Because Cornerstone was perceived to be a forced seller due to an expensive convertible bridge loan to an IPO that did not happen after extensive marketing, there is probably further upside to the pricing point achieved here. Furthermore, Petrogas was actually not an EPL incentified buyer, even though there were EPL sensitive bidders competing as we understand it.

• There are other ways to look at valuation comparables that show further support for upside in the near term and in the future, to be discussed in the comments if so interested.

Catalyst

Conclusion of the farm out process by Q1 2023 and the announcement of development milestones thereafter.