Description

Harvest Natural Resources represents a compelling opportunity to invest in an asset and cash rich company that can easily double in the course of the next year and potentially even triple within a couple of years.  Amazingly, these types of outcomes are quite achievable even though an investment in Harvest has the significant downside protection afforded by the fact that the company will soon have a net cash balance exceeding 50% of its market capitalization. 

How can such an attractive risk/reward skew exist?  Well, the company’s largest asset resides in Venezuela, which has been reason enough for most investors to toss Harvest out without second thought – in fact, to such an extreme that I believe the current price borders on the absurd and offers low downside and tremendous upside.  Furthermore, a recent sale transaction of similar assets supports a valuation of Harvest of more than 2x the current price.

I will go into more detail below, but first I will provide a quick summary of the current situation.  Harvest has been operating with a strong track record in Venezuela since 1992 through its 80% owned Harvest Vinccler subsidiary.  Through 2005, Harvest had been operating the oil-rich South Monagas Unit (SMU) when Venezuela converted all operating agreements to mixed companies and imposed additional taxation and royalties on these companies.  As a result, Harvest Vinccler received a 40% stake in a newly-formed company called Petrodelta, which is 60% owned by the Venezuelan national oil company, PDVSA.  The deal actually was a wash for Harvest from a value standpoint as the mixed company was granted three other significant fields as compensation and Harvest’s license to operate the SMU was extended by five years (from 15 to 20).  Interestingly, during this period, Harvest was not able to recognize its interest in Petrodelta for GAAP purposes and only recently has this asset (and related income) again been recorded on the books. 

This period of uncertainty caused Harvest’s stock to fall from a high of $18 in late 2004 to a low of around $9, before drifting back up to the low teens.  Despite finalizing the conversion and removing this uncertainty, Harvest’s stock has come all the way back to around $9 recently (which is particularly surprising given the fact that oil prices have roughly doubled over that time and the company’s assets have soared in value).  The primary reason for the recent decline has been a change in sentiment as Venezuela has imposed a “windfall” tax on oil companies operating in the country.  I will discuss this a bit more later, but I don’t believe the impact to be particularly large and certainly the benefit of the rise in oil prices offsets any negatives.

Today, Harvest’s assets consist of its cash at corporate, a receivable from Petrodelta to account for the cash that has built up there during the past two years, its interest in Petrodelta and a smaller exploration portfolio around the world that could produce relatively large upside potential over time (Gabon, Indonesia, US Gulf Coast and China). As of March 31, Harvest had $3.33 per share of net cash at corporate (note the small debt shown on the balance sheet resides at Harvest Vinccler and is collateralized by restricted cash).  In the next 30 to 60 days, the company will receive around $40 million from Petrodelta, which will amount to another $1.13 per share in cash.  On top of that, I estimate Harvest has a share of around another $0.51 of cash that is sitting at Petrodelta that may be distributed in the near future. 

The estimated assets of the company are listed below in a variety of scenarios.  I think the low to high cases show a reasonable range of trading outcomes for Harvest, but I also showed a downside and upside to show the tails.  The downside presumes the worst case scenario of an expropriation by Venezuela for zero consideration – I believe this is incredibly remote, but I wanted to show it anyway.  The upside illustrates how much potential asset value exists as well as how dramatic the upside opportunity is here.  In all cases, I valued the corporate cash and the dividend receivable the same as there is little to no risk around these values.

The dividend receivable is not disclosed in the public financials, but management discussed it on the recent conference call – $30 to $50 million paid to them in 30 to 60 days (I used $40 million).  Next, I estimated the company’s share of the undistributed cash at Petrodelta.  This is based on looking back at the operating cash flow over the past two years which I estimate to be around $180 million at Petrodelta of which Harvest owns 32% or around $58 million.  This $58 million will be reduced by the dividend received of around $40 million, leaving $18 million or $0.51 per share.  In the extreme downside case, I have assumed that Harvest would never see this cash.

Next, I looked at Petrodelta’s reserve value.  Simply put, Petrodelta has a tremendous amount of asset value.  I would suspect that Harvest will ultimately produce at least the proved and probables (2P) and history would tell us that they may be able to recover more than the proved, probables and possibles (3P).  This is supported by the fact that Harvest has recovered 27% of the oil in place from the SMU from 1992 to 2006.  The current reserve estimates include very conservative assessments of a recovery factor of 12% on the current asset base since Harvest has only recently received the new fields.  However, the geology of these new fields is virtually identical to the SMU and it would not be inconceivable to see recovery rates closer to those enjoyed over the past 15 years.  As you can see below, I have provided various haircuts to the proved, probable and possible reserves to show a range of reasonable outcomes.  As I just mentioned, it is important to note that taking the recovery factor up only a few points can add tremendous value here.  The values I have used are based on an independent report from Ryder Scott, adjusted for my estimates of the recent tax changes and forward oil prices (the net effect is around 10% lower than the numbers in the report).  I have severely discounted them to account for the uncertainty of operating in Venezuela.

Finally, the company’s exploration projects in other regions of the world have the potential to be significant, but there is no way to value these with any precision.  I have assumed about $0.50 per share in the Base Case, zero in a Low Case, and in the High and Upside Cases, I assumed they can be worth multiples of the Base Case.  In reality, they could yield significantly more value, but again, it is impossible to quantify.

In summary, I believe a reasonable trading range for Harvest is between $12 and $31, with the most reasonable estimate being in the low-20s or over double the current price. 

I think there are significant catalysts that are unfolding that should cause the stock to more appropriately reflect its intrinsic value:

1)  Petrofalcon/Anadarko Transaction.  My estimated valuation of Harvest’s interest in Petrodelta is supported by a very recent transaction.  In April 2008, Petrofalcon (PFC CN) acquired 100% of Anadarko Venezuela for $8 per 2P BOE (after deducting royalties), a price that would equate to a Harvest stock price of over $20 per share.  The acquired fields are adjacent to Harvest’s and for what it’s worth, Harvest management believes Petrodelta’s fields have considerably more exploration upside potential.  Also, since the transaction, Petrofalcon’s share price has increased almost 50%.  I think this transaction should serve as a powerful benchmark in determining what Harvest is worth.

2)  Ramp up of Production and GAAP Earnings.  While the conversion process was taking place, the production out of the SMU declined from 30k barrels per day to around 15k barrels per day as new drilling ceased.  Now that the conversion is complete, drilling on the SMU and the new fields should take production up to closer to 40k barrels within a couple of years.   This should produce GAAP earnings of around $1.30 per share by 2010.  By then, Harvest should also have over $6 per share of cash.  Deducting the cash plus $0.50 for the exploratory assets results in a net P/E that will be under 3x at that time if Harvest’s price does not appreciate.  Given that production should go even higher from there (based on August 21, 2006 release the company stated production could grow to 75k BOE or more by 2011), I think this valuation highlights how dramatically undervalued Harvest is. Also, during the conversion process, the company was not able to recognize the earnings or assets from Petrodelta under GAAP until the final outcome was certain.  In 2007, the conversion process was completed and only recently has Harvest actually started recording income from this asset, which should bring attention back to the earnings power of the company.

3)  Increasing Proved Reserves.  Harvest will be drilling extensively over the coming year to prove up probable reserves.  Given the rich geology of these fields and Harvest’s track record, this should lead to a significant increase in proved reserves over the coming years, which should increase Harvest’s valuation.

4)  Possible Sale of the Whole Company or the Petrodelta Interest.  The stark discount between the public and private market value of Harvest increases the possibility of a sale transaction or a sale of an interest in Petrodelta.  As I mentioned earlier, the Petrofalcon/Anadarko transaction demonstrates that the private market value of Harvest is at least $20 today.

Background

Harvest Natural Resources has operated in Venezuela since 1992 through its 80% owned subsidiary Harvest Vinccler.  Until 2005, the Company operated in the South Monagas Unit which includes the Uracoa, Bombal and Tucipita fields, representing some of the most oil rich fields in the world.  According to the United States Geological Survey, the Orinoco Belt (the area around these fields) is the “largest single hydrocarbon accumulation in the world”.  In 2005, the government of Venezuela converted all operating agreements to mixed companies, in which PDVSA (the state-owned oil company) would have a controlling interest.  On March 31, 2006, Harvest signed a MOU to convert the operating agreement to a mixed company called Petrodelta. The key terms of the arrangement were:  (1)  PDVSA would own 60% of Petrodelta and Harvest Vinccler would have a 40% interest (therefore, Harvest would have a beneficial 32% interest in Petrodelta), (2) the agreement would be retroactive to April 1, 2006 (which would entitle Harvest to back payments once the deal was finalized), (3) Petrodelta will operate the fields for 20 years (up from 15 years under the former arrangement), (4) Petrodelta would pay a 50% tax rate and incur a 33% royalty and (5) the company was contributed several new fields (Isleno, Temblador and El Salto) that are adjacent to the SMU. 

The conversion was approved in June of 2007 and finalized in the fall of 2007.  During the process, Harvest was unable to report its interest in Petrodelta for GAAP purposes.  With the most recent 10K, the company has once again started recording this asset and related income.  Based on a recent Ryder Scott report conducted in December 2007 when WTI was $91.50, Harvest has a net interest of 44 million BOE of proved reserves (1P) with an after-tax present value (PV10) of $523 million, 75 million of proved and probable reserves (2P) with an after-tax present value of $790 million, and 147 million proved, probable and possible reserves (3P) with an after-tax present value of $1,483 million.  In total, these reserves represent $42 per share of 3P value from these fields.  However, the story is even more interesting since the 3P value assumes a recovery rate of the total oil in place of only 12% which is dramatically below the 27% recovery rate that Harvest has experienced at the SMU.  As the company commences its drilling program over the coming months, I would expect the 1P, 2P and 3P values all to increase.  

It is important to point out some of the attractive attributes of these assets.  At around $5 per barrel, the operating costs in these fields are among the lowest in the world, which provides a nice high margin income stream even at substantially lower oil prices.  Second, most of the costs are fixed, so as Harvest ramps up production, its operating cost per barrel should fall meaningfully.  Finally, replacement costs are only around $4 per barrel which will provide for extremely high incremental returns on capital.

Recently, Venezuela imposed a “windfall” tax on oil sales in the country which amounts to 50% of the excess of Brent Crude over $70 per barrel and 60% of the excess over $100.  The tax is in turn deductible to Petrodelta.  The net effect of this tax should be to lower the value of the reserves by about 20% when oil is between $70 and $100.  However, since the forward price of oil has appreciated by at least 10% since the reserve value was measured at year end, I think the decline in the value from the Ryder Scott report looks more like 10%.  Therefore, the after-tax 3P value from above should be around $38 per share after the tax change takes place.

At the end of March 2008, Harvest had $117 million in net cash or $3.33 per share.  Additionally, Harvest expects to receive $30 to $50 million in dividends related to Petrodelta’s 2006 and 2007 operations, which will amount to around $1.13 per share in cash.  Finally, I estimate that Harvest should also have an interest in Petrodelta’s cash balance that amounts to around $0.51 per share.  In total, in the coming months, Harvest’s cash balance should be around $4.97 per share, representing over 50% of its current market price.

In addition to the cash and Petrodelta assets, Harvest has exploration assets in Indonesia, Africa and China.  The Indonesian assets consist of 1.4mm acres on shore in Budong-Budong and the African assets consist of 680,000 acres offshore Gabon.  Additionally, the company has 6.2 million acres in the South China Sea.  Also, the company recently announced a venture in the Gulf Coast where it will provide drilling, engineering and operational services and fund the first $20 million of lease acquisitions.  Management believes these projects could result in material value to the company, but given their early stage, I am hesitant to ascribe much value to them.

Thoughts on Venezuela Risk

The obvious issue one has to assess when considering an investment in Harvest is what is the risk associated with Venezuela and Hugo Chavez.  While I am certainly no fan of Hugo Chavez and the Venezuelan government, I do not believe the real risks posed to Harvest are anywhere near the level being reflected in the stock price.  Most importantly, it is in the interest of Venezuela to have a company like Harvest operate the fields.  Before they took over, the recovery rate in the SMU was only 8%, which Harvest has been able to increase to 27%.  With the royalties, taxes and 60% ownership in Petrodelta, the value from increased production that Harvest brings to the situation is significant.

Also, while I believe this fact makes severe government action highly unlikely, in prior cases (for example, the mixed company conversions for the oil industry, the privatization of CANTV in 2006 and the privatization of utility EDC in 2006), the government gave meaningful consideration for any change in economics or privatization.  While political risk is inherently difficult to assess, I think even in the worst case of a privatization, any proceeds that Harvest would receive as compensation for its stake would likely exceed its stock price (not because Venezeula is so generous, but because Harvest’s stock price is so low). 

While uncertainty will always remain with regard to Chavez’s next moves, I believe after the changes imposed over the past few years, he is in a position now where the government gets the value it needs out of the oil assets to fund its social projects.

Finally, the Petrofalcon transaction provides a meaningful private market benchmark for how to discount the Venezuela risk.

Petrofalcon Transaction

In April 2008, Petrofalcon (PFC CN) acquired 100% of Anadarko Venezuela for $200 million.  Additionally, Petrofalcon received a voucher for new oil and gas investments with a face value of $58 million.  Given the uncertainty around the exact usage and value of the voucher, I believe it is appropriate to discount it meaningfully.  Using a 50% haircut, the enterprise value paid to Anadarko is $171 million or about $8 per 2P BOE (after deducting royalties).  This valuation would put Harvest’s interest in Petrodelta at $15 per share, consistent with the Base Case valuation I used above, and would point to a Harvest stock price of over $20 per share.  Also, it is important to point out that since the deal was announced, Petrofalcon’s shares have appreciated significantly. 

Catalyst