Description

Quick pitch

Buyout with a unique structure that’s obscuring the potential to produce high annualized and absolute returns.

**I submitted this writeup as my application a couple of weeks ago, so some of the language around dates and prices is slightly off.

**The stock trades in pence (denominated with “p”), but reports in USD Dollars (denominated with “$”). 

**I wrote this writeup over the course of the week of May 1-5 and use a current share price of 7.5p for my calculations, which was about the average for the week. 

**I use a currency conversion of 0.8 $/£. Hurricane trades in pence, but reports in USD.

Overview

Hurricane Energy plc (AIM: HUR £150MM/$190MM) is an upstream offshore oil producer with one well located in the Lancaster oilfield just north of Scotland. Hurricane fully owns license blocks 205/21a, 205/22a, 205/26b and 205/22b in Licence P1368 (Central) that make up the Lancaster oilfield, which is about 110 miles north of Scotland at an average depth of around 500 feet. They also own adjacent blocks P1368 (South), P2294, and P2308, some of which have been explored, but none have been developed.

At this time, Hurricane operates a single well in Lancaster oilfield, which is connected to Bluewater’s Aoka Mizu Floating Production Storage and Offloading (FPSO) vessel. The Aoka Mizu is currently under indefinite contract at a day rate of $75,000 and 8% royalty. In their most recent financial statements, Hurricane has averaged 9,000-10,000 bopd with a self-reported 98% operational uptime. 

Start up and early production

In 2017, initial geological surveying estimated contingent resources of 129.1-1,116 MMbbl in a fractured basement reservoir of P1368 (Central). Historically, oil companies have stopped drilling once they hit basement rock, but more recent research has suggested that there could be significant reserves deep in the basement rock in pockets where hydrocarbons can accumulate. Operating fractured basement reservoir wells are rare globally, and the well at Lancaster oilfield was the first and only attempt to-date to develop what could be substantial oil assets on a shelf off the northern coast of the UK.

The Aoka Mizu first arrived at the Lancaster oilfield in March 2019 and a well was drilled. Early testing and pumping indicated strong pressure that they estimated would enable them to lift 20,000 bopd at 100% uptime. Full operations began to ramp up in June 2019 and early results exceeded expectations, with flow and pressure surpassing estimates even without the assistance of an electric submersible pump (ESP).

2020 and their “Profoundly Challenging Year”

Hurricane entered 2020 with a high degree of energy and optimism, but the Chairmain ultimately and accurately described the year in their annual report as “A Profoundly Challenging Year.”

Several things went wrong in 2020. Perhaps least surprising among them was the fact that the collapse in oil prices caused by the COVID-19 pandemic significantly impaired the company’s finances, with global oil prices falling to $13/bbl in April 2020.

While this ultimately proved to be a temporary blip, the more concerning development of the year was a rapid decline in well pressure and flow, with daily rate falling to 10,000 bopd despite adding pressure, which was significantly below their estimated 20,000 bopd production when they tested the well a little over a year earlier.

As a result of these operational challenges, they reassessed the Lancaster oilfield, which led to a substantial downgrade of contingent resources from 129.1-1,116 MMbbl to 11.3-86.9 MMbbl, with 4.1-9.1 MMbbl of developed reserves. This resulted in a write-down of the carrying value of Lancaster field of $567.1MM and a write-down of deferred tax of $54.2MM, resulting in a tax loss of $625.3MM for the year. 

Hurricane has two large shareholders who together control 45% of the company. The largest shareholder is a £200MM UK activist fund called Crystal Amber, who owns 29% of the company. The second largest shareholder is Kerogen Capital, a self-described “private equity fund manager specialising in international energy,” with “$2 billion in AUM.”

The board initially proposed wiping out 95% of Hurricane’s equity to pay of $50MM of their $230MM convertible bond, which was set to mature in July 2022. Crystal Amber and a majority of other shareholders opposed this restructuring. A High Court Judge sided with shareholders and denied the board’s restructuring attempt. Crystal Amber then proceeded to fire the non-executive board and brought in two new directors.

2021 and their “Year of Profound Change”

In a saga fit for the booms and busts of oil and gas, 2021 turned out to be a stellar year for Hurricane as oil prices surged and the company was able to stabalize long-term flow around 9,000-10,000 bopd through a variety of strategies. They started paying off their debt and accumulating cash. As of December 31, 2022, the company held $122MM of cash net outstanding debt.

2022-Present: the opportunity

The company attempted to pursue further drilling in their licensed territories, but in September 2022 the North Sea Transition Authority (NSTA), which licenses and governs offshore oil and gas in the UK, denied their request. Following this development Crystal Amber expressed its desire to monetize the company and stated that they did not support a growth strategy.

An unsolicited offer of 7.7p/share cash offer was made in November 2022, which the company rejected, but this catalyzed the commencement of a formal sales process.

On March 16, 2023, Hurricane announced that twelve companies had engaged in the sales process leading to five actionable offers.

The offer that Hurricane’s board recommended to shareholders, with support from both Crystal Amber and Kerogen Capital, is a fairly complex offer made by Prax Exploration and Production, which is a subsidiary of Prax Group, a $10-billion revenue British oil conglomerate. Prax is currently a midstream and downstream producer, but wants to branch into upstream production. Hurricane not only offers them a cash-producing entry into upstream production, but their unused tax losses from the write-down of Lancaster reserves in 2020 also supplies them with a vehicle to do future tax-advantaged acquisitions (this is important later on).

Prax’s offer was for total consideration of up to 12.5p/share, a ~75% upside from the ~7.2p shares were trading at just before the announcement. The share price subsequently fell to ~6.5p on high volume and has since stabalized around its pre-offer price of 7.2-7.5p/share.

Why did the market react negatively to Prax’s offer?

To start, the offer was broken into four payments:

1. 0.83p/share cash consideration made at the time of the transaction

2. 3.32p/share transactional dividened, payable within 14 days of the arrangement becoming effective

3. 1.87p/share supplementary dividend, the timing of which is subject to Hurricane cash reserves

4. An exchange of one Deferred Consideration Unit (DCU) per share, which pays out up to 6.48p between now and the end of 2026, subject to performance of the Lancaster well (based on a 17.5% revenue royalty rate).

At first glance, this looks like a bad offer, especially compared to their 7.2-7.5p share price and the 7.7p cash offer they were made in late 2022. The reason shares likely sold off to ~6.5p is because payments #1-3 above add up to 6.02p and the market briefly valued the DCUs as nearly worthless. 

I’ll dig into the details of the offer and why I think that it actually offers high annualized return potential with a decent margin of safety, but first, I want to fully catch up to the present situation.

On May 2, 2023, Hurricane announced that it lifted 541,000 barrels from Aoka Mizu. This significantly derisked payment #3 above, which I’ll expand on below.

On May 4, 2023, shareholders officially approved Prax’s offer with 87.55% voting in favor. The acquisition is expected to close in June 2023.

Payment items #1 and #2 above are straightforward, but #3 and #4 both come with caveats, which I believe is a big reason why shares have not traded higher.

Let’s start with payment #3. The official terms of items #1-#3 is that they are to be paid out using Hurricane’s restricted cash. As of December 31, 2022, the company had cash reserves of $200MM and debt of $80MM, which is equivalent to 5.19p/share of cash and 4.95p/share of cash net of debt. Payments #1-3 total 6.02p/share, slightly higher than what they had at year end. 

However, the scheme stated that so long as at least 450,000 barrels were lifted in the then upcoming lift (the one that occurred on May 2nd), the full supplementary dividend would be paid with the incremental cash. Since 541,000 were ultimately lifted, there should be no problem fully paying out #1-3 above within a few weeks of the acquisition closing in June, for a total of 6.02p/share. 

I view this 6.02p floor as the margin of safety for this investment as I think there is very little risk that full payment of items #1-3 isn’t made. At the current share price of 7.5p/share, your max loss is 1.48p/share, or about a 20% downside. And that’s before valuing the DCUs at all.

For the purposes of illustration, I’m going to assume the deal closes in June and the DCUs start paying out in the second half of this year, as expected.

The DCUs are essentially a royalty agreement where holders are entitled to 17.5% of revenue from oil lifted from Lancaster through the end of 2026, up to 6.48p/share. The deal was structured this way because of the risk of operating a single well, and given that both reserves and flow at Lancaster have been below what was initially expected. 

It’s also worth noting that Prax management is personally incentivized with a £3.5MM payout spread across employees if and when the DCUs reach their max payout.

My first question when I saw this payout structure was, do they have the resources to fund the DCUs after the write-down in reserves? With 1,990.4MM shares outstanding, in order to hit the full 6.48p they need cumulative DCU payments of ~£139MM, or $161MM. Backing that out of the 17.5% royalty rate, we need cumulative revenue of $920MM. The average price of oil over the last two years (post the COVID crash) is around $80/bbl, which implies 11.5MM barrels lifted, about equal to the low end of contingent resources and exceeding developed reserves. This means capex will likely be required to reach the full payment, but that won’t affect Hurricane shareholders as Prax will foot the bill and our royalty is based off revenue. Hurricane management has stated that they believe drilling a second well and injecting water would speed the flow of oil from the well significantly. I think that in the end, there should be enough oil to make the full payment, though the well prematurely running dry is a risk.

Even if the well runs dry, there is almost certainly plenty of oil to make a strong return (as illustrated below), and there are other ways we will likely reach the full payment while extracting fewer total barrels from this well (also explained below).

Let’s talk about a bear case first and consider the outcome where we get a repeat of 2020 with oil prices plummeting. And not only that, but instead of rebounding, they either stay low all the way through 2026, or the well starts producing significantly lower output. Even in 2020 when they nearly went bankrupt, they managed to lift $180MM of oil. In 3.5 years of lifting at those levels, they’d hit $630MM, or £504MM. Their 17.5% cut leaves £88.2MM. With 1,990.4MM shares outstanding, that works out to 4.43p/share. 

So in this case, we don’t make it all the way to the full 6.48p/share payment, but we still get back 10.45p/share overall and make a 39% profit. Furthermore, I would argue that since investors can reasonably expect to get back the 6.02p/share from items #1-3 within the next couple of months, really the only capital you have tied up long-term is the 1.48p/share difference between the current share price and the sum of payments #1-3. In this case, we turn 1.48p/share into 4.43p/share in 3.5 years, about 37% annualized. I know this is a bit wonky and doesn’t account for the rest of the capital being tied up for a couple months, but I think looking at both calculations makes sense to analyze the potential payoff.

There is a risk that the well stops flowing alltogether, but I think that over a 3.5 year period they are unlikely to do worse than what happened in 2020 when they had issues with COVID, historically low oil prices, and with the well itself. They have now been operating at near 100% uptime for a couple of years and flow has normalized, though it is slowly declining, as one would expect. Prax is both financially aligned and capable of doing the necessary capex on the well if and when it’s needed.

Even in a bad outcome, I think that investors would likely receive enough distributions to be made whole on their share price purchase today. In order to pay 1.48p/share, we’d need a total royalty payout of £29.5MM, or $36.8MM. That equates to required oil sales of $210MM over 3.5 years. Let’s circle back briefly to the 541,000 barrels they just lifted last week. Management estimated that they only needed to lift 450,000 to make payments #1-3, so they’ve already lifted 91,000 that under the terms of the DCUs should be eligible for distribution. At an average price of $80/bbl, Hurricane should already have $7.28MM of the $210MM in excess cash reserves on the day of the acquisition. Just a couple more lifts of this size, and shareholders will be made whole.

The worst-case scenario is that the well fails the day after the deal closes, but even in this case, Hurricane would sustain more tax losses and I think it’s likely Prax would use the company to make an acquisition, which would contribute revenue, and by extension, DCU payments would be made. Hurricane has to give Bluewater 6 months notice to cancel service, so if we want to be as pessimistic as possible, there is a small chance that the deal closes, the well fails before the cash dividends are paid, and Prax decides to permanently cap the well. In this case, it’s possible that a substantial percentage of Hurricane’s cash would be used paying Bluewater a termination fee, as well as other costs associated with closing the well. I think this is highly unlikely and would require a perfect storm, but it is possible.

As a middle case, lets assume that Prax does no capex, but that the well operates through 2026 at a typical flow decline of 2.5%/month. Using the most recent 8Ks, Hurricane stated that on April 18th that the most recent flow rate was 7,460 bopd.

Using 7,460 bopd as a starting point, I decreased flow 2.5% each month through the end of 2026 and assumed 95% uptime. Total barrels lifted added up to 5.87 MMbbl. At $80/barrel, they bring in $470MM revenue, or about 3.30p/share. That brings total income to 9.32p/share, a 24% absolute return and 6.4% annualized. Looking at just the 1.48p/share that’s tied up long term, turning that into 3.30p/share over 3.5 years is 26% annualized return.

Now let’s consider a bull case and assume all four payments are made in full by the end of 2026, which management expects to be possible if the well continues to flow at it’s current rate and oil stays near $80/bbl. Capex will be needed, but investors and Prax are aligned on generating maximum flow and Prax is willing to do capex if they believe it will improve flow. That gives investors the opportunity to turn 7.5p/share into 12.5p/share in 3.5 years, a 67% absolute return and 15.7% annualized. 

However, I think there is reason to believe that the full 12.5p/share will be paid back quicker than 2026. I mentioned earlier that Hurricane has substantial unused tax losses. I believe that part of Prax’s strategy in acquiring Hurricane is to use the company as a tax-advantaged vehicle to make further acquisitions. Any revenue Hurricane produces would entitle DCU holders to 17.5% of revenue. Thus, I think that it’s likely Prax makes a future acquisition under Hurricane and/or drills additional offshore wells that could also flow to the Aoka Mizu, speeding up payments. The timing of and value of this can only be speculated on, but I don’t think it’s unreasonable to think that annualized returns could push above 20%. 

I’m not one to speculate on commodity prices, but since we considered a case where oil prices plunge back to historical lows, I think it’s also worth mentioning that if prices go higher than $80/bbl, full payment will also be made quicker and with fewer barrels lifted, which will increase annualized returns.

And just for kicks, if you buy my thesis that payments #1-3 are essentially guaranteed in the next couple of months, then really you’re only locking up 1.48p/share long term. Turning 1.48p/share into 6.48p/share in 3.5 years is 52% annualized.

Conclusion/Catalysts

As outlined above, I believe that Hurricane Energy plc currently offers investors an opportunity with limited downside and the potential to produce high annualized returns. I think the situation exists because the sum of payments #1-3 above (which are the less complex and more traditional portions of the buyout offer) total 6.02p/share, which is both less than the current share price of 7.5p and less than the buyout offer last autumn of 7.7p/share. 

There are certainly risks involved, but given the limited downside of 20% and the potential to turn the remaining 1.48p/share into as much as 6.48p/share in 3.5 years or less, I like the risk-reward potential. 

One of the beauties of this opportunity is that last week it was significantly derisked with both the official shareholder approval of the acquisition and the 541,000 barrels being lifted, which virtually guarantees full payment of items #1-3. We don’t need the market to change its assessment of the situation and reprice shares as all of the return to shareholders will come via cash considerations and various dividends. 

Disclosure: I own HUR stock and May trade in and out of the security at any time without notice. This is not investment advice, do your own due diligence.

Catalyst

Acquisition closes.

Payments #1-3 made in full, which leaves 1.48p/share invested long-term and de-risks the investment.

Prax announces another acquisition using Hurricane as the investment vehicle.