Description

IPCO SS 

Summary Thesis

International Petroleum Corporation (IPCO SS) is a well managed,low cost, conservatively financed, international oil and gas producer whose stock is currently trading at a 65% discount to a conservative estimate of net asset value.

Background

International Petroleum Corporation (IPCO SS) was spun off from Lundin Petroleum (LUPE SS) via a tax free dividend on April of 2017 and listed in the Stockholm and Toronto  stock exchanges. Lundin Petroleum, a $9.5 billion market capitalization company controlled by the Lundin family, contributed “non-core,” low cost, highly cash generative assets in Malaysia, France, and Netherlands to the formation of IPCO. As per IPCO’s 2017 Annual Information Form, “The vision and strategy of IPC’s management from the outset was to use the IPC platform to build an international upstream company focused on creating long term value for IPC’s shareholders, launched at a favorable time in the industry cycle to acquire and grow a significant resource base.”

Management’s strategy since the spin off has been to optimize the low cost assets it already owns, mainly the oil producing assets in Malaysia and France.  In the past two years, IPCO has been able to generate cash in excess of capital expenditures and to replace reserves while investing less than depreciation and depletion charges through investment in enhanced recovery and highly accretive infill drilling.  These assets produce high quality, light sweet crude and therefore realize a price per barrel in excess of Brent while having a very low production cost of $17/barrel inclusive of royalties. The cash generation from these assets has enabled the company to repurchase 20% of its shares since the spin and to fund the acquisition of a company greater than its market capitalization at the time.

IPCO SS  completed two major acquisitions within twelve months. In January 2018, IPCO completed the acquisition of the Suffield assets, mostly gas producing assets in Alberta, Canada, for CAD 520 million in cash. These were non-core assets owned by Cenovus,  and Cenovus needed to sell these assets in order to achieve its deleveraging plans. In December 2018, IPCO completed the acquisition of publicly traded Black Pearl resources, a Canadian heavy oil producer with assets in the provinces of Alberta and Saskatchewan, via an all share transaction. The transaction, which was announced in mid October and completed in December, was structured without a collar, and it increased IPCO SS’  fully diluted shares outstanding from 99 million to 175 million. (All references to shares outstanding are relative to the Swedish listing because it is the most liquid).

Why is this interesting? The people involved and their history of value creation.

The E&P industry collectively destroys value. The beta of E&P stocks to the oil price is 70%. Due to the cyclicality of the oil price, it is difficult to discern luck from skill. There seem to be lot of promotional management teams with terrible capital allocation skills. And, due to the technical complexities of oil and gas reservoirs, it is difficult for most investors, including myself,  to gauge the veracity of managements’ claims.

I decided to pursue IPCO SS, notwithstanding my apprehension towards the sector, because of the people involved. The Lundin family has, since the 1960’s,  created a net worth estimated at $3.2 billion and market capitalization of $14 billion investing in resources, mainly oil. This has been achieved through good execution and, more importantly,  sound capital allocation decisions. For example, IPCO SS’ parent company Lundin Petroleum (LUPE SS), itself a spin off resulting from the strategic sale of a business, has delivered a total shareholder return to date of  31% cagr in USD since it was listed in 2001, despite the recent 35% decline in its stock price. Over this period WTI has traded at a high price of $145/barrel, a low price of $17/barrel and an average price of $64/barrel.

The fact that many of the people behind Lundin Petroleum’s  success opted to joined IPCO is encouraging. The former CEO of Lundin, Ashley Heppenstall, joined as an IPCO board member.  The former CFO of Lundin Petroleum, Mike Nicholson, joined as CEO.The former Treasurer of Lundin Petroleum, Christophe Nerguarian, joined as CFO. Other key executives who opted to leave Lundin Petroleum and join IPCO at the time of the spin off are Ryan Adair, IPCO’s VP of Reservoir Development, and Daniel Fitzgerald, IPCO’s VP of Operations.

Management and the controlling shareholders have a significant interest in the company. Prior to the Black Pearl all share acquisition, the Lundin Family and management owned 33% of total shares. They did not sell any shares when the company repurchased 20% of shares outstanding. Following the all share acquisition of Black Pearl Resources, which increased the number of shares outstanding from 99 million to 175 million (77%)  insiders, including management, the Lundin family, and the former CEO of Black Pearl, who will join IPCO as a board member, will collectively own roughly 28% of the shares outstanding. Management will continue to be highly incentivized via a long term equity ownership scheme.

Valuation

E&P enterprises are very difficult to value. Earnings multiples are meaningless because they do not capture the reserve life of the production assets. A company might trade at a very low PE but only have two years of production left. By the same token, it is common for E&P companies, especially shale oil producers, to  claim to have huge IRR’s at the “wellhead” level, but never generate any free cash flow or GAAP earnings. E&P's lend themselves to the worst abuse of pro-forma numbers. Bob Brackett, oil and gas analyst at Bernstein Research, drew the analogy that traditional businesses are like chicken farming. You raise chickens and generate continuous cash from the sale of chickens and eggs. And, E&P companies are like  turkey farming. You focus on growing turkeys (reinvesting cash to grow your  NAV), and you realize the value on Thanksgiving Day (a corporate sale).

IPCO SS, actually generates cash flow. It generated trailing twelve month operating cash flow of $254 million as of September 2018. And, it trades at  3.6x 2018 estimated GAAP EPS. However, these numbers are meaningless in the sense that the company just increased its share count 76% to acquire a business that will be highly dilutive to earnings and cash flow in the near term. However, it is highly accretive to NAV per share.

The key is to arrive at a somewhat accurate measure of NAV/share and then observe whether management is able to grow that NAV over time. Under SEC rules or, in this case, Canadian Securities Law (IPCO’s main listing is Sweden, but it is also listed in Toronto) E&P companies must provide an annual DCF of their resource base. In the case of Canadian listed companies, National Instrument 51-101-Standard Disclosure of Oil and Gas Activities, requires an in depth,  third party audited report of the resource base. Of course many assumptions are provided by management, but they must be vetted by a third party engineering firm, and the focus is on conservatism.

The Annual Information Form provides, several present value calculations with the intention of  providing some insight into the potential value of the asset. Different discount rates are used and different criteria are used. The most conservative valuation is that of Proved Reserves or P1. The next one, more aggressive, is Proved plus Probable, P2. The most ambitious includes “Contingent Resources”

As per NI 51-101 and the Canadian Oil and Gas Evaluation (COGE) Handbook: “Proved reserves are those reserves that are likely to be estimated with a high degree of certainty to be recoverable. It is likely that the actual remaining quantities recovered will exceed the estimated proved reserves.” “Probable reserves are those additional reserves that are less certain to be recovered than proved reserves. It is equally likely that the actual remaining quantities recovered will be greater or less than the sum of the estimated proved plus probable reserves.”

The after tax PV10 of 2P is a calculation of the net present value of revenues that will be derived from Proved and Probable reserves minus all cash outflows (production costs, development capex, well abandonment and reclamation costs, and royalties) using a 10% discount rate.   Indirect costs, such as corporate overhead, are not included in the present value calculation. 2P  excludes “possible reserves” as well as “contingent resources” which could be very material. Contingent resource are, “those quantities of petroleum estimated, as of a given date, to be potentially recoverable from known accumulations using established technology, but which are not currently considered to be commercially recoverable due to one or more contingencies.” E&P companies historically tend to trade at a premium to PV10 of 2P because the market  value of contingent resources can be meaningful. Given the current negativism towards the industry, there are more companies trading at a discount to the PV10 of 2P such as the case with IPCO. 

The exact way to  value an E&P company would be to do a risk adjusted DCF of each oil well, but that is incredibly difficult as an outsider to do. Therefore, I use the after tax PV10 of the Proven and Probable reserves (2P) as a proxy for NAV.  Since there is a lag in reporting, I am using the 2017 year end reports filed by IPCO and Black Pearl and aggregating them. A big variable in the present value is obviously the price of oil. I think the 2017 report is a fair approximation because the forward curve assumptions have not changed dramatically from year end 2017 to today. Notwithstanding short term oil price volatility, average WTI prices  have actually been less volatile: 2015 $49/barrel, 2016 $43/barrel, 2017 $51 barrel, 2018 $65/barrel. The fact that IPCO has a cash operating cost in the low teens makes the NAV less sensitive to oil price fluctuations than would be the case for a higher cost producer.

Below is the data derived from the 2017 reserve reports:

I am using an NAV/per share of $12/share for IPCO which yields an unusually large discount for a well capitalized, low cost, conventional E&P company with a good management. I derive the $12/share NAV in the following manner. I take the after tax PV10 of proved and probable reserves (2P) at the year end 2017 measuring date ($2,412 million) minus debt outstanding ($302 million) and divide it by the fully diluted shares outstanding (175 million). I do not capitalize and subtract corporate overhead, which is roughly $10 million a year because I'm assigning zero value to contingent resources, which I believe are going to be a meaningful source of NAV growth in the future. To put the $12/share NAV number in perspective, at the time of the spin, a similar calculation would have yielded a value of roughly $4/share. The change has been driven primarily through better exploitation of existing resources and smart capital allocation decisions since the forward price assumptions used in the appraisal have not changed dramatically from the time of the spin.

Risks
The price of oil. I am constructive on oil over the medium term. If you are a long term bear on oil because of electric vehicles, etc, you should avoid this. 

Catalyst

Analyst Day February 12, 2019. I think that the company has been through a lot of changes recently which have not been digested properly by sell side analysts.