Ithaca Energy IAE CN
April 20, 2011 - 1:15pm EST by
2011 2012
Price: 2.35 EPS $0.21 $0.31
Shares Out. (in M): 258 P/E 13.3x 7.7x
Market Cap (in $M): 600 P/FCF 0.0x 0.0x
Net Debt (in $M): -190 EBIT 38 180
TEV ($): 410 TEV/EBIT 10.8x 2.3x

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I am recommneding the purchase of Ithaca Energy (IAE CN or IAE LN), a mid-sized producer of oil and gas in the UK North Sea.  North Sea oil and gas production is characterized by harsh operating environments, high rates of production declines and relatively high tax and royalty rates. Throughout the long operating history of this mature basin, when these undesirable characteristics have coincided with low oil and gas prices, the result has been a few different series of bankruptcies and restructurings by smaller players and disinvestment or outright abandonment by the larger energy companies. This spotty history has resulted in North Sea focused companies generally suffering from low valuations, even adjusting for the short reserve lives that come with the rapid decline rates and for the high taxes.  Following the Deepwater Horizon disaster, valuations in all offshore areas, even those like the UK North Sea which are not in deep waters and have strong safety records, contracted further to reflect the increased regulations and costs. More recently, a proposal announced in March by the UK government to raise marginal tax rates on North Sea oil revenues pushed Ithaca and its peers into deeply out-of-favor territory. However, aided by the high Brent crude oil prices (which are trading at a $13 per barrel premium to West Texas prices) and reasonably high UK natural gas prices, I believe that Ithaca's valuation now over discounts the risks and ignores tremendous upside.

At a recent stock price of $2.35 and with shares outstanding of 258 million, Ithaca's market capitalization is $600 million. The company has approximately $190 million of cash (on top of an undrawn $140 million credit facility) and no debt, so the enterprise value is $410 million. The company is guiding to an average production rate in 2011 of 5,325 barrels of oil equivalent per day ("boe/d"), comprised of 90% oil and liquids and 10% natural gas. This incorporates two recent mechanical issues that have temporarily curtailed production and are in the process of being fixed. Using a conservative price deck of $100 per barrel of Brent crude oil (currently $120) and 55 British pence per therm gas (currently 67p) and the OPEX/SG&A per barrel of $28, the operating cash flow for 2011 would be approximately $140 million. This represents a multiple of 4.3 times on the basis of market cap and 2.9 times when backing out the net cash and using enterprise value.

I view this as a conservative starting point as far as looking at valuation. The conservatism is embedded in the fact that these production levels give no credit to the relatively low risk organic growth opportunities the company is pursuing that should deliver 11,000 boe/d in 2012 (roughly double the average 2011 rate) and over 20,000 boe/d in 2014. Clearly how one interprets the risk profile of this production growth is subject to each investor's interpretation of the geological and mechanical/operational risks inherent in offshore oil production. Without going into too much gory detail, I tend to emphasize the track record of senior management and their technical team in delivering production growth on time and on budget in similar projects. Then I will use the reserve report, if available, to gauge the degree of certainty that exists with respect to the reservoir size, quality and accessibility. I also evaluate certain features of the development that may present drilling and completion challenges such as depth, pressure, or water issues to assess whether the next barrel to be produced sits at the low or high end of the risk spectrum.

In the case of Ithaca, the growth to 11,000 boe/d next year, which comes predominately from the addition of the Athena development slated to be in production at the end of this year, has very low exploration risk as the field has been extensively drilled prior to being analyzed and booked into reserves by respected independent reserve engineer Sproule Associates. The development risk is somewhat higher as it is always an engineering challenge to bring a new offshore production platform on stream. However, the configuration of assets and the well drilling and completion techniques are very similar to those employed at the company's existing and highly successful Beatrice and Jacky developments and are very standard in the industry.

Admittedly, the step-function growth to 20,000 boe/d involves much more exploration risk as the Harrier and Hurricane fields that would be next in line for development after Athena have had much less work performed on them. Still, this is not considered high risk exploration as would, for example, drilling in an under explored basin or testing a new oil formation or recovery technique in a mature basin such as this one. The development risk is similar given that this is all within the same UK North Sea playbook that forms the foundation of the company.

In summarizing the upside case, I will couple the production growth scenario with the same conservative price deck of $100 per barrel oil. At 20,000 boe/d, the company would produce 7.3 million barrels and would be cash flowing $570 million. As of April, 2010, the proved and probable reserves booked by Sproule was 42 million barrels, which implies a reserve life of just under six years at the 20,000 boe/d pace, which equates to undiscounted cumulative operating cash flow of $3.3 billion. Additional upside comes from the so called possible reserves calculated by Sproule at an additional 35 million barrels of oil equivalent, which is another 4.8 years of production. This excludes likely reserve additions from work-overs at their existing Beatrice and Jacky fields as well as upside from developing recent small UK North Sea acquisitions that Ithaca made from Talisman and GDF Suez at very attractive multiples per barrel of proved and probable reserves of $4.7 and $5.6, respectively.

The company has the cash and operating cash flow to bring this 20,000 boe/d production online without the need for any additional external financing, which is what got several now defunct peers into trouble in the past. In fact, my model indicates that at the current oil and gas price levels, the net cash will not drop below $100 million despite the investment required to bring the new fields online. This would allow the company to continue to make small accretive acquisitions. Finally, on the tax issue, Ithaca has $200 million of NOLs and due to the production growth will continue to layer on tax shields as the up-front drilling capital expenditures is recouped before taxes are owed. This means that the company is unlikely to be in a position of paying cash taxes until 2015, which enhances the appeal of Ithaca to a strategic acquirer looking to grow its light oil production. The stock's reaction to the proposed hike in rates was an overreaction and presented an opportunity to buy a stock that was already cheap at an even more attractive level.


- Athena development coming on stream by the end of 2011 will be a major catalyst
- Minor catalysts include the sell side updating their production numbers for the recent acquisitons which are about to close
- I would expect Ithaca to make a few more small, accretive acuisitions this year (large independents like Nexen are likely sellers)
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