Description

Having dropped from 37 to 25.70 since September, this well financed, high growth oil company is now available at a compelling valuation.

Pan-Ocean is poised to triple its production in the next couple years just from existing discoveries, yet sells at a 20% discount to a conservative NAV and a sharp price/CF discount compared to generic mid-cap producers with inferior growth profiles. If you liked Vaalco, you should love Pan-Ocean. If POC’s capable management team executes on its plan to grow daily production from 11k to 30k bbls/day in a couple years and value that production at $C 40,000 per daily bbl (as slower growth Vaalco and Total Gabon are currently rated), you are looking at a stock price in the mid 40’s. Any exploration successes could increase these numbers substantially.

Overview:
Pan-Ocean, like Vaalco Energy (EGY), operates in Gabon, West Africa. In fact, Pan-Ocean is EGY’s partner in the offshore Etame permit. Pan-Ocean holds a 31.4% interest vs. EGY’s 28.1%.

Also offshore, POC holds a 25.71% interest in the Iris and Themis Marin permits operated by Sterling Energy Plc. The first exploration well was found to be water bearing, but another exploration well is planned in September of next year.

Unlike EGY, Pan-Ocean boasts onshore assets whose growth is likely to far exceed that of the Etame field. The company is currently producing about 11,000 bbls day. 5800 offshore, 5200 onshore. This onshore production could well quadruple in the next couple years, while the Etame production will bump up with the tie in of the discovery well and then flatten out, absent new discoveries. All the current onshore production is from 90%+ owned and operated properties. The company hopes to reach 30k boe day by 2007.

In addition, the company has a 40% interest in a JV with Shell on the Awoun permit, where 2 discoveries were made last year. Shell has yet to make a decision on how to proceed with the development of the JV. In the meantime, POC has begun constructing an export pipeline to debottleneck their owned fields as well as to offer early production options to Shell. My sense is that Shell will likely make their decision before the pipeline comes on in June of next year. Shell could agree on a development plan with POC, or
sell their interest to Pan-Ocean or another party. While the two recent exploration wells drilled did not encounter commercial hydrocarbons, the co. is still enthused with the prospectivity of the block. They are busy tweaking their geological models and would expect to drill more exploration wells. It is worth noting that a large swath of the permit, to the northwest, has barely been touched by seismic.

Very few companies possess such an inventory of development opportunities- those that do, tend to be rewarded with very rich valuations.

Yet, POC sells

- at a 20% discount to NAV (based on 2004 year end reserves)
- at well under 5x 2006 CF estimates, vs. ave. mid cap producers @ well over 5x
- at 4x 2006 Q4 annualized cash flow estimates and less than 9x earnings




Why have the shares performed poorly?

I like to understand why a stock is selling where it is. I attempt to answer the question below:

Shortly after raising $C40m in a secondary offering in September that was 11x oversubscribed, a flow of negative news ensued:

- a succession of three dry exploration holes
- a production glitch at the offshore Etame field
- the oil price dropped from $70+ and energy stocks sharply corrected

The exit of burned momentum investors and tax loss sellers has created an attractive situation for value investors who can take a longer view.

- The offshore problem was accurately addressed by mm202 in his write-up of Vaalco.

-Exploration dry holes are to be expected. The company has encouraged people to put odds of about 1 in 3 on exploration drilling. In my opinion, the company became a victim of its own success because they had been batting an unsustainable 1.000 the couple years previously.

- I can’t predict what the oil price is going to do, but the price has held in the mid to high 50’s and most major oil stocks are well off their lows. The growth profile here should provide a way for investors to make money, even if oil prices continue to correct.

The company’s website contains maps and detail on the fields as well as research reports and presentations.

http://www.panoceanenergy.com/index.aspx

Management:
I have known Chairman David Lyons for number of years and have been very impressed with how he has built this company. His knowledge of Africa and how to do business there is extensive. I have found management conservative in their forecasts and not overly promotional. Insiders own 18.5% of the fully diluted shares. Lyons controls the company through his ownership of the voting stock.

Valuation of the onshore assets:

Because Vaalco and Pan-Ocean share an interest in the same field, the market valuation of Vaalco can help us understand what we’re paying for the non-Vaalco assets of Pan-Ocean.

Enterprise Value of EGY full diluted =
US$ 186m
11m implied value of EGY’s onshore deal (based on 20c share pop on announcement)

$176m x 3.56 = 627m (implied market value of all of Etame) x 31.36% = US 197m = the value of Pan-Ocean’s share of Etame.
= $C 230m
+ $C 8.58 per POC share

EV of POC:
MC 695m
25m options proceeds
44m net working capital @ 9/30 – legal settlement paid post quarter

= 626m EV
- 230m EGY implied value of Etame = 8.58 per POC share

So you’re paying 396m, or $ 14.78 share for the non Vaalco assets.

If the company meets its development plan, onshore production should grow from 5200 bbls/day to north of 20k bbls day within a couple years. Vaalco’s production is currently valued at about $C 40k per bbl of daily production.
21k bbls x $C 40,000 = $C 840m = $31 per POC share + another $15 of value for the Etame production at the same Vaalco rating. This leaves a total value of $46 per share for Pan-Ocean. I would suspect that if Pan Ocean delivers this kind of growth the multiple could actually be much higher for the onshore portion. This analysis also assumes there is no further exploration success on the Shell JV properties or on either of the offshore permits.

Catalyst

Shell decision by spring
Achievement of expected production growth
Increased market interest in production growth stories, vs. commodity price momentum plays
Exploration upside