Description

Remington stock is an attractive investment for the next 24-36 months to earn 2- to 2.5-fold return at very little downside risk.

· At the current price, the stock of Remington Oil & Gas (REM) is trading below an estimated reserve value of $21 per share for the end of 2004 (a 17% rise from $18 per share estimated at the end of 2003). In addition, REM has over $0.50 per share net cash estimated at the end of 2003. Also, its proprietary 3-D seismic data library in the GOM market, which carries zero value on the balance sheet, is worth at least $4 per share.

· In the base case, which assumes a very conservative F&D cost of $2.00-2.25/Mcfe, the stock could rise to $37-38 per share, almost doubling the current price. Upside by another $5-10/shr appears to be a reasonable expectation if either the natural gas price is priced higher than $5/Mcfe I assumed, or REM production growth is further accelerated beyond +15% currently budgeted, both of which are quite possible. That’d take stock price up to $42-46. Further upside is likely if more exploration successes lower down F&D cost to its historic average of $1.5-2.0/Mcfe, which could bring another $5-8 per share value. In that setting, REM can be a $50 stock.

A. The management predicts REM’s oil & gas production (65-70% in gas) to grow at a minimum of 15% per annum over the next three years before any new success in finding prospects. Assuming NA natural gas price holding up around $5/Mcfe, REM could generate a total amount of $600MM operating cash flow during 2004-2006, or $21+ per share.

The following table shows REM’s strong production, cash flow growth and consequently strong capability to spend on exploration programs while still maintaining a net-debt free balance sheet:


B. Assuming between 2004-2006, REM just spends $500MM out of the total amount of $600MM operating cash flow, at an average Finding & Developing (F&D) cost of $2.00-2.25/Mcfe, which could prove too conservative for the reasons explained in the next paragraph, REM can add well above 200Bcfe new reserves. Subtracting 140Bcfe production estimated during the same period, net reserve addition will be 80+ Bcfe and therefore its reserve base will rise up to 300+Bcfe from 220Bcfe estimated at the end of 2003, representing a compound annualized growth of 12%.

The table below is my estimate for the reserve addition based on $500MM capex budget btw. ’03-’06.

Ending December FY03 FY04 FY05 FY06 Total btw. '03-'06

Capex 114 139 167 200 506

Proved reserve at y/b 204 220 241 269 220
Add: discoveries 51 62 74 89 225
Minus: production (35) (40) (46) (53) (140)
Proved reserve at y/e* 220 241 269 305 305
YoY growth 8% 10% 12% 13% 12%

*: Proven undeveloped reserves (PUDs) represent 40-45% of total reserve. The average time horizon between booking PUDs to start drilling is just 6 months. Hence very little risk in negative revisions of reserve and asset quality is high.

C. The management concurs that the likelihood of a reserve multiple expansion for GOM assets from the current level of $2.25/Mcfe is high due to the following reasons

o NA natural gas price, as REM and we both believe, will very likely trade at a sustainable high level ($4.50-5.50/Mcfe) over the next three years
o Industrywide, average F&D cost has been rising in the GOM and will continue to do so with the increasingly difficulty of finding new reserves. REM’s F&D cost has been well below the industry average, and the management indicates normalized F&D cost for REM is within a range of $1.50-2.00/Mcfe, based on a 3-yr rolling average.

· Below is the info provided by the management, which shows REM’s significant cost advantage:
F&D cost ($ per Mcfe) Historic avg. till '02 2002 2003/2004

Stone Energy (SGY)- 5-yr avg. $2.10 $2.40+
Spinnaker Energy (SPE)- 4-yr avg. $2.21 $ 6+

Remington (REM) 4-yr avg. $1.44 $ 2.40* $2.05-2.25

*: REM’s recent two years’ result was depressed with unfortunate luck of finding reserves. The management suggests the 3-yr rolling average is more reliable a number for projection purpose, which ranges from $1.50 to 2.00/mcfe. It appears the REM’s F&D cost peaked in ’02 and has started to trend toward the normalized level since then.

The actual 4-yr F&D cost for REM are:
1999 2000 2001 2002 2003
F&D ($/Mcfe) $0.69 $0.97 $1.68 $2.40 $2.25
Res. Add (Bcfe) 30 75 67 50 51

· REM has achieved such cost advantage thanks to the proprietary ownership of its industry’s leading 3-D seismic data library in the GOM offshore market. The value of this rich data library is estimated by the management at $100-150MM, assuming a minimum price tag of $40,000 per block on totally 2,700 blocks, or $3.57-$5.36 per share (on 28mm shrs.)

o For each $0.05/Mcfe increase in the valuation multiple, the equity value could rise by roughly 40-50 c/shr [=250Bcfe x $0.05/Mcfe/28mm shrs]

The following table illustrates how the reserve value of Remington as well as its equity value will grow over the next three years, assuming reserve multiple expanding by $0.15/Mcfe each year, and excluding seismic library value of $4-5/shr.

Ending December FY03 FY04 FY05 FY06

Proved reserve at y/e (Bcfe) 220 241 269 305

Reserve multiple ($/Mcfe) $2.25 $2.40 $2.55 $2.70
Value of reserve ($ MM) $495 $578 $686 $824
Per share (on 28mm shrs) $18 $21 $24 $29

Cash, net of debt ($ MM) $16 48 76 98
Equity value ($ MM) $511 $626 $762 $922

Equity value/share(28mm shrs) $18 $22 $27 $33


D. REM has significant upside in adding more reserves on top of previously estimated 200+Bcfe gross, or 80+Bcfe net, reserve addition. The 200Bcfe from our estimate included, the firm is targeting totally 1.6Tcfe net unrisked reserve potentials in the GOM market. Based on the risk profile, the maximum reserve addition could come within a range of 400-600Bcfe, which can be ideally added over the next three years in a pace of 50/25/25 (see the table below). If excluding 200Bcfe already assumed in the base case, that’d leave an upside potential of at minimum 200Bcfe.

(Bcfe) Net unrisked Probability of success Expected net reserve adds
Bcfe Potential Low-end High-end Low-end High-end

Low risk 176 75% - 80% 132 - 140.8

Moderate risk 486 40% - 50% 194.4 - 243

High risk 920 10% - 20% 92 - 184

Total prospects 1,582 26% - 36% 418 - 568


1st Year 50% 209 284
2nd Year 25% 105 142
3rd Year 25% 105 142
Total 100% 418 568


Based on a finding cost of $2.25/Mcfe, which could prove conservative if F&D cost reverses to its historic average of $1.50-2.00/mcfe, it would require an additional capital investment of roughly $225MM for each additional 100Bcfe new reserves. Incremental funding from incremental operating cash flow can be available (without levering up its balance sheet which is not value-accretive to a large extent) if natural gas price exceeds $5/Mcfe on a sustainable basis over the next three years and/or REM increases its production rate more aggressively which in my opinion REM is capable of doing given its high quality assets.
· Each 1% incremental production growth beyond the projected rate of 15% over the next three years will be equivalent to 2.6Bcfe incremental production and consequently generate incremental cash flow of $13MM[=2.6Bcfe x $5/Mcfe]
· Alternatively, an average increase of $0.50/Mcfe in natural gas price beyond $5/Mcfe level would give rise to an incremental excess cash of $70MM during the next three years [=140Bcfe x $0.5/Mcfe].
· As a result, a combination of accelerated production growth and higher commodity prices could help REM grow its reserve base more rapidly with no impact on its balance sheet. For example, let’s hypothetically say, natural gas price stays at $6/Mcfe, instead of $5/Mcfe we assumed in the model, and production growth is 20%, instead of 15% we assumed, then incremental cash flow would be as much as $200+MM.
o From production growth acceleration:
§ (20-15%)/1% x $13MM for each 1% growth = $65MM
§ Plus: $1/Mcfe higher pricing x13Bcfe incremental production=$13MM
o From higher natural gas price: $1/Mcfe / $0.5/Mcfe x $70MM = $140MM
o Sum: 65+13+140=$215-220MM
o $215-220MM incremental spending can support a reserve addition of 95+Bcfe, based on F&D cost of $2.25/Mcfe. Net of incremental production of 13Bcfe, net addition could be 80Bcfe. At a reserve multiple of $2.70/mcfe, reserve value can be enhanced by $215+MM, or approximately $8 per share.


E. It’s important to point out that investors are with a management team that is highly competent with a respectable track record, conservative management style and highly entrepreneurial spirit. With insiders (managers and directors) owning 7% of the firm and management getting paid big with stock options, they seem to be quite shareholder friendly (so far, my experience of IR communication and response has been one of the best within the companies I cover). Senior managers are in their late 40s or early 50s. We were told that they would not be against a deal if the price is right.

Target stock price


Valuation (by '06)
Base Case Bull Case
I II III
03 Base production (Bcfe) 35 35 35 35
Production growth btw. '04-'06 15% 20% 20% 25%
Natural gas price (Mcfe) $5 5.5 6 6
Avg. cash cost ($/Mcfe) $0.80 $0.80 $0.80 $0.80
Avg. F&D cost ($/Mcfe) $2.25 $2.25 $2.25 $2.25

Accumualitve production
btw. '04-'06 (Bcfe) 140 153 153 167
Accumualitve cash flow
btw. '04-'07 ($ MM) 587 719 795 867

Incremental production (Bcfe) - 13 13 27
Incremental cash flow ($mm) - $132 $208 $280

Incremental addition of
net reserve (Bcfe) 45 79 98

Proven reserve at y/e (Bcfe),
net of production 300 345 379 398

Reserve multiple ($/Mcfe) $2.70 $2.70 $2.70 $2.70

Reserve value ($mm) $810 $932 $1,024 $1,073

Cash ($m) 100 100 101 100

Value from seismic
database ($mm) 125 125 125 125

Total value ($mm) $1,035 $1,157 $1,250 $1,298

Per share (on 28mm shrs) $37 $41 $45 $46



Risks
1) Commodity price: REM has very little hedge in place, which could hurt cash flow in a low price environment which we don’t foresee for the next several years;
2) Exploration failure: already factored into the classification of risk profiles with each prospect
3) Quarterly earnings volatility: by using “success effort” instead of “full cost” accounting, REM expenses all the dry-hole cost. Despite a conservative methodology, it could cause dramatic earnings volatility. However, it has little impact on cash flow since exploration expense is added back to calculate operating cash flow.
4) Trading liquidity: daily trading volume is under 150K shares, which is the reason for high volatility in the stock.

Catalyst

Annoucement of better than expected reserve additions/lower finding cost over the next 6-12 months