Description

Serica is an independent UK based oil and gas company, 85% of production is gas. Now you might think this is what I should have bought a year ago before Putin invaded Ukraine. However, based on the current share price of 296.5GBp the EV based on my year end net cash estimate is just GBP 293m; i.e. well below the late 2018 and 2019 EV of GBP 613m and GBP 397m respectively (based on net debt of GBP 271m and GBP 53m respectively, share price was in both cases around 130 GBp).

Currently the stock offers FCF to EV yield of 81% for 2023 and thus competing with Australian coal stocks for the highest FCF yield in the energy sector. Thus, in my view too cheap to ignore.

We got into this situation for 3 reasons. The UK windfall profit tax, which was indeed just increased on Thursday (Nov, 11), secondly the warm fall and full storage which brought European gas prices down and lastly the absence of share buybacks.

I think all these 3 factors should stop suppressing the share price in the months to come.

Firstly, with the tax for UK oil and gas now at 75% we are at the level of Norway (78%) and thus also a high level in international comparison. Even the Labour Party justified their call for higher taxes mostly with the comparison to Norway, in light of the small difference this is clearly not worth to once more rock the boat for the paltry 3%. The deductibility of investments was however retained (91.4%) and this allows Serica to mitigate a significant part of the tax burden.

Due to the mandatory push for an early fill-up of storage in the EU, gas prices spiked in summer after the halt of supplies via Nordstream. Coupled with a warm fall this means that storage in the EU is now effectively full (95% in the EU, Germany even above 99%, compare  https://agsi.gie.eu/#/graphs/DE ), which obviously brought prices down. Indeed the EU Benchmark price Dutch TTF is now at a level of around EUR 100 MW/h, i.e. pretty much the level of fall 2021 before the invasion. This level should hold, as Europe needs to offer some premium to Asian prices (JKM currently EUR 85 MW/h) to attract LNG flows, as the real challenge is not surviving this winter, but rather to not totally drain storage, as the H1 2022 flows out of Russia need to be replaced in 2023 as well. TTF and NBP, the British benchmark are tightly correlated due to the connection of the pipeline network, there is however one specialty, the UK has basically no storage (1.6% of annual consumption), thus in winter we often get weather induced spikes. Serica is mostly unhedged (see price deck below) and sells on NBP day ahead prices. My price assumptions are based on the future curve. Strip currently puts 2026 prices already at the pre-invasion level, i.e. August 2026 at 77p/therm compared with a historical level of 77p/therm in September 2018. With 75% of Nordstream now destroyed the risk (at least for Serica) of a quick resumption of flows from Russia is effectively gone and it’s much more likely that the situation doesn’t improve as quickly as priced; Bear in mind 77p/therm is equivalent to USD 50bbl oil, thus there should be no gas/oil switching. Both short and long term gas prices have now more upside than downside.

Lastly cash return to shareholders (LTM dividends 17p; 5.7% yield). Serica reported a September 23 gross cash level of GBP 482m or 177GBp per share or 59.6% of Friday’s closing price (cash includes collateral for hedges, financial liabilities only relate to some GBP 39.6m contingent payments relating to the BKR acquisition ). Management’s reasoning for not returning more cash to shareholders is firstly the volatility of Gas prices which might lead to margin calls (peak margin call this year GBP 300m in Sept 2022). With all hedges rolling of by September 2023 and less than 15% of the Jan 2022 hedged volume outstanding by March 2023 this argument is quickly disappearing after the end of winter. Secondly Serica is currently drilling an exploration well at its North Eigg prospect, which is estimated to hold 60 mmboe recoverable resources (P50), i.e. potentially doubling reserves (2P 62mmboe). Should this be successful some of the cash would flow towards the development of this resource. As the share price does not reflect a North Eigg discovery, this is a kind of win-win situation, either a transformative additional resource or a large share buyback.

Results for North Eigg are expected in December. As the prospect is close to Serica’s Bruce hub, it would require comparatively low capex. In light of the 91.4% tax incentive for investments Serica’s after tax investment requirement would most likely be some low double digit GBPm figure. A rough estimate of the potential value based on P50 would thus be somewhat over 300m GBP or around 110p per share based on a production start in 2025 and strip prices. However, given the strong backwardation of the futures curve, the valuation is very sensitive to the speed of development. That said, on a risked basis taking management's assessment of success chances (20%) North Eigg would be worth an additional 22 pence to my valuation of the share.

Serica’s specialty is adding more value to mid-life fields. While the company was already founded in 2004, the transformative event was the acquisition of BKR (Bruce, Keith, Rhum) in November 2018 in an innovative deal structure with a very large earn out component (only GBP 39.6, contingent liabilities remaining). BKR stands for 80% of Serica’s production, with the remainder from Columbus (50% share, Serica operated) and Erskine (18% share, operator Ithaca Energy).

Serica has a strong track record of prolonging field life, managing to keep reserves largely stable in the last three years, despite the maturity of the fields. In summer it performed its first light well intervention campaign at Bruce, increasing production rate at two wells by 1500 and 1900 boe/d thereafter (12% of the daily production of the group in H1). There are some 5 to 6 wells where management sees further potential and thus another campaign is scheduled for 2023 due to the success.

Based on these measures I expect the reserve life to continue to be prolonged.

Valuation:

I’m valuing Serica based on the current futures curve:

My cash flow estimates are based on 27kboe/d production for H2, i.e. the midpoint of full year guidance. Based on 26.6k boe/d production in H1 and the successful well intervention program which lifted July production, this should be a conservative estimate. Costs of USD 16.0 per boe are in-line with H1 (16.07) given the stable figure yoy (H1 2021: 16.05) this looks reasonable. H2 2022 taxes are based on 65% tax rate and as of 2023 the new energy levy will lead to 75%. The high capex of 80m GBP in H2 reflect the North Eigg exploration (H1 2022 only GBP 21m Capex).

In a conservative DCF at 8% discount rate which assumes cumulative production of 63.8 mmboe (1.5mmboe more than current reserves, i.e. assuming a small benefit to reserves due to the light well intervention) until 2029, i.e. assuming no terminal value, I get to GBp 432 fair value. Most likely I’m way to conservative regarding the reserve life, however I don’t want to extrapolate the 100% average reserve replacement of the last years into to the distant future. Still, even on this conservative basis, this gives you 45% upside for a stock with a rock-solid balance sheet. Including my 22 pence risked estimate for North Eigg you get to a value of 454 GBp of 53% upside.

Catalyst

North Eigg discovery

Cash return to shareholder

Gas price