November 11, 2005 - 9:16am EST by
2005 2006
Price: 3.59 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 210 P/FCF
Net Debt (in $M): 0 EBIT 0 0
TEV (in $M): 0 TEV/EBIT

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Vaalco Energy is a rare case of undiscovered value in the energy sector, and is valued at an extreme discount to both proven reserves and current operating performance. At the current run rate based on third quarter results recently released, it has a p/e of about 4.5 and checks in with an enterprise value of only 1.9 times EBITDA. Not only are the company's current operating results compelling, but the stock also trades at a discount to reserve valuations and the next drilling prospect (Avouma) will bring approximately 50% more production online in the next 12 months. Couple EGY's attractive current valuation with the fact that the next drilling prospect has already been successfully tested with an exploration well, and you have a recipe for a low risk, high reward investment in Vaalco.


The Company operates the Etame field on behalf of a consortium of five companies offshore of the Republic of Gabon (West Africa). The Phase 1 development of the field occurred in 2002 and consisted of completing three wells producing into an FPSO. Phase 2 development commenced in 2004 with two wells planned, one of which has already been drilled and completed. The second well of the Phase 2 development was drilled during the middle of 2005. The Company’s subsidiary, VAALCO Gabon Etame, Inc. operates and owns a 28.07% interest in the Etame Field. After completion of the first Phase 2 wells, the Etame field is currently producing at approximately 18,500 BOPD. Almost all of the Company’s oil production is located offshore of Gabon and the Company produces into a 1.1 million barrel FPSO and sells cargos to Shell Western Supply and Trading, Limited at spot market prices.

EGY's attractive valuation is partially the result of an overreaction to a September 12, 2005 news item and the fact that the market had to absorb roughly 65% of the outstanding shares of the company in a relatively short time period earlier in 2005.

On September 12th, the company announced that it had to cut back production levels after the addition of the new well brought online in Q3. “The higher initial production levels experienced with the addition of the Etame 6H well resulted in pressure interference with nearby wells and some declines in their productivity. Rather than risk local pressure decline, and possible damage to the reservoir, the Etame ET-3H well will be shut in. By resetting production the consortium expects improved aquifer support and stable production.” This development didn't change reserves in place or materially affect the long-term prospects of the company. Even after shutting in 3H, the addition of the new well still raised net production levels.

“In connection with a merger with 1818 Oil Corp. in 1998, the Company issued to the 1818 Fund II, L.P. (the “1818 Fund”) Common Stock and Preferred Stock which votes as a class with the Common Stock on an as converted basis, representing approximately 65% of the outstanding voting power of the Company on an as converted basis.” In late 2004 and early 2005, the 1818 Fund decided to wind down its operations and liquidate. The Fund sold its entire 35,898,695 stake of EGY common stock in a series of block trades in March 2005. The shares sold by the Fund represented approximately 63.9% of Vaalco’s outstanding common. All these shares had to be absorbed by the market in a relatively short time period, and now we have a good balance of ownership with no party owning more than 10% of the company.


In Q3 2005, Vaalco earned $11.9 million or $0.20 per diluted share on $26.2 million in revenue. The company generated $22.9 million in EBITDA, and ended the quarter with essentially no debt and $45 million of cash in the bank. The company's enterprise value based on the diluted share count currently stands at only $166 million.

After bringing the new well online at the beginning of August, the higher production levels for August and September brought Q3 to a total quarterly production and revenue base about equal to the current run rate of 18,500 BOPD. Production in future quarters should be similar to Q3 until the new Avouma field is brought online late in 2006.

Judging EGY’s financial ratios versus its peers over the trailing twelve months, Vaalco has a PE of only 8 versus an industry average of 16, and a price to sales of 2.8 versus an industry average of 3.5. EGY’s annualized PE based on Q3 earnings currently stands at 4.5, while its annualized price to sales ratio is 2.1.

EGY is also one of the least expensive energy stocks on a cash flow basis. Cash flow from operations came in at $17.75 million in Q3, and has totaled $34.69 million for the first three quarters of the year. I expect 2006 cash flow to be at least $60 million. On this basis, EGY trades at roughly 3.5 times forward cash flow, while peers on average are trading at about 5.5 times forward cash flow.


As of September 30, 2005, the Company had a term loan with the International Finance Corporation (“IFC”), a subsidiary of the World Bank, in the amount of $2.0 million. In June 2005, the Company executed a loan agreement for a $30.0 million revolving credit facility secured by the assets of the Company’s Gabon subsidiary.

While the company expects cash on hand and current cash flow to be sufficient to fund capex over the next 2 years, the facility may be utilized to finance a portion of the Avouma and Ebouri development activities if they find projects outside of the Etame concession to pursue (note that all of the “announced” development activities for 2006 and 2007 lie within the “Etame” permit). The facility goes through June 2008 at which point it can be extended, or converted to a term loan. It is anticipated that this facility will become effective during the fourth quarter of 2005 after requisite loan registration filings with the Gabon government are completed. This facility will replace the existing term credit facility, which will be repaid (the balance is currently less than $1 million outstanding).


As of December 31, 2004, the company's last annual report indicated that the “Standardized measure of discounted future net cash flows at 10% showed the present value of oil reserves to be $123.3 million based on year end oil prices. As of the end of 2004, in Gabon, the price was $40.28 per barrel representing a $0.19 discount to the spot price of Dated Brent Crude at December 31, 2004. In Texas the price was $42.76 per barrel of oil."

It goes without saying that since the company’s average sale price was $58.75 per barrel during the third quarter of 2005, the reserves have room for upward valuation adjustments. Based on current commodity prices, an upward adjustment of about 25% to reserve valuations would be conservative and prudent when considering the fact that oil prices are nearly 50% higher than they were at the beginning of 2005. After replacing the net property and equipment line on the balance sheet with a more realistic valuation of reserves, Vaalco’s tangible assets alone are worth approximately $20 million more than the company’s entire enterprise value.

In addition, the market is placing zero value on the reserves of future drilling projects, which have a potential for a profound impact on reserve valuations. Approximately 2.5 million barrels of proved developed reserves were added just on completion of the Etame-6H well alone as noted in the press release from August 1st, 2005.

The Company maintains a policy of not booking proved reserves on discoveries until such time as a development plan has been prepared for the discovery. Additionally, the development plan is required to have the approval of the Company’s partners with respect to the discovery. Furthermore, if a government agreement that the reserves are commercial is required to develop the field, this approval must have been received prior to booking any reserves. For the Ebouri discovery, because of the decision to participate in a seismic shoot over Ebouri and other areas in the northern part of the Etame Block, the Company did not request any approvals for the development of the Ebouri discovery from its partners or the government, pending seismic results. Therefore, the Company had not booked any reserves for the Ebouri discovery when reserves were last reported, on December 31, 2004. The Company has likewise not booked any reserves associated with the North Tchibala discovery on the Etame block.

Note that based on the map of the existing planned drilling locations, North Tchibala lies directly between two proven locations- Etame and Avouma (approximately 5 miles from each). And the Ebouri discovery is only about 5 miles northeast of the main Etame field. There are numerous other leads within Vaalco’s existing permit boundary, and the odds of substantial future upward adjustments to reserve valuations remain high.

Judged against three of the company's peers (other AMEX listed small cap stocks with 100% of their oil production off shore) – TGA, TMY, and CNR-EGY boasts very attractive valuations to tangible assets. Applying the same methodology above (increasing proven reserves by 25%) we see that EGY checks in at an EV to tangible assets ratio of only .90 versus a ratio of 1.5 for TMY, 1.9 for TGA, and 4.2 for CNR. These are all conservative estimates because 2005 reserve additions are not included. However, EGY stands out by any measure.


The next series of wells will be drilled in the Avouma prospect in mid 2006. This is a high reward, low risk project as the Avouma exploration well tested 6600 barrels per day on a half inch choke. There will be 2 initial wells tied into this platform, and both are expected to be producing at rates similar to the exploration well. The platform for the field is currently being built, and drilling will commence next year. Management expects a gross production rate of 10,000 to 12,000 BOPD from this field by the end of 2006, which would translate into 2800 to 3370 BOPD net production owned by EGY (approximately a 50% increase to current production levels). The reserve pool of this field is independent of the existing Etame production field and will not affect current flow rates.

Management is also optimistic about the Ebouri prospect (which is about 5 miles northeast of the existing production field) and may announce platform development and drilling plans for that prospect in the coming months. Ebouri could come online in early 2007 and also add significantly to reserves and production rates.

Capex for any of the fields within the existing Etame permit will be limited to only the platform for each field and a pipeline to the FPSO. With the relatively close proximity to the existing oil storage location, the existing FPSO will be used for oil storage for each of these future prospects. Therefore, the production cost per barrel will go down after the Avouma field is producing.

Management is also presently evaluating at least two opportunities for reserve growth “through the drill bit” outside of the existing Etame permit. Management understands that in the current competitive energy environment a small company like Vaalco can’t compete by buying reserves, but rather that exploration is necessary. The company desires to be the operator of any new field, and also desires to retain an ownership position of 50% to 100% of any upcoming prospects. EGY has an exceptional balance sheet, exceptional cash flows, and a large untapped credit line by which to grow the company’s reserves substantially through the drill bit. Management desires to stay relatively debt free. However they are willing to use the credit line if the right opportunities present themselves.


The company has also realized this year that it needs to increase awareness and knowledge of the company on Wall Street. In the Q3 conference call, management stated that three analysts are currently in the process of picking up coverage of the company. Management also stated that they are looking to hire a professional IR firm to assist with shareholder relations.


Increasing production by 50% over the next 12 months.

Decrease in the company’s production cost per barrel in Gabon upon bringing Avouma field online.

Analyst coverage by three new firms and hiring professional IR.

Upward revisions to proven reserve valuations.

Continued solid operational performance and gradual valuation ratio increase in-line with peer valuations.

Announcement of drilling plans for Ebouri and other prospects outside the Etame permit.
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