Description

WesternZagros (WZR CN) -- Long Idea

An investment in WesternZagros offers a compelling opportunity to participate in the exploration and production of Kurdistan, which contains one of the largest untapped onshore oil reserves in the world.  The stock is a cheap call option, trading at C$2.25 per share, down from almost C$4.00 in October/November due to technical selling pressure.  The upside is at least C$7.50 based on our NPV, assuming US$75 oil.   Transaction comps suggest even greater upside of C$14.00 to C$49.00 per share.   The downside risk is zero (100% loss), assuming no development deal with the Kurdish Regional Government (KRG) and no drilling success.  

The market is meaningfully underestimating the probability of success.  Comparable adjacent oil fields are already producing over 100,000 bbs/d and reserve adjustments on those properties continue to increase significantly.  Furthermore, the KRG is trying to establish an independent viable government within the context of unified Iraq and this requires harnessing its oil reserves.  This ultimately means that the will KRG need foreign assistance and expertise.  Therefore, we believe that a final development deal will be signed soon and that it will be economically attractive to WesternZagros shareholders.

We also believe that there is strategic interest in WesternZagros.  DNO, one of the other operators in Kurdistan, has already received substantial bid from an unidentified international oil company.  We would not be surprised if the company is acquired by one of the majors within the next 12-18 months, particularly following the approval of the Federal Petroleum Law, discussed in greater detail below. 

WesternZagros is a pure play exploration and production company operating in the Kurdistan region of Iraq.  It was formed as a subsidiary of Western Oil Sands to hold the Exploration Production Sharing Agreement (EPSA) governing the Kalar-Bawanoor block.  It was spun out as a separate entity following Marathon Oil’s acquisition of Western Oil Sands on October 24, 2007.

The depressed stock price is the result of several factors, including temporary technical selling pressure by merger arbitrage funds, misunderstood Iraqi/Kurdish political risk, and undue concern over Turkey and PKK fighting in the northern part of Kurdistan. 

The stock has been pressured by temporary technical selling as shareholders dumped the stock following the spin from Western Oil Sands.  In particular, merger arbitrage funds have had a bad year and were likely using WesternZagros as a source of funds.  Additionally, the spin fell outside of the purview of some Canadian fund managers’ investment mandate.  The company’s small market cap means it probably falls under the radar screen of some of the much larger funds focused on the sector. 

The stock price has also been under pressure because of the uncertainty with respect to ongoing negotiations with the KRG concerning a revised EPSA.  These concerns are overblown and misunderstood.  At the end of December, management stated unequivocally that it has orally agreed to the revised EPSA terms and expects to have a signed agreement very soon.  In fact, WesternZagros is still importing equipment into the area and the KRG has been facilitating the process, according to management.  Addax Petroleum, another publicly trader operator in the Kurdistan region, has also publicly expressed the same high level of confidence. 

As a brief history, WesternZagros was one of the first companies to enter the Kurdistan region, signing its initial EPSA in 2006.  However, following the KRG Oil and Gas Law in signed in August, the Regional Oil and Gas Council began reviewing the EPSAs of the companies whose contracts predate the new law.  Importantly, the EPSA terms are less favorable to the initial EPSA holders.  Thus far, the initial EPSA holders (WesternZagros, DNO, Addax Petroleum, Hawler Energy, and Shakal) haven’t signed a new agreement with the Council.  Given the amount of time that has passed since August, the concern has been that both sides are in a deadlock.  Management has stated that it will not drill the first well unless a final EPSA is signed.    

Since the revised terms have been in force, several EPSAs that have already been awarded (see www.krg.org).  Dr. Ashti Hawrami, the KRG Minister of Natural Resources has said “these contracts are a major step towards the Kurdistan Region’s goal of increasing oil production from the Region to one million barrels per day.  This new level of exploration and production activity in the Kurdistan Region will also galvanize investment interest for the rest of Iraq once a transparent, investor-friendly and unambiguously constitutional oil and gas law for Iraq is in place.”  Dr. Hawrami is running a one man show and simply hasn’t had the time to hammer out the final details.  Since WesternZagros has agreed to the revised EPSA terms, we are confident that this issue will be resolved very soon.             

The other issue is that the EPSAs signed with the KRG prior to the approval of the Federal Petroleum Law may be deemed invalid by Baghdad.  While uncertainty remains, all of the contracts signed to date are in line with the constitution and the draft Petroleum Law.  Therefore, there is very little risk of material modification to the revised EPSA. While an agreement with the central government must be signed before WesternZagros can begin exporting oil, time is on its side.  We don’t expect exports to commence before 2011.  Management has stated that it will begin drilling without a final agreement with the central government. 

WesternZagros is sitting on one of the most coveted properties in Kurdistan.  The EPSA lands cover 2,120 square kilometers, which are adjacent to a number of historic oil and gas discoveries.  Importantly, WesternZagros was one of the first to enter into an EPSA with the KRG.  Management specifically targeted this block after studying the opportunity for many years.  The prolific Kirkuk – Kor Mor – Chia Surkh structural trend runs through the EPSA lands, and the Jambur – Pulkhana – Qamar trend skirts along the southern margin of the EPSA lands.  These reservoirs are all located within 100 kilometers of the EPSA lands.  According to information obtained from the KRG and the federal Ministry of Oil, wells at Kirkuk have flowed up to 100,000 bbls/d (average 13,500 bbs/d). 

Five seismically identified structures, three conceptual stratigraphic plays and additional undrilled structural leads evident from surface geology have been identified on the EPSA lands.  These five structures have been internally assessed as potentially containing undiscovered resources of approximately 5.4 billion barrels, assuming that the structures contain oil and not gas or gas condensate.  The three conceptual structures and the two northern structural leads have been internally assessed as potentially having undiscovered resources of approximately 4.7 billion and 1.7 billion barrels, respectively.  Sproule and Associates, one of Canada’s leading independent reserves engineers, has independently audited these estimates. 

The total gross risked prospective resources are 1,330 MMbbls and net risked prospective resources (after taxes and royalties) is over 230 MMbbls.  This assumes a 30% recovery factor and 60% probability of success (vs. 80% historical success rate in Iraq).  No dry gas has been found in the region, although it’s a risk.  Additionally, finding gas with oil or gas with condensate are also possibilities, and would modify the cost/price/recovery rate but still make this a very attractive opportunity.  

No petroleum exploration wells have been drilled on the EPSA Lands and, consequently, WesternZagros has not established any reserves yet.  However, we expect the company to begin drilling its first well by the end of March 2008.  It has completed seismic data on 750 kilometers and plans to ship a rig from Houston to the area by the end of January.  Additionally, we believe that there’s a high likelihood of drilling success given that oil is seeping to the surface in certain parts of the EPSA Lands.  There’s a photograph of the Tukin Oil Seep in the company’s slide presentation (www.westernzagros.com).

Financials

The company has a strong balance sheet, entering 2008 with C$90 million of cash and no debt.  Additionally, if the company’s warrants are exercised (strike of C$2.50) on January 18^th, the cash balances should increase by $C38 million.  Management expects exploration and production costs to run in the C$65-C$70 million for the first two wells.   If the warrants are not exercised in January, management has stated that it will have to raise additional capital by the end of the year.

The fully diluted share capital is as follows:  165 million shares issued to Western Oil Sands shareholders, 5 million shares issued in a private placement, 16.5 million warrants, and 18.7 million shares reserved for issuance pursuant to an option plan.  Management has not priced its options yet.

Valuation

Based on our NPV and comparable company analysis, WesternZagros is realistically worth between C$5.00 and C$15.00 per share.  As a benchmark, management invested C$10 million at a price of C$2.50 per share upon the spin.  Based on the revised EPSA terms, we estimate an NPV value of C$7.50 per share.  This assumes an oil price of US$75 per barrel (3% inflation rate), 53% working interest, and 15% discount rate.

Additionally, there are two other operators in Kurdistan that are useful comps.  Addax Petroleum (AXC CN) in one of the partners in the Taq Taq field (45% working interest), which is located north of Western Zagros’ block.  Independent reserve estimators assign a value of US$3.34 per barrel to Addax’s 2P reserves.   Applying this value per barrel to WesternZagros would imply a NAVPS of C$12.00 ([1.3 billion barrels x $3.34 x 53% working interest x $129 million cash] / 205 million shares). 

DNO (DNO NO) started drilling the Tawke field (55% working interest) in November 2005 and is now delivering crude to the domestic market.  On December 18^th, DNO more than doubled its estimates for reserves at the Tawke field in Kurdistan, from 100 million barrels to 230 million barrels (gross recoverable) with the potential for substantial upside to the revised amount.

In August 2007, it was reported that the company rejected a $700 million bid from an unidentified international oil company for its Tawke field.   This would imply a NAVPS of over C$24.00 for WesternZagros.  Additionally, the UBS analyst estimates that after backing out DNO’s other assets, the implied value for its Tawke field is US$14.00 per barrel, or C$49.00 per WesternZagros share. 

Catalyst