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Hanson Westhouse Heritage Oil June 09

Hanson Westhouse Heritage Oil June 09



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Published by TTTADVFN1
Research note on Heritage Oil June 09
Research note on Heritage Oil June 09

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Published by: TTTADVFN1 on Jun 23, 2009
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Heritage Oil
585pExplorer Extraordinaire
03 June 2009Our note on Heritage Oil has been overtaken by events. Whilst we intended to re-iterate our BUY recommendation, events today, when the company asked for its sharesto be suspended due to discussions with a third party regarding a possible reversetakeover, have made a Buy un-actionable.
 Yet there are no guarantees regarding the outcome of current discussions, as such we believe there is merit in releasing our note illustrating the value we believe resides within Heritage and which will still be of interest to potential buyers of the company in the weeks ahead as eventsunfold.
Key Financial data Year Revenue Operating Income EPS2007
$3.7m -$49.6m -$0.16
$5.1m -$37.6m -$0.37
$8.4m -$46.4m -$0.15
$153.5m $4.8m $0.02
Market Cap
Net debt to equity 
Net Cash
1. Based on reserves at end of 20072. As per management in May 2009 following Oman sale and Genel back-in right in KRI3. Assumes convertible bonds are converted into shares
 Heritage produced a mere 450 barrels of oil per day last year and yet the market cap stood atnearly £1.5bn prior to the suspension of shares on 3 June. As the table above suggests, this valueis not based on current operational status, rather it is the huge potential upside in Uganda and theKurdistan Region of Iraq.
On a sum of the parts valuation of the group’s asset base, we value Heritage at 890p per share.
 Heritage has enjoyed exceptional success in drilling campaigns in Uganda and the Kurdistan Regionof Iraq. So much so, that we anticipate the group’s interests will yield implied recoverablereserves in excess of 2 billion barrels.In our view, these resources will prove to be too enticing for either a national oil company or aninternational oil company (IOC) to resist. While yesterday’s events have not taken the exact shape we anticipated, corporate activity involving Heritage was in our view inevitable given a litany of reasons not least of which are:
 the move away from exploration to capital intensive development,
a track record of realising value through asset sales,
 the large scale of its discoveries and
 the need for IOCs to replace resources when access to new exploration areas is limited.
 Although Heritage’s share price has been a strong performer in 2009, we believe thatthere is significant additional upside. What follows is our analysis to arrive at thisconclusion and our target sum of the parts valuation of 890p per share.
This does notinclude any premium in the event of a still possible corporate takeover, which we would expect to be significant.
 ANALYSTDavid Hart
+44 (0)20 7601 6124
 Peter Bassett
+ 44 (0)20 7601 6125
SPECIALST SALESMalcolm Graham-Wood
+44 (0)20 7601 6138
Mid-cap oil & gas explorer andproducer 
Ticker HOILListing LSENo. of shares 253.3mMarket cap £1,482mEnterprise value £1,414m
 Albion Energy 32.50%Lansdowne Partners 7.30%Capital World Investors 5.71%London & Capital 3.81%Firebird Management 3.61%Blackrock Group 2.48%
For important regulatory disclosures,please refer to the information on page17 of this report.
Company overview 
Heritage was formed in 1992 by the current Chief Executive, Anthony Buckingham. It was originally called Land and Marine Hydrocarbons Development Limited but the name was changed to Heritage Oil& Gas Limited in 1993. Until 1996, operations were confined to Angola when the group acquired a 10%interest in Block 8, offshore Oman. This interest was sold earlier this year for $28 million and $400,000in working capital adjustments.In 1997, Heritage expanded into both the Congo and Uganda. In 2004, the company sold out completely from the Kouilou licence area in the Congo and later sold the Kouakouala licences to Maurel et Prom, a French exploration company, and Burren Energy in 2007. We believe that these sales demonstrate a  trait of realising value through asset sales that remains today. In Uganda, Block 3 would later bereconfigured and a portion re-awarded (Block 3A) to the group in 2004. Another asset in the Congo, the Noumbi licence, where Heritage established a position in 2004, wasalso sold to Afren (Symbol: AFR; Mkt Cap: £378m) for a combination of cash and warrants in 2006.In 2005, Heritage obtained Russian assets when it acquired a 95% interest in the ZapadnoChumpasskoye licence in West Siberia. This was followed by the establishment of a presence in theDemocratic Republic of Congo (formerly Zaire), the Kurdistan Region of Iraq (KRI) , Mali, Pakistan,Malta and most recently Tanzania. Although Heritage listed on the TSX in 1999, it was not listed in London until the first quarter of 2008.The company’s shares are now a component of the FTSE 250 Index. At the same time as listing inLondon, a new parent company, Heritage Oil Limited, was established in Jersey and the company'sshares were split on a ten-for-one basis.Throughout this period, founder and Chief Executive, Anthony Buckingham has been a constant featurebehind the group’s development. His experience in the industry dates back to 1972 when he began work as a saturation diver. His biography and a full list of the board and key managers leading Heritage today is in Appendix 1.
Heritage operates a straightforward strategy. Primarily, the group sets out to identify and establish early positions in high potential hydrocarbon basins utilising internal expertise and a well developed network of industry contacts. The company then attempts to upgrade these assets through exploration, appraisaland development depending on its stage of entry. As with any strategy which sounds good in theory, it is the execution in practice that sets ultimateperformance apart. Here, we believe that Heritage has excelled as recent exploration success can attest.This is testament to savvy management and bold decision making. When unsuccessful, these attributescan lead to accusations of excessive risk taking. However, in the case of Heritage, we believe that major discoveries in Uganda and the Kurdistan Region of Iraq have vindicated the group’s strategy.
Investment Case
For an E&P company with a market cap exceeding £1 billion and with output measured in the hundreds of barrels per day, Heritage does not have a typical production driven cash flow with which to value theshares. However, it is not difficult to understand how the development of star assets in Uganda and theKRI would lead to substantial levels of positive cash flow. As such, the investment case for Heritage can be distilled down to the undervalued assets in Uganda and the KRI. That is not to say that there is no value in the group’s other exploration interests or the Russianassets which are in production. However, we believe that the tremendous upside we see in the value of Heritage comes from these two regions. At this stage of development there are two straightforward ways for Heritage to recognise and monetise the value of its existing assets for the benefit of shareholders. First, developing the assets in Uganda and the KRI itself would take the longest and expose shareholders to the most risk. On the other hand, anacquisition by a large international oil company (IOC) or national oil company (NOC) could beaccomplished relatively quickly with the added benefit of crystallising a portion of future returnsimmediately through what we would anticipate to be a significant takeover premium.Of these two options we believe a full takeover is the most probable. Several reasons support thisconclusion:
Realising value from Heritage’s relative strength as an explorer rather than development company 
Heritage has a proven track record of selling assets to realise value
 Acquirer would gain operatorship of both primary assets whilst retaining partnership with existingparties to share risk and cost
 Additional capex requirements for full development of assets in Uganda and the KRI
 Avoid execution risk associated with large scale development of discoveries
The share price has already incorporated a portion of exploration upside – incremental increasesfrom here will be forthcoming but in smaller percentage gains
Need for IOCs to expand dwindling reserve bases in environment of limited access to other largehydrocarbon basins
 A key metric for an acquisitive oil major is the price it must pay for new reserves. In the case of Heritage, we believe its enterprise value per barrel of implied recoverable oil below £1.00 makesit attractive in this sense.
Large field size with exceptional remaining upside will be attractive to IOCs and NOCs as thefields can materially impact reserve and production figures. Operationally, the risk of full fielddevelopment remains, however the need to develop 10-20 smaller fields for equivalentproduction is avoided.
Exploration to date has significantly de-risked the company’s portfolio and also highlightedsignificant remaining upside.
 Ability of net saving nations such as China to put foreign exchange reserves (sovereign wealthfunds) as well as industrial output (steel industry) to work.
Incorporate field development with other investment and development programmes.In the case of NOCs:
 Ability of nations to secure energy resources
Expand outside of home market
Foster closer ties between acquiring nation and region.

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