(Disclosure: The following represents my opinions only. I am not receiving any compensation for writing this article, nor does Hydra Capital have any business relationship with companies mentioned in this post. I am long SDX.V)
Bottom Fishing With the Dragon
I’ve followed Sea Dragon Energy (SDX on the TSX Venture) for years. Long ago, in a time since forgotten, the company was relatively widely held by institutions and retail investors alike. In the past, I don’t think I’d ever owned the name as I never really knew where the company was going and if you recall, Egypt had a fair bit of “country risk” for a while there. Today, things in Egypt seem to be settling down and there have been some developments over the past year or so that have caught my eye when it comes to the SDX’s future prospects.
You’d never know it from the chart, but I think that SDX has passed through the flames and emerged more or less intact. Looking past the current 2.5-cent share price and somewhat bloated outstanding share count of 376 million; I think the company may actually represent an interesting speculation over the next 12-18 months. Corporate production in 2015 is expected to average around 1,000 barrels of oil per day (net) from the company’s 10% interest in the NW Gemsa asset. NW Gemsa is a multi-reservoir, multi-field asset with a multi-year reserve life, which is big enough and long enough for the purposes of my thesis on this story. Keep in mind that I am targeting a 12-18 month time frame here… if I’m looking for 300+% returns, they typically don’t come in a few weeks or months. It’ll take patience and a little luck, but I think SDX has the right ingredients to be a multi-bagger.
My thesis for SDX is about as simple as it gets. I am only considering NW Gemsa and the newly acquired South Disouq (pronounced, dis-ook) concession in my analysis. Gross cash flow (revenue net of royalties minus direct operating costs) from NW Gemsa at plateau production rates of 10,000 bopd gross (1,000 bopd net) should be somewhere in the range of $5.5-6.0 million per year assuming $15/bbl netbacks. Corporate G&A run rate is currently around $3.5 million per year, which I think is reasonable for an international junior with a head office in London and operations in Egypt. That leaves somewhere around $2.0-2.5 million per year available for operations, $1.7 million of which will be spent on NW Gemsa development wells in 2015. At the very least, it appears that SDX has what it needs to keep the lights on for a while. Not that exciting yet, right? Enter South Disouq.
They say the best place to find oil or gas is where it has been found before and in my mind it’s even better if you can go looking there under the guidance of someone who has previously found it there.
When I saw SDX secure the rights to the South Disouq concession in early 2014, I really started paying attention. A farm-out process was started soon afterwards, which eventually resulted in a private company called IPR Energy Resources agreeing to pay the (capped) cost of an exploration well, $1.9 million of the signature bonus, the posting of a $6 million work program guarantee, and its proportionate share of a 400 square kilometer 3D seismic survey in exchange for a 45% interest in the block. A subsequent prospective resource report on the block by well-known engineering firm Ryder Scott showed an unrisked prospective resource estimate of 11.2 mmboe (P90) to 242.2 mmboe (P10), with a mid-case (P50) of 73.2 mmboe. In gas terms, as that is the targeted commodity here, that’s a range of about 66 BCF on the low end and 1.4 TCF on the high end (using a 6:1 mcf:bbl ratio)… but I must stress that those are simply goalposts, as there are no discovered resources on the block yet.
Given that SDX trades at 2.5 cents and has a market cap of about $9 million with net debt of around $3 million post farm-out, it wasn’t hard to convince myself that this was a decent speculation. In its most recent reserve report, the company’s existing reserves have an after-tax NPV15 of CDN$20 million on a proved basis and CDN$27 million on a proved plus probable basis. In terms of access to capital, the company has an existing credit facility that it should be able to draw on for its portion of the South Disouq 3D seismic survey costs. Call me an optimist, but I suspect that at least one “sizeable” prospect will be revealed by that seismic survey, at which point the market will be free to speculate on the potential value of any future discovery. Based on data from limited historical wells and seismic, the up-dip pinch-out of the targeted stratigraphic package is expected to occur within the South Disouq block, which is what sets up the potential trapping mechanism. Any gas that migrated up-dip towards that pinch-out edge could be trapped along it as long as the edge seal is intact. Limited vintage 2D seismic data gives some encouragement that this may be the case, but the 3D survey should be far more illuminating.
I think that my 12-18 month horizon allows for enough time for the seismic tendering process to be completed, followed by seismic acquisition and processing, and eventually the drilling of a well some time in 2016. The well itself won’t take long to drill, but it can’t be rushed… SDX needs that 3D seismic survey to: (a) have confidence in what they’re drilling and (b) know what they’re dealing with in terms of a discovery should they make one. For some people 12-18 months might seem like forever, but if my past experience is any guide, the speculation cycle starts earlier than you think. The key to successful speculation in my mind is to be early and patient, as entry price is one way to limit the associated risk. Even small bets in the early days can make for great wins in the long-term if the company can survive long enough to see the “option” play out. In this case, I think SDX’s core business at NW Gemsa will indeed carry the company through to that potential blue-sky event.
To take a hypothetical approach, I asked myself what would happen if SDX shows they have 300 BCF of good-looking prospect(s) once the 3D is shot (recall that the P50 case as estimated by Ryder-Scott is for 440 BCF equivalent). What would a 300 BCF resource be worth? In light of favorable gas terms that could see SDX selling any discovered gas to 3rd parties for $5-6/mcf locally (that’s a new development in Egypt) coupled with nearby access to two main gas pipelines, I would have no problem assigning $1/mcf to my imaginary target (for reference, Centurion sold for about $2/mcf). That would put 55% of $300 million on the table, which is $165 million. That’s a fair bit of upside for a company with a current market cap of $9 million and well costs are relatively cheap in this play, perhaps $2-3 million. For me, this is the definition of “option value”. I feel comfortable that I’m somewhat backstopped by NW Gemsa given the reserve values discussed above and as a result I think SDX presents a highly skewed risk-reward profile.
I suppose the real bet here is that the 3D seismic shows a valid exploration target(s) of decent size. If it doesn’t, I would likely move on and take a manageable loss in the absence of any other corporate developments. If it does however, you can bet that I’ll be holding at least a partial position right through the drilling of that first exploration well.
I’ve seen this kind of story enough times before to know that I like where the stock is now from a valuation and sentiment standpoint. Today, no one owns the stock and no one really cares about it. It’s been forgotten and orphaned, waiting to be rediscovered by the market when (and if) there is actually a real exploration target on the table down the road. If the 3D lights up a good gas target, I’m fairly certain that the sentiment (i.e., price) pendulum will start accelerating in the positive direction. For now, I’ll have to be content with my hypothetical South Disouq exploration target and NW Gemsa valuation backstop. Patience is going to be the key on this one, but if I size my bet properly I won’t mind waiting it out.
** for those who are interested, the most recent corporate slide deck can be found here: