(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 VLE.TO)
The Valeura Barbell
A lot has changed since I first started writing about Valeura Energy (VLE on the TSX), with the two shallow discoveries on Banarli and Statoil's recent interest being the two most prominent developments. Based on the number of inbound emails and calls that I'm getting lately, I thought it would be useful to put together a "state of the union" with respect to the story. The goal here is to describe what is best described as Valeura's "barbell" approach, to borrow a term from VLE's recent marketing trip. On one side there is a shallow gas business that is about to embark on a path of internally financed production and cash flow growth. On the other side, there is a parallel program targeting the multi-TCF tight gas upside potential of what I will refer to as the Thrace Basin BCGA. This sets up a compelling risk reward situation which I'll take a shot at quantifying below.
Valuing the Shallow Gas
There are a variety brokerages with varying price targets covering Valeura: Mackie ($1.30), Dundee ($1.60), First Energy ($2.00), Canaccord ($1.50), and Cormark ($1.60). Price targets can be derived in a number of ways... cash flow projections, reserve values, and risked prospective resource estimates all usually figure in these analyst reports, but none of them would include any value for the BCGA prize right now. That's because the BCGA prize is so big that even putting a very low chance of commercial success on the BCGA play would likely add "dollars" to analyst price targets. So, setting the BGCA potential aside for a moment and polishing my crystal ball a little, I'm going to suggest that VLE is likely to grow its shallow gas production to around 2,000 boepd by the end of 2016 and to 3,000 boepd by the end of 2017.
My math is pretty simple. The company currently produces about 1,000 boepd and should start drilling again on Banarli in late June/early July. Initially, two to three wells are planned and these wells are likely to be drilled to offset the Bati Gurgen and Yayli discoveries, which makes them relatively low-risk development/appraisal locations. Based on nearby wells, average IP30 production per well could be expected to be 300-500 boepd per well (2-3 mmcf/d). There's also the pending completion of the Osmancik zone at Yayli-1 over the next two weeks or so, which probably adds an additional 150-300 boepd. On finalization of the Statoil deal, something which I see very little risk on, VLE is set to receive roughly US$6 million in back costs, which would fund an additional three wells, all likely drilled by the end of the year. That means that VLE is probably going to drill 5-6 new shallow gas wells in 2016. Valeura's historical success ratio on shallow gas drilling is running >90% if my memory serves correctly. At 300-500 boepd per well, I really don't think it's a stretch to see VLE exit 2016 at 2,000 boepd net of any production declines you could dream up. That would put VLE on a cash flow run rate of around $22-23 million per year, which would then set the company up to drill a well per month on average in 2017. I'm going to take a conservative stance and say 7-8 of those wells are productive, which lets me get to a 3,000 boepd 2017 exit rate net of declines with plenty of room for error. At 3,000 boepd, VLE would cash flow something on the order of $35 million per year net of all expenses, royalties, G&A, etc.
VLE has roughly as many locations in its Banarli drilling inventory as would be needed to meet my best guess through 2017. Importantly, in mid-2017, it's expected that Statoil will start covering the remaining 400 square kilometres of the Banarli block with 3D seismic. Given the stacked/multi-zone nature of the geology and the number of faults already mapped through the block on 2D, I'm pretty confident that that program will turn up dozens of new targets, which means that VLE will have plenty of shallow inventory for 2018 and beyond. That's a nice piece of business.
At the current share price of C$1.20, VLE's market cap is roughly $70 million. That means VLE is trading at about 2x EV/CF, on what I think is a very reasonable run-rate cash flow estimate. I should stress that I'm looking out 18 months here, but when you are actually looking at a sustainable, self-financing shallow gas business, that's not too far to think about given the BCGA prize that I think investors pay nothing for right now. For the market to value VLE at 4-6x EV/CF once my crystal ball math becomes a little more tangible isn't out of the question at all. I think that is likely to start to happen by the end of 2016, which means that VLE's share price could double or triple from here and I think that I would still be getting the BGCA exposure for free.
Valuing the BCGA Potential
I mentioned above that the BCGA prize is so big that it can't be included in analyst targets at even very low chances of commercial success or it will distort their price targets. I took a stab at putting some OGIP numbers to it earlier this week in one of my notes (link to it here). I actually think that the estimate that I put forward in that note is pretty conservative given how thick the sedimentary package is as you move towards the centre of the basin, but I'll run with it here. I've said there is at least 1.5 TCF recoverable on the table if only one-quarter of the Banarli lands have 150 metres of gas pay in them. Recall that Yayli-1 found 128 metres of gas pay on the very edge of the potential BCGA cell, so I don't think my 150 metre assumption is at all a stretch... in fact, it's probably overly conservative. That would mean that VLE would be looking at minimum 0.75 TCF net to their interest in a successful Banarli BCGA case.
I should stress that this is very, very speculative at this point, but I think it's always useful to know what's on the table before the cards are dealt. As more information becomes available (that process starts in Q4 when Statoil starts drilling their first deep well) the market will have a better idea of how real these massive OGIP numbers are, but for now it's enough to know that there is a boatload of gas in play. Back when I worked at PanCanadian about 15 years ago, we used to say that if you could wave your arms around (i.e., extrapolate based on a small amount of data) and come up with 1 TCF, that it would be worth about $1 billion in its undeveloped state, provided that someone had proved that economic production was viable within the play as mapped. Sticking with that as a very general guideline, that would mean there is some $750 million on the table for Valeura in a conservative BCGA case. Even assuming VLE issues more shares along the way, the leverage is pretty clear given that the company currently has 59 million shares outstanding with Statoil funding the BCGA program through to 2018.
Remember the Macro Picture
To revisit the big picture, when I saw the headlines late last year citing the downing of a Russian bomber in eastern Turkey by Turkish F-16's, it really put the spotlight on Turkey's gas market for me. Russia-Turkey relations went ice cold overnight and almost immediately news articles started circulating about Turkey's need to diversify gas sources. Since then, Turkey has been actively courting Azerbaijan, Iran, and Israel (to name a few) for gas supply contracts and energy infrastructure deals. Pretty much any country that could provide incremental supply has been put into the mix. Recall that Turkey imports 98-99% of its gas needs… and almost 60% of its imports come from guess who? That's right… Russia. To put it further in perspective, the U.S. EIA reports that Turkey relied on natural gas for roughly 40% of its electricity generation as of 2012 (that number is now closer to 50%). They say a picture is worth a thousand words... so have a look at these EIA charts below:
In terms of area, Turkey is slightly larger than Texas and has very good geologic potential for both gas and oil depending on what part of the country you're in. The country has good domestic distribution infrastructure, multiple regions of historic and current drilling activity, one of the best fiscal regimes in the world (12.5% royalty and 20% corporate tax), and one of the world's longest histories of trade and commerce. It ranks 18th in terms of global GDP, so we're talking about a real market here. Gas pricing is also very strong... VLE currently receives roughly $10/mcf... 5x the current North American price. Heck, even if Turkish gas prices were half of what they are today, it would still be enough to make any North American gas company salivate. Given all of the above data points, I would be shocked if there are not a number of other companies looking at how to get into Turkey's gas market right now.
I often hear people mention Turkey and "country-risk" in the same sentence, but that's not something that keeps me up at night. Erdogan is certainly taking a more authoritative stance from a civil perspective, but when it comes to business, Turkey has a strong legal framework and rule of law. Relationships with local landowners and government officials are excellent and the nice thing about where VLE is operating is that it's far, far away from any of the security troubles near the Syrian-Iraqi border. The Thrace Basin region has similar physiography to say, Alberta... it's a great place to operate and has multiple options for gas evacuation, sales, and transport. I don't want to discount country-risk completely, but VLE management's last rodeo was in Libya and they can't say enough good things about Turkey as a place to operate. In general, I think a lot energy investors actually know very little about Turkey because of it's relative obscurity on the energy scene.
I think that once the market realizes that VLE is about to become two companies in one (i.e., a growing, self-funding shallow gas business running in parallel with a multi-TCF-potential deep gas program financed for the foreseeable future by Statoil), that much broader interest and higher valuations will follow. None of these things happen overnight, but when I look ahead, I see VLE tracking on a good trajectory to make the transition from obscurity to the mainstream. When the shallow gas program starts in 4-6 weeks, VLE will be drilling low-risk, 100%-interest wells with quick payouts (6-8 months) and strong netbacks ($45/boe) and I think that's when the production growth potential should become much more apparent to the market. Given that the after-tax NPV10 of VLE's existing reserves is C$98.7 million, or roughly $1.65/share, I'd say that current analyst targets have nowhere to go but up with continued drilling success... and I'd say the odds of that are pretty good indeed.