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Executive Summary

Pan Orient Energy (OTC:POEFF, POE on the TSX Venture) represents one of the best risk-reward scenarios that I have seen in the international E&P space in recent memory. I have followed the company since inception and the position that POE is now in has been years in the making. The company is entering one of the most active drill programs in recent years with targets that have taken years to define, rank, and now drill. In the following paragraphs, I'll detail how the current share price of $2.86 values only POE's existing production base while offering multiple "free options" that can range from $5-10+/sh (incremental) each.

This is primarily a Southeast Asian asset base with a Canadian SAGD sidecar asset in the (net) 150 million barrel recoverable range (contingent resource best (mid) case estimate). The SE Asia assets are a mix between production (Thailand) and high-impact exploration (Thailand and Indonesia), but what I find most compelling is the apparent lack of value assigned to anything other than the company's current base production of 1500 bopd.

In mid 2012, POE sold a portion of its onshore Thai assets for approximately $170 million. Without going into the details, this was a transformational deal for the company, and one which I believe the market has yet to fully appreciate. As of their most recent Q3 2012 financials, POE had net positive working capital position of $130 million and no debt.

Pan Orient has 56.7 million shares outstanding and the stock price is $2.86 as I write this note. That's a market cap of $162 million on a company with around $130 million in cash. That leaves an enterprise value of $32 million for the balance of the company's asset base.

The assets are spread over 3 regions with a focus on SE Asia: 1) onshore Thailand, 2) onshore Indonesia, and 3) Alberta, Canada. The company has current production of 1500 bopd from onshore Thailand, on which they receive revenue on the order of 85-95% of Brent pricing. Production expenses and royalties in Q3 2012 were approximately $24 per barrel, leaving POE with about a $75 per barrel netback.

At a $75/bbl netback, 1500 bopd generates about $40 million in gross cash flow per year. Even at a $50 netback, that gross cash flow would be about $27 million per year. The company's G&A run rate is about $5-6 million per year. Recall that the enterprise value of the company is $32 million currently.

To put it another way, POE has $2.29/sh in cash and does between $0.39 to $0.60/sh in cash flow per share (using a $80-105/bbl Brent price range) at the current rate of 1500 bopd. With the stock at $2.86, that translates into 0.9-1.4x EV/CF.

The main question is with respect to the reserve life of the company's production base. Depending on the ultimate size of the company's most recent Thai discovery, total current recoverable resources appear to be in the range of 1 million (low case) to 5 million (upside case) barrels which means at 1500 bopd, the RLI (reserve life index) of POE's producing asset base is between 2 to 9 years (more detail here in the Q3 MD&A), so with an EV/CF ratio of 0.9x-1.4x even POE's existing production base is conservatively priced by the market.

Typically, a company with reserves of this size wouldn't interest me, but POE's exploration portfolio offers multiple drill-ready targets ranging from 50-500 million boe net recoverable each. On a well-financed company with a $32 million EV, discoveries on targets of that size can be very lucrative for investors, and free options on targets like that are what asymmetric risk-reward profiles are all about.

The Upcoming Drill Program: Indonesia

Onshore Indonesia is where the biggest near-term targets are being drilled. First, some housekeeping on the events of 2012 that I believe are a factor in the market's current "lack of optimism", which has set up the current opportunity in my view. Drilling difficulties on two wells last year (Jatayu-1 and Cataka-1) led to a wellbore re-design which has been incorporated into to 2013 program, with early drilling at Cataka proceeding smoothly now. Geulis-1 was a low probability commitment well that had to be drilled in 2012 and was unsuccessful. Jatayu was recently abandoned before hitting target depth due to high pressures and gas flows encountered as the company tried to salvage the initial well with a slim hole rig. Safety concerns led the company to abandon that well with a new well (with a larger surface hole to allow for more casing strings) potentially to be drilled in 2013. Both of those targets are each in the 300-400 BCF recoverable range in terms of prospective resources.

Rule-of-thumb valuation for Indonesian onshore gas is about $1/mcf in the ground and POE is close enough to infrastructure for this rule of thumb to apply. The Jatayu and Cataka targets are still "alive"... the drilling difficulties to date have not condemned the targets themselves, just the well designs. For context, at $1/mcf, 300-400 BCF would be worth $300-400 million. Given that the wells should cost $6-8 million each to drill, these are attractive exploration targets. The new Cataka well is currently drilling and I would expect that it should take about another month to drill to total depth. The company will decide whether or not to revisit Jatayu after the Cataka well is completed.

The real jewel in Pan Orient's Indonesian asset base is arguably the Batu Gaja PSC (production sharing contract) where the company holds a 77% operated interest in the block. Batu Gaja is "first round relinquishment" land, which means it was the land given back to the state after an initial (i.e. the first) exploration program was conducted. Basically, that means that one company got the concession, shot seismic and drilled what they could in the initial exploration phase and at the end of that exploration period they were only allowed to keep a certain percentage of the land area (this is standard practice in international PSCs). You never get to drill everything in an initial PSC. You keep what you can and give the rest back for someone else to explore later. All of this is to say that first-round relinquishment land can be highly prospective as it's only been through the exploration process once before.

There are numerous oil, gas, and condensate discoveries in just about every direction of POE's targets on the Batu Gaja block, and I would encourage keen investors to reference the (somewhat dated) Pan Orient corporate presentation here for maps and more detail. A recent update from Pan Orient states that a 3 well back-to-back drilling program on the Batu Gaja PSC is expected to start in late January or early February. In particular, Shinta-1, Buana-1 (aka NTO-2 in the corporate presentation), and Kemala-1 are slated to be drilled in the upcoming program.

Going into prospect-by-prospect detail would be painstaking and may put you to sleep, but Shinta-1 is representative of the quality of the targets on the block and is worth discussing. Shinta is a target literally surrounded to the north, south, east, and west, by oil and/or gas fields. The fluid type may be oil or gas if a discovery is made at Shinta. In the oil case, the mid-case prospective recoverable resource is 137 million barrels, while in the gas case the mid-case prospective recoverable resource is 404 BCF (source: Pan Orient corporate presentation). The structure is covered by 3D seismic and is similar in structural style to the producing fields around it (owned by PetroChina). Shinta is a multi-zone target with direct hydrocarbon indicators evident on seismic. All of these play elements serve to reduce exploration risk and the rewards are potentially significant... Net to POE's 77% interest, the gas case would be worth $300 million using $1/mcf while the oil case would on the order of $800 million using $8/bbl in the ground, which are both fair rule-of-thumb numbers based on my experience in the sector. Start dividing those numbers by 56.7 million shares and the leverage becomes clear.

I could go on for pages and pages on each of the targets, but I will leave that deep-dive for those who are truly keen. The Sogo Utara prospect (future drill target, no date set) is probably a 1 TCF target, while the Anggun prospect (future drill target, no date set) on a separate PSC (East Jabung) is described by Pan Orient as potentially holding in excess of 500 million boe recoverable (this big 4-way closure target is in an area where drilling has only recently been allowed). (Most companies operating offshore, where well costs can be 10x as much, can't offer exposure to targets of this size). Anyone reviewing the exploration portfolio will be impressed by the size, quality, and number of exploration targets in the Indonesia portfolio to which investors have this "free" exposure.

The Upcoming Drill Program: Thailand

The upcoming Thailand drilling is expected to start on January 5th, 2013, and 5 wells are planned. One to two wells is/are to be an exploration well(s) targeting 5-10 million barrels recoverable on a new target on the L53 block, while 3-4 development/appraisal wells are planned for the L53-D discovery found in 2012. The goal of the program is two-fold: 1) increase production and upgrade reserves through low-risk development wells and 2) attempt to establish additional resources on nearby lands. The wells should be quick and cheap, at $1.5-2.0 million each. It is worth noting that even a 2 to 5 million barrel discovery is material to Pan Orient at this stage. Later in 2013, there is a chance that additional drilling may be carried out on a prospect to the north of the L53-D field where initial seismic work suggests there may be a structure capable of holding 10's of million of barrels of recoverable oil.

To sum up Thailand, it is a cash flow engine that drives near-term revenues that help offset capital expenditures in Indonesia with moderate upside potential through exploration drilling. Again, investors arguably pay nothing for the Thai exploration upside, so I tend to look at this as a free option on top of the Indonesian free option.

SAGD in Canada at Sawn Lake: Is it Worth Anything?

The last asset worth discussing briefly is Pan Orient's 71.8% holding in a private Alberta company called Andora Energy. Andora's key asset is a SAGD project with a best (mid) case contingent resource of 214 million barrels recoverable, which translates into just over 150 million barrels net to POE. Pan Orient invested nearly $25 million into Andora earlier in 2012 to start a SAGD pilot project at Sawn Lake, with two intentions: 1) determining/proving the well-pair economics, and 2) converting the contingent resource into reserves if the project is successful. Honestly, at this stage, no one really knows how to value Sawn Lake. Q1 2012 engineering reports peg the 100% interest value at $600 million (before tax NPV10 basis), which would be about $420 million net to POE now that they have upped their interest to 71.8% (link to the press release here), but the market consistently values the project at zero. Similar assets in junior oilsands companies appear to be valued at anywhere from 10c per barrel in the ground to $1 per barrel in the ground depending on the market's level of optimism.

The market should see progress on this asset in 2013 via pilot project work/preparation. I will look at this too as a free option.

Summary: Skewed Risk Reward

If you've made it this far, you have likely grasped the impression that POE at current levels offers a set of outcomes skewed to the upside as a result of multiple, potentially significant, free options via assets outside of the Thai production base. Given the pristine balance sheet and base production value, investors have the benefit of downside protection (through cash balances and simple math on the production base) while the exploration program kicks into high-gear in Q1. It is this limited-downside-with-significant-upside dynamic that I look for in this space and POE fits the bill. This is not to say POE is without risk, because that is simply not the case, but it is fair to say that the odds are skewed in investors' favor with what is on the table today.

The Risks

Investing in any oil and gas company comes with inherent risks, and international oil and gas stocks are no different.

Off the top of my head summary of the risks for Pan Orient include but are not limited to: inherent risk associated with exploration and development drilling, reservoir performance of producing assets not meeting expectations, expropriation of assets by foreign governments or regulatory agencies, oil/gas price fluctuations, natural disasters, local opposition, regulatory changes, failure to find additional resources, and any liabilities that may arise in the normal course of business for any E&P company. To the best of my knowledge, none of these are factors outside of those encountered in the normal course of business (dry holes, for example) with respect to POE, though I will point out that Thailand does seem to change governments via a coup on a fairly regular basis (almost standard practice over there) and Indonesia has recently re-organized their regulatory agency with little fanfare. I find that setting up a "google email alert" for news stories involving Indonesia and Thailand and the words oil or energy will help catch regional political/regulatory developments early.

I also feel that it's worth noting the following in this "risk" section... In discussing POE with investors, I have heard some say, "Their capex is set at $73-95 million in 2013, so using today's cash value for determining an EV/CF ratio is aggressive". While I understand that viewpoint, there is an inherent assumption in that statement that implies that Pan Orient may just as well pile $73 million into a giant heap and set it on fire. There is nothing "wrong" with that view, but for obvious reasons I believe it is exceedingly pessimistic.

To assume that a company will generate zero net return from 100% of its capital program is about as pessimistic as one can get, but technically it can happen. This is typical of market psychology, when times are good and money is freely flowing, E&P stories often start incorporating "risked value" in order to justify their valuations. At times, this risked value can become absurd (I can think of some offshore oil plays around the world that attained >$500 million market caps on the very possibility that their totally undrilled acreage may hold the next big discovery). It is my view that the market's willingness to pay for "risked value" in an E&P stock is a pendulum that swings back and forth. I would suggest that at this point, the pendulum for POE is still in a favourable position given that the "base case" presented here involves assuming a net flat return on the 2013 capex program (i.e., spend $73mm, generate $73mm in value). Obviously a hit on any one of the aforementioned exploration wells would take care of that and then some. If every single well is dry, that would be some bad luck indeed!

Source: The (Pan) Orient Express - A Highly Skewed Risk/Reward Situation