The recent stock decline and low EV for Hyperdynamics (HDY) significantly discounts the possibility of successful drilling in one of the most lucrative yet overlooked regions.
- A high net cash position provides downside protection while expected drilling in 1H14 provides upside potential, possibly compounded by a short squeeze.
HDY is an independent E&P company focused in Guinea.
Investors should look beyond domestic shale
Investors focused on the growth of domestic shale may have overlooked similar potential in West Africa. There are two encouraging signs that highlight the value of assets in the region. First, there have been multiple discoveries made by other companies along the Equatorial Atlantic margin, many in deepwater where HDY operates.
Second, 3D seismic studies and previous drilling experience with the Sabu-1 well reveal a potentially significant petroleum system in the Guinea Basin. For example, Tullow's exploration director described the Sylli prospect (one of the two prospects HDY is focused on) as a Jubilee-type prospect* and that the geology of offshore Guinea is superior and more prospective to what they've seen in the Ivory Coast and Sierra Leone.
Moreover, management said at a recent conference (free registration required to view transcript), that a third-party resource estimate issued in late 2012 increased the potential resource from 6 billion barrels to 10 billion.
*This refers to a 1.5 billion barrel discovery made by Tullow (and partners Kosmos and Anadarko) in 2007 that was brought on stream in only 3.5 years, a record for an ultra-deepwater according to management.
Farm out agreement skews risk/reward in shareholders' favor
In order to fund deepwater drilling, HDY wisely decided to enter into a farm out agreement rather than attempt to fund most of these costs itself, which mostly likely would have resulted in massive dilution.
At the annual meeting, management used a baseball analogy to compare HDY to domestic shale plays by labeling the latter as hitting for "singles" while the former hits for "home runs". However the risk of a "strike out" in this case (e.g. drilling disappointment) is reduced given the farm out agreement and strong balance sheet (see below).
In December 2012, HDY sold a 40% gross interest to Tullow Oil and received $27 million for reimbursement of past costs. Tullow agreed to pay HDY's participating interest share of drilling costs for an exploration and appraisal well up to $100 million while HDY is responsible for its share of costs above $100 million. HDY now owns a 37% interest (from 77% before), Tullow owns 40% and Dana Petroleum (subsequently acquired by Korean National Oil) owns 23%. HDY chose Tullow (after interest from eight pre-selected companies) due to its excellent track record in offshore West and Northwest Africa, high overall drilling success rate of 74% and access to one of the best deepwater rigs in the world under long-term charter.
While HDY gave up a portion of the potential upside, it is no longer responsible for a significant portion of the costs, which is a "positive expectancy" trade for a microcap, independent E&P company.
There are three primary value drivers and one near term catalyst.
Value driver #1 - valuation disparity. While a traditional valuation analysis is difficult given the lack of production, the below peer comp supports a significantly higher valuation.
Another relevant peer comp is Cove Energy (another E&P company focused on Africa). Cove went from "founding to finish" in less than three years after it was acquired by PTT Exploration and Production (Thailand's biggest oil and gas company), who won the bidding war and paid 1.22 billion GBP.
Source: ERHC Energy company presentation
Value driver #2 - understated book value. As shown in the chart below, the high net cash position and lack of debt limit the downside. The implied value for its 37% interest overcompensates for the lack of current production and higher risks involved in deepwater drilling. Moreover, HDY significantly reduced its annual burn rate to ~$12 million by reducing the workforce by two-thirds and closing its offices in London and Guinea.
Value driver #3 - potential sale. While management downplayed the possibility of selling the company at the annual meeting, the CEO said that "selling the company before the well is drilled takes away that upside". This implies that if there is a successful discovery, the management and/or board may be more willing to sell, especially as the value of the company would have increased significantly. Moreover, the current high industry interest in the region would support a higher exit price.
Near term catalyst. The expected 1H14 drilling represents a significant catalyst. The low EV and recent stock decline (as shown in the chart below) may drive a short squeeze (e.g. short ratio of 16.4) as there is little implied faith of drilling success.
HDY is dependent on a single exploration asset and has no proven reserves, revenue or production. The following are the primary threats to the investment thesis:
Drilling is speculative and expensive. The cost of its exploratory well (Sabu-1) was higher than initially expected and oil was not discovered in commercial quantities. Additional risks include the inherent uncertainty regarding estimated reserves and the increased time and expense of drilling in deepwater compared to shallower waters.
Geopolitical risk. The sole potential revenue generating asset is located in Guinea, a country with a history of civil wars and corruption. The risk of the former is mitigated after a president was democratically elected in 2010.
DoJ subpoena. In September 2013, HDY received a Justice Department subpoena requesting documents relating to its business in Guinea, which caused a 15% drop in the stock. This may have been an overreaction as HDY said in October 2013 that the probe likely won't affect drilling.
Need for future funding. HDY may need to issue shares in order to fund future drilling, especially if costs exceed the $100 million cap. Dilution could be avoided by another farm out agreement.
HDY has no control over the level, trend or volatility of oil prices.
Much like Applied Minerals, arriving at a target price is difficult and subject to greater than normal uncertainty. However, even if HDY only regained a portion of its recent losses (e.g. target of $4), this would represent a significant gain.
The support area around $3.15 provides a natural place for a stop loss, which should be wider than normal to accommodate the higher volatility (but still no more than 10%). Gap risk can be reduced using options, which typically are not available for sub-$100 million stocks. The time frame is one year given the previously discussed near term catalyst.