Stop Hyperventilating Over Hyperdynamics

Back in mid-December, I cited 101 reasons the market looks overheated. One of the examples I offered of a speculative stock showing signs of froth was Hyperdynamics (AMEX: HDY), a small company with a large exploration license in offshore Guinea. Amazingly, the stock has doubled since then.

Your first guess might be that Hyperdynamics made a huge discovery sometime in the past month. Well, that's not the case. The firm isn't planning to drill its first well until the fourth quarter. The only material news is that Hyperdynamics has entered into a letter of intent with a large independent E&P regarding a farm-out.

Farm-outs are pretty straightforward. A license holder sells down its interest in the exploration block to a partner who, in addition to possibly paying a signing bonus, agrees to foot a portion of future costs, as well as project-related costs incurred to date. Hyperdynamics brought in Dana Petroleum (since taken over by KNOC, Korea's national oil company) as a 23% partner about a year ago. It's now looking to farm out an additional 30% to one or more companies, in order to fund a three-well program expected to cost $129 million.

I should note that Hyperdynamics announced a letter of intent with Repsol (NYSE: REP), which was to operate the project with a 37% interest, in late 2009. That deal was not completed. If the current negotiations fall through, I expect the shares to take a dive. But let's assume Hyperdynamics does bring in a strong partner like Noble Energy (NYSE: NBL) or Nexen (NYSE: NXY) to take the entire 30% farm-out. That leaves the company with its desired 47% interest and the ability to proceed with drilling.

How much is that barrel in the window?
Netherland, Sewell (NSAI), one of the top independent reserve estimating outfits, has placed a best estimate of 2.26 billion barrels of gross unrisked resource potential on Hyperdynamics' block. On the December conference call, management said that NSAI assigned the company a "risk-weighted resource estimate of about 350 million barrels." That translates to about a 20% chance of success on Hyperdynamics' 77% working interest pre-farm-out. If we use the same chance of success on Hyperdynamics' post-farm-out 47% working interest, that's 212 million net risked barrels.

With a touch over 125 million shares outstanding, Hyperdynamics' market capitalization is currently around $900 million. On an adjusted enterprise value basis, assuming the closing of the pending farm-out, I see the market valuing Hyperdynamics at roughly $4 per risked barrel.

$4 per barrel? Sign me up!
That might not sound like much, compared to an international oil price flirting with the $100 level. An oil barrel in hand is worth a heck of a lot more than two in the possible bush, however. Four dollars is on the high side for undiscovered oil barrels in a virtually undrilled frontier province. I used a $5-per-risked-barrel metric for my valuation exercise on Cobalt International Energy (NYSE: CIE) last year, but that company focused on the Gulf of Mexico, Angola, and Gabon. Unlike those well-developed oil markets, Guinea has not seen any modern offshore drilling, and I assume it has little to no relevant infrastructure.

I'm not questioning the prospectivity of offshore Guinea. Anadarko Petroleum (NYSE: APC) made a discovery in neighboring Sierra Leone in its first attempt. Further up the coast in Mauritania, there have been a string of discoveries as well. I do think Hyperdynamics should get a larger frontier risk discount than investors are currently awarding it, however.

An attempt at an apples-to-apples comparison
Consider Chariot Oil & Gas, a U.K.-listed company with major acreage offshore Namibia. Namibia, another virtually unexplored oil frontier, is just south of OPEC member Angola, and smart folks such as HRT Oil & Gas' Marcio Mello (formerly of Petrobras (NYSE: PBR)) argue that it's analogous to offshore Brazil and its massive pre-salt oil deposits. It would seem that Namibia is at least as prospective as Guinea.

Chariot has brought in Petrobras as a 50% partner on part of its acreage. Looking at only the portion covered by that farm-out, and assuming the same 20% chance of success as with Hyperdynamics, Chariot is valued at around $0.80 per net risked barrel. These guys use NSAI to do their reserve estimates as well, though this week's resource update has not yet been independently verified.

Chariot doesn't have much money, and it also has no drilling timetable, so I would expect it to trade at a fairly hefty discount to Hyperdynamics. Still, the valuation gap is pretty striking. Is Hyperdynamics really worth five times as much? As always, I encourage you to sound off in the comments section below.

Disclosure: No positions