VAALCO Energy Means Value

| About: VAALCO Energy, (EGY)

Houston-based Vaalco Energy (NYSE:EGY) produces about 5,000 b/d net of royalties in offshore Gabon [1] and plans to ramp production to a stabilized 5,800 b/d net in the third quarter. At current production rates and Brent prices, Vaalco generates at least $16M per quarter in operating cash flow (excluding capital costs). At $70 Brent and third-quarter estimated production of 5,800 b/d, it would be a minimum of $14M per quarter. At $4.60/share, Vaalco’s enterprise value is barely 3-3.5x cash flows. [2], [3]

The reason for this ultra-low valuation is Vaalco’s short reserve life. Vaalco’s 2006 proved reserves, net of royalties, were only 6M barrels, implying a reserve life of three years (2007-2009).

However, the combination of a) year-end 2007 production constrained by the offloading facilities, b) anticipated third-quarter production constrained by royalty rate issues, and c) decline rates of 12% on the earliest wells in the field is inconsistent with the 2006 reserve estimate.

Indeed, Vaalco estimates recoverable reserves at 10.8M barrels, for a reserve life of more than five years. Addax Petroleum, which is a co-owner of the same offshore field, estimates its 3P reserves (i.e., proved, probable, and possible) at a level that implies a net of 17.7M barrels to Vaalco.[4]

In November, Devon Energy (NYSE:DVN) sold its interest in an offshore Gabon field having 5M proved barrels, 3,750 b/d of net production, and some exploration prospects for $205.5M. This translates into $41 per proved barrel or $55,000 per flowing barrel per day. These values are 20% higher than Vaalco’s valuation per proved barrel and more than 35% higher than Vaalco’s valuation per flowing barrel per day. Moreover, Vaalco estimates that its exploration prospects in Gabon could add 14M barrels of net recoverable reserves, for a total of 24.8M barrels.

Vaalco has more than $75M in net cash, or almost 30% of its market cap. It is using the cash to a) upgrade the offloading facilities to accommodate increased production, b) build a new platform to start production from the most recent discoveries, c) accelerate exploration in Gabon and Angola, and d) partner with Bow Valley Energy (BVX.TO) and Marathon Oil (NYSE:MRO) to drill a prospect in the U.K. North Sea.

The first two actions will increase production throughout 2008, while the latter two have the potential to increase reserves several hundred percent. Bow Valley describes the U.K. North Sea prospect (Block 9/28b) as a “low-risk exploration project,” (at 19:08 through 19:24) “with reserves of approximately 29M bbl. (using a conservative recovery factor of 35%).” Vaalco has a 25% interest in the well. Drilling results are due within days.

Vaalco estimates 2008 capex at $30-35M, implying at least $25M in free cash flow, for a free cash flow yield of 9%.[5] This is among the highest free cash flow yields of any U.S. E&P company. Recognizing this combination of low valuation, high cash balances, and strong cash flow, Vaalco recently approved a stock buy-back program of up to $20M, or more than 7% of all shares outstanding.

Vaalco offers a low-cost value play and a low-risk growth play, combining a strong balance sheet and strong cash flows with solid exploration potential. Not only does the current valuation disregard the North Sea prospect as well as every other prospect, it doesn’t come close to fully pricing in current production or reserves in Gabon. From a tactical perspective, Vaalco is likely to defer any buyback if the North Sea well is a success. Such a success would be worth more than $2 per share. On the other hand, a dry hole would trigger a short-term decline and create an opportunity for a market-supportive buyback at modestly lower levels. On a risk-adjusted basis, the conclusion is that for long-term investors Vaalco means value right now.


[1] 21,000 b/d gross field production as of 2007Q3 * 0.28 Vaalco interest in field * (1 – 0.15 royalty) = 5,000 b/d.

[2] Taxable income in Gabon is gross income minus Gabon production costs and Gabon capex, excluding DD&A and G&A. Cost account balances and tax rates vary, with higher rates applying to lower cost account balances. Assuming zero deductible capex, zero cost account balances, and excluding $11.50/bbl DD&A, which is not deductible for Gabon tax purposes, the most conservative possible estimate of Vaalco’s operating cash flow at $70 oil and 5,000 b/d would be approximately as follows: $70/bbl - $8.50 LOE = $61.50 taxable * 0.5 tax = $30.75/bbl – $4.50 G&A = $26.25/bbl cash flow * 5,000 b/d net * 91.25 days per quarter = $12M/qtr or $48M/yr. At $90 oil and 5,000 b/d = $16.5M/qtr. or $66M/yr. At $70/bbl oil and 5,800 b/d net = $14M/qtr. or $56M/yr.

[3] 60M shares o/s, fully diluted * $4.60/share + $5M long-term debt - $80M cash = $201M EV. $201M EV / $60M annualized operating cash flow = 3.4x.

[4] Addax’s 3P estimate of 23.2M bbl / Addax’s 0.3136 interest * Vaalco’s 0.281 interest * (1 – 0.15 royalty rate) = 17.7M bbl net to Vaalco.

[5] ($60M operating cash flow - $35M capex = $25M free cash flow / (60M shares o/s * $4.60/share) = 9%.