Coastal Energy Company: A Traditional Value Investing Opportunity

| About: Coastal Energy (CENJF)
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The Background History

Surrounded by the countries of Malaysia, Thailand, Cambodia and Vietnam, the Gulf of Thailand is a shallow arm of water attached to The South China Sea. With a total coastline that stretches approximately 2,600 kilometers and an average water depth of 45 meters, the Gulf of Thailand creates a very attractive environment for shallow water oil drilling and exploration.

Chevron Corporation (NYSE:CVX), the original explorer, discovered the first natural gas pockets in the region during the early 80s. Several years later, Premier Oil Plc. (LON: PMO, OTCPK:PMOIY), an oil exploration company, began to conduct wildcat drilling activities in the Thai block G5/43 region; this exploratory drilling proved successful. According to Bill Phelps, Chief Financial Officer of Coastal Energy "We cannot speculate as to Premier's rationale for not developing the fields, although we believe they were looking for much larger fields given the commodity price environment at that time".

On July 17th, 2003, NuCoastal Thailand was granted a Petroleum Concession Agreement "PCA" by The Kingdom of Thailand Ministry of Energy, under which a concessionaire may explore, develop, and produce hydrocarbons. As part of this agreement, they were granted the concession area for the Block G5/43, which covered 17,110 square kilometers off the east coast of Thailand. This was the same area successfully explored by Premier Oil Plc. decades earlier.

PetroWorld in 2005 acquired a 50% in the Block G5/43 from NuCoastal Thailand and on September, 25th, 2006 they combined their businesses as part of a reverse takeover strategy. This arrangement provided NuCoastal access to a secured listing on the London and Toronto markets, while PetroWorld provided their expertise in offshore exploratory drilling. As part of the reverse merger, Coastal Energy Company (OTCPK:CENJF) was born.

Many of the larger Toronto Exchange listed oil companies such as Penn West Petroleum, LTD. (PWE) or Canadian Oil Sands Limited (OTCQX:COSWF), conduct their drilling and exploration activities specifically in the North America region. Coastal Energy (C$1.5 Billion Dollar Market Cap.) is the only Canadian company whose exploration expertise is located in the world's true economic engine, Asia.

Why The Recent Stock Drop?

The Short-Term Production Issue finally comes clean…

A March 31st, 2013 Credit Suisse Equity Research report discussed how "Fear Mongers Flee the Forest," because investors fear that Coastal Energy won't achieve their production guidance of 33,000 BOE/D for 2013. The fear, in our opinion, is not a structural change to the business model, but the cost of doing business. As stated in the First Quarter 2013 Quarterly Report, the production slowdown "was impacted by several factors, including longer than expected completion times for the hydraulic fracturing program at Bua Ban South, delayed production from two horizontal wells at Bua Ban North due to the initial installation of 'swelling packers' designed to reduce water production, and the Songkhla A-10 well being down for a majority of quarter awaiting pump replacement." Mother Nature assisted the delays as January and February production months proved challenging due to unfavorable weather conditions. This caused several analysts including CANACCORD | Genuity, to reduce their production guidance citing, "As Coastal needs to produce ~40% above the current offshore production level for the remainder of the year to meet its guidance."

The Year-End 2012 production for Coastal Energy was 21,912 BOE/D. This represents an ambitious 50% increase in YOY production guidance. In a May 15th, 2013 First Energy report, a production guidance of 27,587 BOE/D is forecast for 2013e. This represents an estimated production increase of over 25% YOY. With April production of 25,700 BOE/D, we believe this production guidance represents a realistic expectation for 2013e as production begins to ramp back up from the service delays. In our opinion, the share price completely discounts any production growth as the stock is currently trading at its July 2012 production levels of 20,152 BOE/D (Source: Thailand DMF Number).

We now know that the stock drop was indeed due to a reduction in guidance. The new guidance is as follows (Source: Coastal Energy News Release dated June 17th, 2013):

The Company expects 2013 full-year average production to average between 24,000 boe/d and 26,500 boe/d, with an exit rate ranging from 26,500 boe/d to 33,000 boe/d. The Company's lower full-year average guidance reflects the operational delays associated with the damage which occurred to the two MOPUs during transit as well as the operational and mechanical delays at Bua Ban North & Bua Ban South in the first quarter.

The news has been disappointing, but as stated in the June 18th, 2013 CANACCORD|Genuity analyst report, "we believe the sell-off is heavily overdone as production has been operationally delayed, not lost." It is unfortunate to learn that the MOPUs were damaged in a type of "black swan" accident during transportation, but as further discussed in the note, "if they are successful at bringing the facilities (Songkhla H and Malaysia) on-stream in Q4 2013 then the 33,000 BOE/D exit is easily achievable."

The Other Problem: Exploratory Well Results

There is no exact science when it comes to exploratory oil well drilling. No matter how much science is involved, there are still no 100% sure things. In the Q1 2013, Coastal Energy began their exploratory drilling efforts into the Bua Ban Terrace (87.9 Mmbbls recoverable at the time) and at Songhkla M (89 Mmbbl recoverable at the time) sites. As quoted in the May 15th, 2013 First Energy report, "while these wells did not encounter commercial hydrocarbons in their primary targets, the results have some positive implications for Coastal Energy's exploration portfolio." Coastal Energy's exploration uses new 3D seismic data and drilling, which may lead to the discovery of additional commercial pools. The current market environment makes patience extremely difficult, and there is a tendency for the stock to hang on the announcement of each and every exploration result as if the company's future hung, Damocles-like, in the balance.

The company can afford its cash-flow-supported exploration program, and no individual result can really harm the company at these levels. Taken as a whole, the exploration program seems to be on track to discover more commercial assets, as the "targeting" data is refined and when the sheer number and size of the seismic-identified targets is considered. Recently this idea has been supported by successful exploration.

Along with the sour pills given during Coastal's June 18th General Meeting, there was good news as well. At Bua Ban North, the company found a previously untested oil pool in the prolific Miocene layer. One can see that not all of the company's exploration efforts have failed to bear immediate commercially-viable fruit. This was paired with the failure to find a commercial well (although some hydrocarbons were noted) at the G5/50 Ko Kra well. This is consistent with many analysts who pointed out that the chance of success for these exploration wells are in the 25% area. While no particular well is a guarantee, given the sheer number of 3D seismic targets now identifiable, we believe the overall results will add value to the company. The current valuation of the stock seems to price the exploration value at zero, and we find this to be wildly pessimistic given the company's history and the recent extensive seismic programs results.

The "Margin of Safety" Opportunity for Coastal Energy

Benjamin Graham, known as "The father of value investing," is famous for the investment principle "Margin of Safety." The term suggests that investors only purchase securities when the market price is significantly below its intrinsic value. Even though it doesn't provide a guarantee for a successful investment, it does provide for a margin of error.

When evaluating an Oil & Gas Exploration company, one key valuation technique to understanding the potential "Margin of Safety" would be to evaluate the company's Net Asset Value (NAV). The NAV represents the "value of the company based on the production and sale of its producing and future producing assets" according to Tom C. Wach of Wall Street Oasis. On his blog, he puts together a simple and informative two-part primer Net Asset Value NAV (Part 1) and Net Asset Value Part 2 Are all NAV comparable? .

To build your own NAV model can require a high level of skill and be a time consuming process. Differences in the local politics, taxes, geology, regional market oil prices, etc. can all change an NAV's real value. In the interest of leveraging our time and skill set, we tend to review the street consensus of NAV for Coastal because they have a history of discussing items with analysts that the retail investor is sometimes left in the dark about, in the sense of direct News Releases. Coastal Energy is a well-covered company with 12 analysts currently providing insight and opinion. Below we have attached the NAV estimates from several analysts where we have access to their information.

Coastal Energy Company

June 18th, 2013

$23.67

ANALYST

DATE

NAV

First Energy

June 19th, 2013

C$28.48

CANACCORD|Genuity

June 18th, 2013

C$17.90 - C$23.00

Macquarie Private Wealth

June 17th, 2013

C$20.02

Paradigm Capital

April 1st, 2013

C$22.55

Credit Suisse

March 31st, 2013

C$23.00

Dundee Capital Markets

March 26th, 2013

C$29.94

According to the NAV estimates above, one can draw the conclusion that Coastal Energy is providing a significant "Margin of Safety" relative to market prices. Clearly, when compared to the current value of the stock, one could easily believe that the current NAV will support the value of the stock.

On June 18th, 2013, with Coastal Energy closing share price of C$13.76, trades at a discount to NAV of anywhere between a range of 23% - 54%. The company announced on June 11th, 2013 a 5,680,241 common share buyback over the next 12 months. Our understanding is that since the announcement, Coastal Energy has been in a black-out period and are unable to buy back shares in the open market. At over a 40% discount to its own NAV assessment, management sounded aggressive in the annual meeting with regard to the share repurchase. According to the June 19th, 2013 First Energy research note, it expects "that 50% of the shares targeted by the program will be bought back in 2013." This is a company with a very large insider presence and we must assume that they too are feeling the decrease in their own personal accounts.

The Heart of the Story: Coastal Energy Company's "Non-Existent" Future Opportunities

You do not invest in a given stock for its past accomplishments, but for its future opportunities. Coastal Energy currently has the opportunity to de-risk up to 477 Mmbbls over the next year as per the Annual General Meeting report.

Bua Ban South

As of March 2013, Bua Ban South was the first commercially successful offshore fracturing stimulation the company has conducted inside the Gulf of Thailand. Fracturing both the A-01 and A-03 wells clearly indicates that it is worth pursuing these assets that were previously considered to be non-commercial. The three stage frac of the A-01 well produced an initial rate of 1,200 BOEPD with a stabilized rate of 450 BOEPD. The six stage frac of the A-03 well produced substantially better results with a stabilized rate of 1,450 BOEPD. As near as we are able to tell from analyst comments, this well is still producing at nearly its initial rate. This is a remarkable fact and points to the potential energy reserves available to Coastal in its offshore fracking program. According to the June 18, 2013 AGM Presentation, the company expects further optimization, which should improve results while reducing fracturing costs. They also believe that Bua Ban South contains 56 Mmbbls (34 Mmbbl Miocene and 22 Mmbbl Tight Sands) of prospective resources.

Bua Ban North

Currently the largest producing asset in the Songkhla Basin, Bua Ban North represents nearly 80% of the offshore 2P reserves for Coastal Energy. "The Bua Ban North B-17 well encountered 34ft. of net pay in the M100 Miocene reservoir with an average porosity of 23%" according to the June 17th, 2013 research note from Macquarie Private Wealth. According to The First Energy report on June 18th, 2013 they state the "well could have found an additional 10 Mmbbls." This is a well that was currently excluded from The First Energy valuation.

As part of Coastal Energy's developmental efforts, they have currently drilled four out of the eight planned wells at the Bua Ban North location. The three horizontal wells were completed with new "swelling packers," which are expected to minimize water production and increase ultimate recovery. We have heard second hand reports that these swelling packers have not been performing particularly well and some analysts have reported that in fact these swelling packers are not functioning very well at all.

However, even if these swelling packers end up being a bad idea, these wells have not removed the oil from the reserves. Even an absolute worst case of re-drilling these wells (which is by no means the sole solution available) is hardly a disaster worthy of the stock's recent plunge. The success of their exploration has 95.2 Mmboe of 2P reserves so far, with the intentions to test for 79.5Mmbbl of prospective resources (recoverable) in 2013. A number of wells have been drilled, including one into a previously undrilled compartment. Given this, we believe that some of the recoverable resources are already "on the books."

Benjarong South

The Benjarong South area on the Coastal Energy exploration map does not receive the slightest bit of attention. It is believed that the Benjarong South contains prospective resources of 125.6 Mmbbl's (recoverable), including 80.3 Mmbbl in the Lower Miocene. In the Annual General Meeting held on June 18th, 2013, the executives were very excited by this exploration as the well maintains a 14% porosity, which makes it an Eocene frac prospect. The first fracs performed by the company have been exceeding expectations, therefore it's certainly an exciting prospect. Of course, the success of two wells at different locations does not mean that this is a "sure thing." Nonetheless, indications are positive thus far and as time moves along, we will be able to better gauge this tremendous opportunity.

The Malaysian Opportunity with PETRONAS

Undertaken in 2010 as part of a major economic initiative by the Malaysian government, The Economic Transformation Programme was developed as a blueprint to guide Malaysia to economic prosperity over the next decade. One of the key identifiable areas for growth was the development of their offshore marginal oil fields. Coastal Energy Company on July 5th, 2012 was one of the first companies to be granted a Small Field Risk Service Contract "RSC" with Petroliam Nasional Berhad or "PETRONAS."

Located off the coast of Malaysia, the Kapal, Banang and Meranti cluster is known as "The KBM Cluster." These fields are located within 20 kilometers of each other in a water depth of 60 meters. This is an exciting new area of opportunity for Coastal Energy considering their expertise for shallow water drilling in The Gulf of Thailand. In an article written by the Business Times on April 24th, 2013 entitled Exciting Future for Malaysia Oil and Gas Industry, the author discusses the enormous opportunity for the region.

A RSC is a new form of petroleum arrangement that PETRONAS is implementing in Malaysia. Under the service agreement, PETRONAS will be the owner of the project and Coastal Energy will be a 70% / 30% contractor for the project along with local Malaysian partner Petra Energy. As part of the agreement, the RSC requires the contractors to provide the project's upfront costs, which Coastal Energy projects to be $320 Million USD over 3 years. Upon commercial production, Coastal Energy will recover its capital and operating expenditures. The company will also be paid a remuneration fee, which will be adjusted by key performance indicators.

Coastal Energy has fast-tracked the development of The KBM field by acquiring a second Mobile Offshore Production Unit ("MOPUs") and Floating Storage Offloading Vessel ("FSOs"). According to Coastal Energy's 2013 Guidance the company expects the first oil from The Kapal Field at the end of Q2, 2013. The estimate of recoverable oil could be anywhere from 15 to 35 Mmbbl's and an average net production of 3,700 BOEPD is expected.

The KBM Cluster field has had to delay its production schedule due to the unforeseen MOPU accident, which occurred prior to reaching Coastal's custody. The MOPU is currently being repaired in port. According to the June 19th, 2013 First Energy research note, "the company now expects first oil from the Kapal field in Malaysia in late Q3 2013." While no delay is welcome, investors have discounted the stock price as if the field won't even be developed.

Dong Mun Gas Discovery

Apico, LLC is a company that Coastal Energy has a 39% working interest for all onshore operations in Thailand. "Following the successful test of the Dong Mun sidetrack well in the first quarter, the company has recorded 59.7 bcf (10 mmboe) of high quality contingent resources." Once a gas sales agreement is secured, Coastal will reclassify Dong Mun into a 1P and 2P reserve and the first gas from the field is currently anticipated to be achieved by the end of 2015.

The Conclusion

We don't view ourselves as Pollyannas while dissecting and analyzing the opportunities for Coastal Energy. Our job is to thoughtfully evaluate and aggressively challenge the conventional thought process. Coastal Energy's discounted share price, as of June 18th, 2013, has virtually ignored the future events of Bua Ban South, Bua Ban North, Bua Ban Terrace, Benjarong South, The KBM Cluster and Dong Mun to zero. It is very difficult to be wrong on a future risk, if the risk is valued at absolute zero. Herein lies the opportunity.

While we find the surface-based operational delays irritating, executives have clearly received the message that they need to reevaluate their recent methods for communicating with shareholders. The market has delivered this message savagely and without mercy. This lack of communication and transparency has led to over a 30% reduction in share price YTD. Our belief is that once the blackout period ends for Coastal Energy, we will begin to see an aggressive buyback of shares at current price levels. This is a company that maintains a large insider presence with a small outstanding float; and we believe this buyback should floor the stock.

As we write this, the most conservative core NAV we are aware of in the analyst community is $17.90 (Canaccord Genuity). This represents over a 25% discount to the current share price, and specifically excludes everything positive that has occurred this year and may occur into the future. The negative sentiment towards Coastal Energy has created a "Margin of Safety" which we believe presents an alpha rich opportunity going forward. In times of uncertainty it sometimes helps to remember some folksy Warren Buffett advice: "Be fearful when others are greedy and greedy when others are fearful."

Disclosure: I am long OTCPK:CENJF. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: We have no plans to transact on any other equity mentioned in this article over the next 72 hours. This article is not a solicitation to participate in any of Volte-Face's strategies or funds. All information provided is on a best efforts basis and without warranty.