Exploration-focused oil and gas companies can give investors a wild ride. That has definitely been the case at Britain's Tullow Oil (OTCPK:TUWOY), as uncommon drilling success built the company into Europe's largest independent, only to see the shares fall more than 20% over the past year on multiple poor results of its exploration program.
I believe that while finding oil is a "win some, lose some" sort of game, Tullow has proven over the years that it will win more than its share. With a strong core expertise in petroleum geology and demonstrated discipline in license acquisition, coupled with a rich portfolio of exploration assets, I believe that Tullow can regain some of its luster and that the shares are 30% to 40% too cheap even if future drilling success rates can't match the company's past levels.
Get The Licenses, Find The Oil, Farm It Down … Rinse And Repeat
Tullow is a large independent exploration and production (E&P) company headquartered in London. Analogies can be tricky, but think of Tullow as more similar to an American company like EOG (NYSE:EOG) or Noble (NYSE:NBL) and much less like a global major like Exxon Mobil (NYSE:XOM) or BP (NYSE:BP).
The basic idea at Tullow is to acquire licenses to promising exploration blocks, particularly in Africa and almost always with partners, drill exploratory wells, and then put economic discoveries into production (and/or farm down the interest to a company willing to pay for the de-risked production). Relative to production-oriented companies like Exxon, Tullow takes on considerably more exploratory risk but offsets that risk with the lower cost of licenses for unexplored areas.
Since 2007, Tullow has averaged a drilling success rate of over 70% - more than double the industry average of around 20% to 30%. By acquiring licenses in unproven areas (but where Tullow's geologists believe the prospects are attractive), Tullow keeps costs down - as seen in the trailing finding & development cost average of just over $5 per barrel of oil equivalent (BOE), the $6 average F&D/boe between 2009 and 2011, and the $8.35/boe figure in 2012.
That success has also led to meaningful reserve growth, as 2P reserves (net of a farm-down in Uganda) have nearly doubled from 673M boe in 2009 to over 1,200 at the end of the first half of 2013. Nearly 90% of the company's booked reserves are located in Africa, with 70% of them consisting of oil.
Even Michael Jordan Missed - Drilling Failures Have Dropped The Shares And Upped The Risks
Although I believe Tullow isn't meaningfully overpriced on the basis of its "safe" production prospects (more on this later), a large percentage of the company's theoretical value is at-risk and dependent upon drilling success. Unfortunately, the company has seen several high-profile setbacks over the last 12 months.
From a dry well off the coast of Ghana (Okure-1, with a scant hydrocarbon column of 17 meters), to a disappointing well off the coast of Mozambique with Statoil (NYSE:STO) (Cachalote), to multiple disappointments off the coast of French Guiana (with Shell (NYSE:RDS.A)), Tullow found itself in the unfavorable position of seeing investors lose confidence and sell-side analysts trim back their net asset value assumptions (NAV) - and not just in the affected exploration areas. Moreover, with first half 2013 exploration success at "just" 63% and five notable failures since October 2012, many people have started worrying that Tullow lost its mojo.
I believe this is short-sighted. Yes, Okure-1, Cachalote, and French Guiana were significant disappointments, but they only represent a small portion of the company's exploration plays. With 20 exploration wells planned for the second half of 2013, Tullow has an opportunity to redeem itself and improve sentiment relatively quickly.
What's more, the last year or so hasn't been a complete disaster - wells in Kenya showed double the expected net pay, increasing the expected recoverable resources by 20% and north of the critical 250M boe point of economic viability for development. In addition, results in Ethiopia have been encouraging and those aforementioned 20 new wells in 2013 will include more exploration in Kenya and Ethiopia, as well as initial exploration off the coast of Mauritania.
Farm-Downs Should Bring In Capital
Tullow is willing and able to produce oil from its discoveries; it is the operator of the large Jubilee field in Ghana, for instance, and the company produced 89,000 boe per day in the first half of the year (up 14%). That said, Tullow is actively looking to farm down (that is, sell off part of its interest) some of its assets. Following a successful move to farm down licenses in Uganda to Total (NYSE:TOT) and CNOOC (NYSE:CEO) back in 2012, Tullow is looking to do something similar with its "TEN cluster" in Ghana, where a 23% stake could prove to be worth more than $750 million.
Tullow is also in the process of selling gas-heavy non-core assets in the U.K. and Dutch North Sea, with hopes that these assets could bring in as much as $500 million. Coupled with the sale of some small properties in Bangladesh and Pakistan, Tullow is more or less on track with its stated goal of using focused asset sales to underwrite its exploration and drilling programs, particularly when the path to production requires time and considerable capital investments.
It's also worth noting that this strategy is something of a "win win" for both sides. Companies like Total and CNOOC want oil, and preferably oil that comes with little exploration risk. Tullow would rather continue to explore than sit on its discoveries, investing the years and billions of dollars it takes to put them into production. Consequently, I don't think finding partners will be difficult - though the exact amounts Tullow receives will tell investors something about the industry's own expectations for follow-on discoveries in these areas (a key component of Tullow's success to date).
Valuation - Inexact, But Intriguing
To be blunt, valuing exploration-focused E&Ps like Tullow is a pain in the neck. Although EV/EBITDA can be used to value these companies, I think Tullow's intentions to farm down its working interest in producing assets makes it less useful here.
More common, though, is to use net asset value in a process that calculates the expected discounted cash flows from existing producing assets, well-characterized undeveloped assets that can be brought into production in a relatively straightforward manner, and unexplored (or partially explored) assets whose value is much more a matter of conjecture.
I am valuing Tullow's "core" assets (producing assets and those with better visibility) at about $13.5 billion, or about $7.50 per share (including net debt). The existing Jubilee field in Ghana is about one-third of this total, with another $1 or so per ADR from expected follow-on discoveries/expansion at Jubilee. All told, African assets account for more than 90% of the core value.
The real upside at Tullow comes from what the riskier exploration assets can produce. Across assets in Uganda, Kenya, Ethiopia, Mauritania, French Guiana, Gabon, Liberia, Sierra Leone, Ghana, Norway, and so on, Tullow could have as much as 2.5 billion net BOE to be discovered and booked with an overall risk weighting of 15% (in other words, 100 barrels times a 50% working interest times a risk weighting of 15% would mean 7.5 net barrels). Certainly there's a wide range of risk exposures here - the company's potential in Mauritania is intensely speculative, while the risk weighting in Kenya is improving, and the risk of the Norway assets adjacent to the Troll field (a legendary field operated by Statoil and holding about 60% of Norway's natural gas reserves) is even better.
That works out to a "risked" value of about $7.6 billion or about $4.25 per share. All told, then that works out to a risked NAV of $11.75 per share, or more than 40% above today's price. As an aside, the average sell-side NAV for Tullow is around $10.60 per share, or almost 30% above today's price (and that includes sell-side analysts that believe Tullow's exploration success rates are downhill from here).
The Bottom Line
In some respects, Tullow is like an energy version of an established biotech - the company has solid core assets, but upside to the shares is going to come from the "pipeline" of exploration properties. To that end, investors who cannot stomach the risk that exploratory wells due to be drilled in Kenya, Mauritania, Ethiopia, and so on later this year will disappoint should not consider these shares. Likewise, it nearly goes without saying that countries like Ethiopia, Kenya, and Mauritania carry elevated political risk when compared to countries like the U.S. or Canada.
With a potential fair value of almost $12 per ADR, though, I believe the potential risk in Tullow is more than compensated for by the potential returns. Although I already own two E&P companies with strong return potential in their own right, Tullow's potential tempts to go overweight in the energy sector to take advantage of what I believe is a proven oil explorer simply going through a rough patch.
Disclosure: I am long STO. 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.