EnQuest: Upside Imminent, Even After Production Delays

| About: Enquest Plc, (ENQUF)
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Summary

EnQuest, the largest independent oil & gas producer in the UK North Sea, is an attractive stock to consider at current levels.

EnQuest stock has been depressed in 2014 due to production commencement delays and this provides an attractive valuation gap to buy the stock.

The company has a strong operating history, rich assets and a strong financial flexibility.

Production from two game changing assets over the next 3 years will trigger significant stock upside.

Thesis Summary

EnQuest (OTC: OTCPK:ENQUF) is engaged in the exploration, extraction, and production of hydrocarbons in the United Kingdom Continental Shelf. While the stock has trended higher by 19% in the last one year, the stock's performance has been dismal in 2014 with the stock remaining stagnant even after a broad market rally. This initiating coverage on the company discussed the reasons for relatively depressed near-term sentiments and the reasons to remain bullish with a 2-3 year investment horizon.

Company And Assets

EnQuest is an oil and gas development and production company in the United Kingdom Continental Shelf. The company is the largest independent oil & gas producer in the UK North Sea.

EnQuest's principal UK assets at the end of 2013 were its interests in the producing operated oil fields Heather/Broom, Thistle/Deveron, West Don, Don Southwest and Conrie, the producing non-operated Alba oil field and the Alma/Galia and Kraken developments, with further development opportunities in the Scolty/Crathes, Cairngorm, Southwest Heather, Crawford/Porter and Kildrummy discoveries.

During 2013, EnQuest also announced its acquisition of interests in the Greater Kittiwake Area producing oil field in the UK North Sea and this transaction was completed in 1Q14. In early 2014, EnQuest was awarded a licence in the Don North East area.

At the end of 2013, EnQuest had working interests in 31 UK production licenses, covering 39 blocks or part blocks, and was the operator of 25 of these licenses; including GKA and the Don North East area licence, the totals increase to 37 licenses and 47 blocks or part blocks, of which EnQuest operates 30 licenses.

As of December 2013, the company had net 2P reserves of 194.8mmboe with a reserve replacement ratio of 450% over the last four years and a reserve life of 20 years. In FY13, the company's reserves increased by a robust 52% to 194.8mmboe from 128.5mmboe in FY12. Further, EnQuest had a total production of 24,222boepd in FY13, a 6.2% increase as compared to FY12 production levels of 22,802boepd.

For FY13, EnQuest clocked a turnover of $961 million and an EBITDA of $621 million, translating into an EBITDA margin of 64.6%. The company also had a robust operating cash flow of $563 million, translating into an EBITDA cash conversion ratio of 91%.

Reason For Stagnancy In Stock Price

The year 2014 has been good for broad markets and also for energy stocks. The sentiments for EnQuest has however been depressed with the stock remaining stagnant in 2014.

While the company has strong fundamentals, strong financial flexibility and rich assets, the reason for depressed stock price is the delay in production commencement from the company's Alma/Galia asset.

EnQuest had earlier expected that production from Alma/Galia will commence by the end of 2013. However, in August 2013, the company announced that the first oil from the asset will be delayed to 1Q14 mainly due to the increase in scope of refurbishment of the existing FPSO marine and process systems.

The first delay was however not the last one as EnQuest again announced in 1Q14 that the first oil from Alma/Galia has been further pushed back to 2H14 with winter weather conditions being the reason for the delay.

The asset is critical from the company's growth and stock upside perspective as the first oil from Alma/Galia will add 13,000boepd to the company's daily production. This is 54% of the company's FY13 production.

Considering the importance of the asset in terms of revenue and growth upside, it is not surprising to see the company's stock stagnate in 2014 with sentiments remaining negative even in the fourth quarter of 2013.

I must mention here that the negatives from delayed production were partially offset by some positive developments in 4Q13.

In October 2013, EnQuest announced the agreement to acquire the UKCS Greater Kittiwake area assets owned by Centrica North Sea Oil Limited as well as Centrica's 100% interest in the Kittiwake to Forties oil export pipeline. This asset added 4.7mmboe to the company's 2P reserves.

In November 2013, EnQuest got a green light for the development of Kraken, one of the largest new oil fields in the North Sea. EnQuest is the operator of Kraken and I will discuss this game changing asset later in the coverage.

Benefit From The Aberration

EnQuest has a strong operating history with the company growing over the years to become the largest independent oil producer in the UK North Sea. Even in 2013, when the production from Alma/Galia was delayed, the company had a 6.2% increase in production. EnQuest has steadily increased its production to 24,222boepd in FY13 from 13,613boepd in FY09.

The growth in reserves was phenomenal with 2P reserves surging by 51.6% to 194.8mmboe and the reserve replacement ratio being equally robust at 850%.

EnQuest has also done exceedingly well in identifying and acquiring rich assets and mature assets. The acquisition of 50% stake in Greater Kittiwake adds 2,000boepd to the company's net production. Also, the Kraken asset acquisition underscores the company's eye for game changing assets.

Even in terms of financial discipline, EnQuest deserves a high rating. As of December 2013, the company had a total debt of $454 million and considering an EBITDA of $621 million, the debt to EBITDA translated to 0.73. Further, considering a cash position of $72.8 million, the net debt to EBITDA is even lower at 0.61. An operating cash flow of $563 million also covers for all the debt. EnQuest therefore has a sound balance sheet and robust cash flows to fund the company's planned growth.

I wanted to mention all these points because EnQuest has a long track record of operational excellence and the company is strong fundamentally. The delay in production from the Alma/Galia is therefore an opportunity to consider exposure to the stock.

In terms of progress at the Alma/Galia asset, all 6 Alma production wells have been drilled with results meeting or exceeding expectations. The EnQuest Producer FPSO is now in a yard on the Tyne, for finishing and commissioning work with production expected in H2 2014.

Therefore, the progress has been relatively slow, but the company is heading towards increasing its daily production by 13,000boepd. I believe that the stock will trend higher as soon as the company announces the commencement of production from the asset.

Revenue And EBITDA Outlook For 2015

I would be more interested in looking at the revenue and EBITDA estimates for FY15. This incorporates further delays in first oil from Alma/Galia with the consideration that production will commence only from FY15. Further, FY15 will be the first year of full production from the Alma/Galia and it would be interesting to note the potential revenue growth coming from Alma/Galia.

Even if EnQuest closes FY14 with a production of 24,000boepd (similar to FY13), the annual production for FY15 is likely to be 37,000boepd considering 13,000boepd production from Alma/Galia. This is entirely likely with all six wells ready for production and drilling results meeting or exceeding expectations.

Even if oil prices are considered to remain at $100 per barrel, the company's likely revenue for FY15 will be approximately $1.4 billion and considering an EBITDA margin of 65%, the EBITDA for FY15 is likely to be $880 million. Therefore, robust revenue and EBITDA growth is lined-up on commencement of production from Alma/Galia. Also, considering an EBITDA cash conversion ratio of 91%, the operating cash flow is likely to surge to $800 million in FY15 from $563 million in FY13 and an expected similar OCF for FY14.

Preparing For The Next Stage Of Growth

After the big production and cash flow bump-up coming from Alma/Galia, the company is already preparing for the next big growth trigger. As mentioned earlier, EnQuest received the approval for development of one of the largest oil fields in North Sea - Kraken.

Kraken is estimated to have 140 million barrels of oil with a field life of 25 years and the asset is likely to be another game changer when the first oil is delivered in 2017. For the same reason, I have suggested an investment horizon of 2-3 years. I do believe that the investment horizon can be extended further based on developments over these 2-3 years.

Coming back to the asset, gross peak oil production in the Kraken is expected at 50,000boepd and considering a 60% stake for EnQuest, the company's production share at peak production is likely to be 30,000boepd.

The development of the Kraken involves the drilling of 25 new subsea horizontal wells which will be connected to an FPSO. The Kraken development project is currently on track with contracts for over 60% of the project signed including subsea umbilical riser and flowlines and FPSO.

Overall, the Kraken asset is estimated to involve a capital and operational investment of $6.8 billion and generate revenue of $15.4 billion. EnQuest needs to invest $1.4 billion before first oil in this asset.

The project is therefore a big game changer for the company and low debt ensures that EnQuest has sufficient financial flexibility to fund the project development. I must mention here that EnQuest has already entered into a committed 6-year $1.2 billion facility and this facility will be used to fund the Kraken development along with internal cash flows.

I expect operating cash flow in FY14 to be in the range of $500 million to $550 million (largely in line with FY13). Further, as discussed, the operating cash flow in FY15 is likely to be $800 million. The credit facility of $1.2 billion and operating cash flow of $1.3 billion over the next two years are more than sufficient to fund the Kraken asset development.

Therefore, I expect the company's balance sheet to remain strong and leverage to remain low even after the company's investment in the Kraken asset development. The $1.2 billion undrawn credit facility might just be dry gunpowder for funding potential acquisitions.

EnQuest has been active in making mature field acquisitions along with the acquisition of long-term game changers and I expect the company's acquisition driven growth strategy to continue.

Another long-term strategy, which I am encouraged with, is the company's decision to look for and acquire assets outside of UK North Sea. I believe that post the Kraken development, the next big game changer is likely to come from outside North Sea.

In 2012, EnQuest entered Malaysia with an initial investment of only $3 million, to acquire Nio Petroleum Limited and thereby a 42.5% interest in Blocks SB307 and SB308, offshore Sabah, Malaysia. As of 2014, a well is being matured for drilling offshore Sabah, Malaysia.

In Q2 2013, EnQuest agreed its first acquisition of international producing assets, acquiring 70% and operatorship of the Didon oil field in Tunisia. EnQuest has also made a small investment in a 50% interest in the North West October appraisal block in Egypt, with the possibility of a future development opportunity.

I believe that this is an excellent strategy as the company is not going all-out on big acquisitions outside the North Sea. The strategy underscores the management's skills as the company is testing the waters in new markets before taking any big plunge. Similar to Tullow Oil (OTC: OTCPK:OTCPK:TUWOY), I believe the company's next focus will likely be on Africa. Acquisition of operatorship in Tunisia might just be the first step towards an untapped market.

Valuations Are Attractive

As a result of the stock price stagnation over the last 6-9 months, EnQuest is trading at an attractive valuation as compared to peers. As mentioned earlier, I believe that the delay in first oil from Alma/Galia is an aberration amidst a strong operational record and sound fundamentals for EnQuest. The current valuation is therefore a good opportunity to consider the company for long-term, taking advantage of the short-term price depression.

EnQuest is currently trading at an EV/EBITDA (trailing twelve month) of 3.45. This is attractive as compared to peers. I must mention here that the company's peers have been carefully chosen with two of these companies, Ithaca Energy (OTC: OTCPK:OTCPK:IACAF) and Premier Oil (OTC: OTC:OTCPK:PMOIF) operating in the North Sea. While Tullow Oil is also domiciled in UK, the company's main assets are in Africa. I therefore consider the first two companies as better peers for relative valuation.

Ithaca Energy is currently trading at an EV/EBITDA valuation of 5.3, Premier Oil at 4.6 and Tullow Oil at 7.7. As compared to an average EV/EBITDA valuation of peers (Ithaca and Premier) at 5.0, EnQuest is trading at a 45% discount with current EV/EBITDA valuation of 3.45.

I believe that the ideal time horizon for this valuation gap to fill is 18 months (end-2015) when the company incorporates a full year of production from Alma/Galia in its revenue and EBITDA. Investors can however consider buying the stock with a 2-3 year perspective as the Kraken development will continue to add to the positives beyond 2015.

A look into the forward valuation also suggests a marginal valuation gap for EnQuest as compared to its closest peers. However, there are two factors that will support an upside greater than that suggest by the forward valuations. First, EnQuest expects first oil from game changing Kraken from end 2016 or early 2017. By the end of 2015 and the beginning of 2016, the stock will start discounting the additional growth from Kraken. Second, EnQuest is undervalued significantly as compared to peers in terms of EV/2P valuation.

Coming to the EV/EBITDA valuation for 2015, EnQuest is trading at a 2015E EV/EBITDA of 3.1 as compared to 4.2 for Premier Oil and 2.7 for Ithaca Energy. The peer average valuation of 3.5 points to a marginal 11% upside, but Kraken and EV/2P valuation will ensure that the upside is significant.

I believe that EV/2P is an excellent metric for oil & gas companies as it outlines the value investors are assigning to the company's reserves.

From an EV/2P valuation perspective, EnQuest is trading at a valuation, which is significantly attractive compared to peers. EnQuest has a EV/2P (current EV and FY13 2P) value of 10.8 as compared to 36.7 for Tullow Oil, 22.6 for Ithaca Energy and 16.8 for Premier Oil. Excluding Tullow Oil, the company's EV/2P is at an 82% discount to peers. Again, as 2P reserves from Alma/Galia are monetised, the valuation gap will close down.

Risk Factors

A potential risk factor is an unstable tax regime in North Sea. With EnQuest spending nearly $1.4 billion for the development of Kraken, this risk needs to be considered as it can impact the company's profitability and returns. The company's Chief Executive, Amjad Bseisu, is of the opinion that the risk related to changes in tax is high in the region following the referendum on Scottish independence in 2014.

EnQuest has been working towards co-ordinating with the Scottish government and according to the company's yearend report -

In respect of the referendum on Scottish independence, senior management liaises with Scottish politicians and others to ensure that third parties are aware of EnQuest's trading and investment activities and the importance of the oil industry in general to the local and national economies.

EnQuest also engages with the Scottish Government and welcomes statements that, in the event of there being an independent Scotland, the Scottish Government plan a stable and predictable fiscal and regulatory regime. EnQuest believes that in order to maximise the extraction of hydrocarbons, there is a fundamental requirement for a stable fiscal regime that incentivises investment.

Therefore, there are positive signs related to this risk factor and I believe that robust activity in the North Sea is critical for the economy and governments will have a favourable tax regime.

Another risk factor worth mentioning is the company's dependence on a third party for delivery infrastructure for oil & gas. The company's processed oil is exported to the Sullom Voe Terminal via the Ninian Central platform.

For FY13, the company's production and transportation cost increased and it was primarily due to an increase in costs per barrel at the Sullom Voe terminal. The production and transportation cost per barrel increased from $32.3 in FY12 to $35.5 in FY13. The company still had a healthy EBITDA margin of 65% and firm oil prices is a critical factor here.

I do believe that oil prices will remain firm given the current geo-political tensions in the Middle-East. The crisis is unlikely to be resolved anytime soon and firm oil prices will ensure that EnQuest's EBITDA margin remains high even with marginal increase in transportation cost.

Conclusion

EnQuest did not have a great 2013 in terms of production upside, but the year was excellent in terms of 2P reserve addition and reserve replacement. While the company's production from Alma/Galia has been delayed to the second half of 2014, the six wells in the asset are ready for production. Strong production driven growth is therefore likely in 2015 and it will trigger significant stock upside.

In addition, the company's Kraken asset development is on track and the asset will be another production and revenue game changer by the end of 2016 or the beginning of 2017. Developments in this asset over the next 2 years will add to the positive sentiments.

In conclusion, the valuation gap, created from delayed production, is an excellent opportunity to consider exposure to a company with a strong operating history and with game changing assets in its disposal. I consider EnQuest as a "Strong Buy" and hold at current levels.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

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