Tullow Oil Is A Long-Term Value Creator

| About: Tullow Oil (TUWOY)
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Summary

Tullow Oil, with 2P and 2C reserves of 1,409mmboe is set for robust production growth over the next 2-3 years.

The company is yet to unlock the East African asset potential where two discovered basins have a production potential of 300,000boepd.

Tullow Oil has an excellent operational track record with a reserve replacement ratio of 770% between 2007 and 2013.

Low leverage and high operating cash flow provide the financial muscles for a high impact exploration program going forward.

Thesis Summary

At a time when energy stocks have done well, Tullow Oil (OTC: OTCPK:TUWOY), an independent oil and gas company, has been a laggard. The company stock has declined by 8.8% in the last one year. This investment coverage discusses the reasons for the stock remaining depressed and the reasons for being bullish on the stock for long-term. I must mention here that I am bullish on the stock with a 2-3 year time horizon. While there can always be positive surprises, I don't expect strong upside over the next 3-6 months. I will discuss the reason for this as well in my coverage. However, the next 3-6 months are ideal for accumulating this stock.

Company Overview

Tullow Oil, an independent oil & gas exploration company has a portfolio of 150 licenses in 24 countries as of December 2013. The company's activities are classified into three broad regions - West & North Africa, South & East Africa and Europe, South America & Asia.

The company West & North Africa business involves nine countries, 39 licenses, 65,000boepd of production in 2013 and 666mmboe of reserves & resources. Overall, the West & North Africa region contributed the majority of Tullow's production as of December 2013. The gross production from Ghana's Jubilee field, Tullow's key producing asset, averaged approximately 100,000boepd 2013. The TEN development project is Tullow's second major operated development in Ghana. The project is expected to deliver first oil by mid-2016. Tullow has also commenced a high impact multi-well exploration program in Mauritania, another asset in the region.

The company's East Africa business consists of three countries, nine licenses, 2.3bbo of gross discovered resources and 1-5bboe of risked, yet to find resources. Tullow Oil asset in South and East Africa region therefore have great potential for exploration and future cash flow. The Group has made seven consecutive discoveries in the South Lokichar basin in Kenya in the past two years and is considering development options for discovered resources in both Uganda and Kenya.

Tullow's Europe, South America & Asia region consists of some of the companies most mature producing assets and areas of frontier exploration.

As of December 2013, Tullow Oil has total 2P and 2C reserves of 1,409mmboe and a total resource potential of 6.2bboe.

Reason For Stock Price Remaining Stagnant

As mentioned earlier, Tullow Oil's stock price has declined by 8.8% over the last one year. The only reason for the decline is the company's failure to meet the production guidance for FY13 and the company's relatively muted guidance for FY14. I emphasize "only reason" as the company has robust fundamentals and excellent assets, which I will discuss later.

For FY13, the company's baseline production guidance was 91,200boepd. However, the company's actually production came in lower at 84,200boepd. The shortfall was principally due to the Jubilee field which had operational difficulties on the FPSO. The key point to note here is that the short-term operational issue and the resulting stock depression is a potential opportunity to buy the company, with prized assets, for long-term.

The second reason for depressed stock price and the reason why I believe that the stock will move sideways over the next 3-6 months is the 2014 production guidance. The company expects production for FY14 to be in the range of 79,000-85,000boepd.

The stagnant production in 2014 is largely because of the potential impact on Jubilee asset of delays in commissioning Ghana National Gas Company's onshore processing facilities. The onshore gas processing plant is required to enable the export of Jubilee associated gas.

Tullow Oil expects that the gas plant will be fully operational in the second half of 2014. Incorporating any further delays, the incremental production impact is likely to come only in 2015. This implies that the company will be closing the year with potentially no revenue growth as compared to FY13. A marginal revenue decline as compared to FY13 might also be on the cards.

Growth Underpinned By Strong Operational Excellence

It is clear that the company's muted production growth is not a company specific factor. While these risks exist, and can hinder growth in expectations, the company's operational excellence strengthens my view of buying the stock in relatively depressed time.

To put things into perspective, Tullow Oil has discovered resources of 1.4 billion barrels of oil equivalent between 2007 and 2013 with a production replacement of 770%. Over the last five years, the company has added, on an average, 188mmboe of contingent resources. Further, over the last five years, the company's oil finding cost has been attractive at $5.2/boe. Tullow Oil therefore has a strong exploration performance record.

The company's strong operational record has also translated into higher working interest production with net production increasing from 58,300boepd in 2009 to 84,200boepd in 2013. This underscores the fact that the company has successfully translated high impact exploration into cash inflow.

I wanted to focus on these numbers to make it clear that the recent stagnation in production is just an aberration and I will discuss the factors that will result in production bump-up over the next 2-3 years.

Robust Financials Will Back Growth Plans

Tullow Oil has strong fundamentals and I will discuss the key operating metrics in this section. The purpose is to underscore the point that Tullow Oil has sufficient financial muscles to grow at a robust pace.

For FY13, Tullow Oil reported revenue of $2,647 million, which was 13% higher than FY12 revenue of $2,344 million. The revenue growth was backed by an increase in production to 84,200boepd in FY13 as compared to 79,200boepd in FY12.

What is most important to mention here is the trend in the company's operating cash flow. Tullow Oil's operating cash flow increased to $1,901 million in FY13 from $1,777 million in FY12. Further, the company's operating cash flow has increased from $605 million in FY09 to current levels of $1,901 million. The company's operating cash flow per barrel of oil equivalent has increased from a low of $37.2/boe in 2010 to $59.8/boe in 2013.

Besides the factor of higher oil prices, improved operational efficiency is indicated by this metric. The point on operating efficiency is clear on considering the fact that the operating cost per barrel of oil equivalent has increased from $12.5.boe in 2010 to $16.5/boe in 2013. Operating cost has therefore been well in control.

I discussed the cash flow and operating efficiency in details as robust cash flows are critical for a company with a high impact capital expenditure program. Tullow Oil had a capital investment of $1.8 billion each in FY12 and FY13. Further, Tullow Oil has a planned capital expenditure of $2.2 billion in FY14. The company's operating cash flow covers a large part of the capital expenditure.

In terms of debt funding, Tullow Oil had a debt of $3.1 billion and a net debt of $2.7 billion as of May 2014. Further, the company has access to $2.4 billion of committed debt facilities. This gives Tullow Oil sufficient cushion to fund its high capital expenditure program. One of the best things about the outstanding debt is the maturity profile, which comes on and after 2017. Therefore, there is no debt repayment or refinancing concern at this point of time. Also, considering an adjusted EBITDAX of $1.9 billion in FY13, the company's leverage works out to 1.6 and this is certainly not a concern from a balance sheet strength perspective.

The Coming Production Upside

Tullow Oil has two key projects, which will change the production scenario over the next 2-3 years. These will be the key stock upside triggers in 2015. I must mention that the company's excellent development in Kenya will also add to the stock uptrend.

The Tweneboa-Enyenra-Ntomme (referred to as TEN) - TEN is Tullow's second major operated development in Ghana after Jubilee. TEN has potential resources of 440mmboe with 240mmboe classified as "to be developed" resources and 200mmboe classified as "upside resources".

The project has made significant progress in 2013, following approval of the Plan of Development by the Government of Ghana in May 2013. All key contracts have now been awarded and the floating production, storage and offloading (FPSO) vessel conversion and construction of subsea infrastructure have commenced.

The TEN development project is on track for first oil in mid-2016 and the company is targeting a gross production of 80,000boepd from the project where Tullow Oil has a 47.15% interest. This will provide a significant production and revenue bump-up in 2016 and 2017.

To put things into perspective, Tullow Oil expects peak production of 80,000boepd by the end of 2016. In other words, the company's production will increase by 37,700boepd in 2017 from this project. At current oil price of $100 per barrel, the project alone will result in an annual revenue (at peak production) inflow of $1.4 billion and a potential cash flow of $1.0 billion. From the company's and investor's perspective, this is a game changing project.

Production Upside From Jubilee - The Jubilee asset in Ghana, where the company has a 35.48% working interest reached gross production levels of 100,000boepd in 2013. In terms of potential resources, the project is significantly bigger than TEN with 1,000mmboe of potential resources. Of the total resources, 100mmboe is classified as "produced resources", 400mmboe as "developed resources", 200mmboe as "to be developed resources" and 300mmboe of "upside resources". Therefore, the production upside potential is immense with significant developed resources.

Tullow Oil plans to ramp-up production (company's working interest) from TEN and Jubilee to 100,000boepd by 2017. Considering the point that 37,700boepd of production will come from TEN, Tullow Oil aims to increase working interest production (Jubilee) from FY13 levels of 34,600boepd to 62,300boepd by 2017.

The incremental production target is likely over the next 2-3 years with FPSO capacity being upgraded at Jubilee. The FPSO has already tested for 126,000boepd and on completion of the FPSO debottlenecking; the company expects oil capacity to surge to 140,000boepd. This initiative alone will increase the company's working interest production to nearly 50,000boepd.

Overall, the incremental production of 27,700boepd (62,300 minus 34,600) from Jubilee can potentially result in revenue bump-up by $1 billion and a cash flow increase in the region of $700-$800 million.

On achieving this target, the company's revenue will nearly double from current levels of $2.6 billion and so will the operating cash flow. I believe that the realistic year of revenue doubling can be 2018 as the company expects to reach net production levels of 100,000boepd sometime in 2017. With revenue expected to remain largely stagnant in FY14, the company revenue will double over the next four years (FY15-FY18) with the biggest upside coming after the second half of 2016. I do believe that as positive developments continue, the stock will start trending higher from 2015.

Another strategy, which Tullow oil is considering, is divesting stake in TEN. While this can impact the projections discussed, it is certainly not negative for the stock. As mentioned earlier, the company's asset in Kenya and Uganda can be another potential game changer. It is likely that the divestment of some stake is done to accelerate development of these assets. To put the asset attractiveness into perspective, two basins have been discovered in the region with a production potential of 300,000boepd.

Conclusion

In terms of risk, I consider the exposure to Africa as one risk factor worth mentioning. The region is prone to political instability and any change in regulations or tax structure can potentially impact the company's growth. On the positive, the region needs to exploit its resources for development and it is unlikely that regulations will be imposed to impact robust tax generators.

On the financial front, the company's risk is minimal with robust cash generation even at current production levels and a comfortable debt maturity profile. I also believe that oil prices will remain firm as tension rages in the Middle-East and hence oil price decline might not be a risk factor to consider.

Considering the potential production upside from two key assets over the next 2-3 years and the long-term potential from Kenya and Uganda assets, Tullow Oil is an attractive stock to consider. As mentioned earlier, the stock might not trend significantly higher over the next 3-6 months. However, 2015 and 2016 can potentially be big years in terms of stock upside. Investors with a relatively long-term investment horizon can consider accumulating to stock for the remainder of 2014. The company's strong operational performance is likely to continue and significant shareholder value creation opportunities are on the horizon.

Additional Notes

Tullow Oil is listed in the LSE with ticker TWL.L where liquidity is significantly higher

Tullow Oil's annual report providing production guidance and assets operational performance

Tullow Oil's Capital Market Day presentation providing updates and outlook

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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