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Quest Petroleum: South Sumatra Onshore Oil And Gas Program Is Transformational In Company History

Quest Petroleum (ASX: QPN) is poised to drill three exploration wells on its Ranau production sharing contract in South Sumatra that is believed to be southernmost extension of the prolific South Sumatra Basin.

While the permit is virtually unexplored, existing oil and gas wells in surrounding permits and observed oil seeps provide evidence for a proven petroleum system.

This includes NuEnergy Gas' (ASX: NGY) recent drilling of two successful coal seam gas wells at the Muara Enim PSC about 100 kilometres north of Quest's Ranau PSC as well as Pertamina's Lavatera-1 gas condensate discovery that it made in February in the Pagardewa area about 50 kilometres to the north.

The NuEnergy wells supported the gas-in-place estimates of 7.25 billion cubic feet per square kilometre at Muara Enim, a result that Quest said improved the prospectivity of Ranau.

Meanwhile, the Pertamina find is evidence that Quest's belief that large scale hydrocarbon discoveries in the greater South Sumatran basin are both likely in areas of limited exploration and can be quickly commercialised due to existing infrastructure and ready markets.

Quest has also completed a joint study with Trisakti University that has identified four sub-Basins.

Share Price: A$0.005
Issued Shares: 2.04 billion
Market Cap: A$10.2 million
Cash: A$2.84 million
EV: A$9.3 million

ANALYSIS

Quest Petroleum is still in the early stages of exploration and while it has identified 16 leads with potential to hold up to 300 million barrels of oil or 6 trillion cubic feet of gas, it will require drilling in order to provide certainty to these figures.

However, there are a number of positives that are value adding milestones in this quest.

Exploration in surrounding areas has already proven that a hydrocarbon system exists in the area, which is close to existing infrastructure.

This, combined with the lower cost of operating onshore, allows Quest to drill wells cheaply and develop discoveries quickly.

The prospectivity of the South Sumatra Basin has also attracted majors such as Santos (ASX: STO) and super majors like ConocoPhillips (NYSE:COP), who do not participate in projects without large prospective upside.

Furthermore, Quest has secured after tax profit splits for Ranau PSC that are more favourable than Santos, which bodes well for the terms it will receive for the additional oil and gas opportunities it is pursuing in the country.

Santos' upcoming drilling program in its permits will also pave the way for Quest to drill its first three wells targeting the Jaya sub-Basin in the Ranau PSC over the next three months.

These have the potential for more than 60 million barrels of oil equivalent each.

Quest provides a more leveraged way to gain exposure to the highly prospective Ranau PSC Basin than Santos, sitting at a market valuation that is primed to move upon spudding of first well and any commercial discovery.

With Quest's attractive 62% revenue split for both oil and gas in the Ranau PSC, even a single discovery will lead to a major upgrade in the company's valuation.

With this split and significant discounting, a conservative 15 million barrel of oil discovery at oil prices of about US$110 a barrels could still be worth a gross A$0.04 per share, far higher than current share prices.

A gas discovery will also find a ready market for both domestic and foreign power generation as well as for making fertiliser.

Additionally, the planned drilling program is focused on just one of the four sub-Basins identified on the Quest's commanding 2123 square kilometre Ranau PSC.

This gives the company a large potential pipeline of further exploration and development opportunities, which will be de-risked in the event of any success in its three well program.

Mochamad Thamrin's role as senior technical advisor brings unparalleled expertise in South Sumatran petroleum geology to the company and is a significant point of differentiation for Quest in Indonesia.

This knowledge will go a long way towards understanding the Ranau PSC to both minimise risk and picking it the best spots for exploration.

Quest is also actively sourcing for additional oil and gas opportunities in Indonesia, which could add further to its value. The company's strategy is to complete further joint studies on areas identified within producing regions with BPMigas and then to apply for PSC's over these areas. On grant of a PSC the company will systematically explore and develop these.

At current market valuation of $12.2 million, Quest is lightly rated given its significant exploration program gathering pace and the prospectivity of the South Sumatran Basin.

However, if there were a commercial discovery at Kayumanis, factoring in the Base Case project economics would see an IRR of 69.2% and an NPV of US$191 million. This is very heady given the current market valuation of Quest sitting at $12.2 million and demonstrates the risk/reward equation is very promising indeed.

At this level of valuation, Quest could be expected to gain a lift in valuation with the onset of exploration and spudding of its first well.

This provides significant upside potential for an investor from the current share price for those understanding the risk/return potential of oil and gas investment.

MANAGEMENT TEAM

John (Gus) Simpson brings over 25 years of experience in managing listed resources companies and an extensive range of corporate and commercial expertise to his role as the company's chairman. Mr Simpson has had extensive commercial experience in Indonesia and brings a broad range of relationships and contacts to Quest. He is also the executive chairman of uranium developer Peninsula Energy Limited.

Mochamad Thamrin is Quest Petroleum's deputy chairman and senior technical advisor of its subsidiary PrabuEnergy with a deep knowledge of South Sumatra's petroleum geology. Mr Thamrin has over 45 years experience in the Indonesian oil and gas industry, including senior geological positions at PT Shell Indonesia and as a production geologist with Indonesian state oil and gas company Pertamina. He also served as Head of Geological Evaluation R&D Division of Directorate E.P. Jakarta and is widely regarded as a leading expert in the Indonesian oil and gas field, having authored over 30 publications and text books on geology and related topics within this area.

Anthony Milewski is the company's newly appointed managing director and chief executive officer. He brings extensive experience in the energy & resource industries and an active involvement in global capital markets having held board positions with several public energy and resource companies in emerging markets prior to joining Quest. Milewski, a lawyer with a M.A. in International Studies and an LLM in Russian law, has spent a significant part of his career living and working in emerging markets, including Africa, Russia and Asia.

Saxon Palmer is a geologist with over 20 years of experience and has appraised oil & gas opportunities in most of the major gas basins in the world. He has held senior management positions with BP and BHP Billiton and was most recently exploration manager Australia/Asia for the resources giant.

BACKGROUND

Sumatra is the sixth largest island in the world, and has had a successful oil and gas industry since 1885 when Indonesia's first successful oil well was drilled in North Sumatra, creating the Royal Dutch Shell group.

Since then, there have been more than 450 oil and gas fields have been discovered containing more than 47 billion barrels of oil equivalent (boe).

Indeed, Sumatra and East Kalimantan together hold the bulk of Indonesia's oil reserves.

South Sumatra contains 189 of these fields with total reserves of about 12 billion boe. It also holds one of the three most prospective areas for coal seam gas in the country.

Notable operators include ConocoPhillips, which operates the Corridor Block and South Jambi 'B' PSCs, and Santos with the Ogan Komering I and Ogan Komering II coal seam gas licences.

Gas from Corridor Block is sold through long-term sales contracts to the domestic and Singapore markets while South Jambi contains three gas fields in various phases of development.

Santos is also planning to drill up to 12 wells in the third or fourth quarter of this year on its PSC's, where coal thicknesses of up to 60 metres have been identified.

Sumatra still produces oil for consumption in domestic and international markets and gas for domestic markets in Sumatra and West Java, and to international markets in Singapore, via pipeline, and North Asia, via liquefied natural gas export.

In South Sumatra, oil and gas fields occur in, and around, discrete sub-Basins, which are the source of the oil and gas. These sub-Basins were formed during back-arc extension, starting in the late Eocene.

Geologically, the Ranau area represents the southern-most extension of the South Sumatra Basin. The Lematang sub-Basin is connected to the Ranau area by the north-south trending Suban Trough.

The source rock for hydrocarbons in the South Sumatra Basin are the lacustrine source rocks of the Lahat Formation, the Lemat Formation and terrestrial coal and coaly shale rocks of the Talang Akar Formation.

Of these, the Talang Akar Formation, which contains oil and gas prone Type I, II and III kerogen, is considered the primary reservoir rock in the Ranau area as it is elsewhere in the South Sumatra Basin.

The reservoir rocks consist of quartzose to argillaceous sandstones that were deposited in a delta plain to open marine setting.

The Gumai Formation shales that were deposited across the Basin in the Lower to Middle Miocene forms the dominant regional seal in the South Sumatra Basin and are also thought to be the seal in the Ranau area.

Most of the hydrocarbon traps in the South Sumatra Basin were formed during the widespread compressional event that modified the basin in the Upper Miocene, Pliocene and Pliestocene.

This formed predominantly northwest - southeast trending anticlines. Stratigraphic pinch-outs and carbonate build-ups (Baturaja Formation) and also locally formed.

RANAU PSC

Quest Petroleum Ranu PSC

Given the large oil and gas majors with blocks in South Sumatra it was conceivable that that this would be the case when Indonesia auctioned Ranau PSC blocks.

However, Indonesia decided to enable local private companies to acquire key blocks and auctioned 9 blocks (11 offered). Quest has maintained key relationships with prominent oil and gas executives in Indonesia, in particular with Mochamad Thamrin, a leading industry professional with a deep knowledge of the petroleum geology of South Sumatra.

His private group holds 20% of Ranau PSC via shares in Prabu Energy. Quest acquired the Ranau exploration block in September 2011 and 80% interest in the 2123 square kilometre Ranau production sharing contract onshore South Sumatra, Indonesia.

The company has closed the acquisition of Merric Capital Pty Ltd, which held the 80% stake through its subsidiary PrabuEnergy Pty Ltd, on 24 November 2011 with the issue of 963.3 million shares along with 296.4 million options exercisable at A$0.015 each.

The Ranau PSC is a 30 year contract with an initial 6 year exploration period.

PrabuEnergy was awarded the Ranau Joint Study in September 2010 that was carried out in conjunction with the Directorate General, Oil and Gas and the geological department of Trisakti University in Jakarta, an Indonesian educational institution focused on the oil and gas industry.

This involved a gravity survey along 225 kilometres with 500 metre spacing. 722 gravity stations were recorded in December 2010 and January 2011, providing good overall coverage of the Joint Study area.

The study also used data from 247 kilometres of 2D seismic that were tied to the Ruas-1, Imus-1 and Sekunyir-1 wells located northwest of Ranau.

Besides identifying four new and very lightly explored sub-Basins as extensions of the prolific South Sumatra Basin, the study also found that the Talang Akar and Lemat Formations had the potential to generate hydrocarbons in the area.

The gas column in the shallow Ruas-1 well provided proof of a working petroleum system within the Sekunyir Graben as it did not encounter any mature source rocks while the source rocks at the Imus-1 well, which had significant gas shows and minor oil shows, were not mature, making it likely the hydrocarbons were generated in deeper parts of the Imus Graben and migrated to this location.

The Sekunyir-1 well had significant gas shows and minor oil shows in the Telisa, Baturaja, Talang Akar and Lemat formations.

Quest believes that within the grabens in the Ranau PSC, the source rocks will be buried to depths of up to 3000 metres and would be mature for generation of oil and gas.

The Joint Study also found that migration pathways are both lateral along permeable beds in the Lemat and Talang Akar Formation and vertical along faults.

These pathways would allow hydrocarbon migration to traps in structures along the flanks of the grabens

Traps in the Ranau area are likely to be in structures associated with reactivation of basement faults along the flanks of grabens. The Imus structure is an example of this type of trap.

The gas and oil shows in surrounding wells along with observed oil seeps within Ranau are evidence of a proven petroleum system in thearea.

Significantly, an adjacent well recorded log and pressure data confirming a 107 metre gross gas column within the primary Talang Akar Formation reservoir.

Existing seismic data adjacent to the Ranau PSC also show potential Direct Hydrocarbon Indicators (DHIs), providing strong support for widespread occurrences of oil and gas in this area.

The study allowed PrabuEnergy to identify four sub-Basins that contain up to 3 kilometres of sediment that are believed to be same oil and gas source rocks and reservoir rocks as those in the South Sumatra Basin.

Quest has identified 16 leads with total potential of greater than 200 to 300 million barrels of oil and/or greater than 4‐6 trillion cubic feet of gas.

Three leads in the Jaya sub-Basin have been prioritised for drilling and the company is in the process of contracting a rig for a 3 well drilling program within the Jaya sub-Basin.

This will target the Kayumanis Lead plus the Sawat and Tabat leads.

Exploration costs in South Sumatra are expected to be low with estimated well and seismic costs likely to be about US$1.2 million and US$2 million (for 500 kilometres of 2D seismic) respectively.

GAS AND OIL MARKET

The Ranau production sharing contract is well placed to capitalise on any discoveries made.

Gas can be commercialised through the nearby South Sumatra - West Java gas transmission pipelines and processing infrastructure, located 55 kilometres east of the Kayumanis lead.

These pipelines supply domestic markets that are growing rapidly as distribution networks are built as well as large markets in West Java and Singapore.

The South Sumatra - West Java pipeline has capacity of 1 billion cubic feet per day with current utilisation of between 50% and 70%.

To top it off, Indonesia's state owned energy company PT Perusahaan Gas Negara (PGN) had recently increased gas prices for its West Java customers by 49% to US$10.13 (A$10.39) per million British Thermal Units (MMBtu) following contract renewals with producers in South Sumatra.

This compares with the previous contract rate of US$6.80 per MMBtu and reflects the steadily increasing demand for gas to generate power in Java.

Quest expects contracted gas prices to be at a minimum of US$6.50 per MMBtu from 2014 onwards.

Other potential gas buyers include the fertiliser market, which is benchmarked to Ammonia - itself correlating with oil prices - with prices ranging from US$6 to US$8 per MMBtu, pipeline gas (US$5.50 per MMBtu), domestic liquefied natural gas and export LNG.

Oil discoveries can also be commercialised through facilities located within 50 kilometres of the permit.

These facilities process and transport oil from the large, Pertamina-operated fields to the north of Ranau.

To top it off, the Indonesian Government is building a 90 trillion rupiah (A$9.09 billion) crude oil refinery in South Sumatra.

Work is currently being carried out to confirm the suitability of the location and construction of the refinery is expected to start in 2013 with completion and start-up estimated in 2017.

This demonstrates the significant increase in domestic demand for fuels and marks a positive development for the South Sumatran oil industry, which over the past 12 months has seen multiple wells with commercial oil and/or gas shows.

Indonesia is a net importer of oil since 2004.

PLACEMENT

To drill its planned wells, Quest is raising up to A$5 million through the issue of new shares in two equal placements to international and domestic institutions as well as existing retail shareholders.

The first tranche of the institutional placement to raise A$1.2 million has already being completed and the company is seeking shareholder approval for the remaining A$1.3 million as well as the entitlement issue.

The shares are priced a5 A$0.006 each and include one free attaching option exercisable at A$0.015 each on or before 30 June 2016 for every two new shares subscribed.

Kayumanis INDICATIVE PROJECT VALUE - Base Case Scenario

  US$ per barrel produced US$ million per year at average production for 12 years
Revenue (20 year weighted average) 87 108.7
Operating Cost 12.97 16.2
Intangible Capex 2.11 2.6
Total Operating Cash Cost 15.08 18.9
Depreciation 3.07 3.8
Total Production Cost 18.15 22.7
Profit Before Tax 38.84 48.5
Tax 15.54 19.4
After Tax Cash Flow 21.04 26.3
Net Present Value   US$191 million
Project IRR   69.2%

Source: Quest Petroleum ASX release

This is an indicative calculation of Net Present Value predicated if Kayumanis results in a commercial oil recovery. Clearly the NPV is based on assumptions including an oil price of US87 per barrel, peak production of 5500 barrels per day and total recovery of 15 million barrels of oil.

Other assumptions include total revenue over the life of the project of US1.3 billion, total capital cost of US$78 million and total operating expenses of US$195 million.

CATALYSTS - 12 MONTHS

- Completion of capital raising program
- Commencement of exploration program
- Gravity survey of Kayumanis lead
- Well planning and approval of Kayumanis
- Results from drilling of Kayumanis
- Gravity survey of Sawat lead
- Well planning and approval of Sawat
- Results from drilling of Sawat
- Gravity survey of Tabat lead
- Well planning and approval of Tabat
- Results from drilling of Tabat
- Acquisition of further oil and gas opportunities in Indonesia

ANALYSIS

Quest Petroleum is still in the early stages of exploration and while it has identified 16 leads with potential to hold up to 300 million barrels of oil or 6 trillion cubic feet of gas, it will require drilling in order to provide certainty to these figures.

However, there are a number of positives in this value adding quest.

Exploration in surrounding areas has already proven that a hydrocarbon system exists in the area, which is close to existing infrastructure.

This, combined with the lower cost of operating onshore, allows Quest to drill wells cheaply and develop and discoveries quickly.

The prospectivity of the South Sumatra Basin has also attracted majors such as Santos (ASX: STO) and super majors like ConocoPhillips, who do not participate in projects with small upside.

Furthermore, Quest has secured after tax profit splits for Ranau PSC are more favourable than Santos, which bodes well for the terms it will receive for the additional oil and gas opportunities it is pursuing in the country.

Santos' upcoming drilling program in its permits will also pave the way for Quest to drill its first three wells targeting the Jaya sub-Basin in the Ranau PSC over the next three months.

These have the potential for more than 10 million barrels of oil equivalent each.

Quest provides a more leveraged way to gain exposure to the highly prospective South Sumatra Basin than Santos, sitting at a market valuation that is primed to move upon spudding of first well and any commercial discovery.

With Quest's attractive 62% revenue split for both oil and gas in the Ranau PSC, even a single discovery will lead to a major upgrade in the company's valuation.

With this split and significant discounting, a conservative 15 million barrel of oil discovery at oil prices of about US$110 a barrels could still be worth a gross A$0.04 per share, far higher than current share prices.

A gas discovery will also find a ready market for both domestic and foreign power generation as well as for making fertiliser.

Additionally, the planned drilling program is focused on just one of the four sub-Basins identified on the Quest's commanding 2123 square kilometre Ranau PSC.

This provides the company with a large potential pipeline of further exploration and development opportunities, which will be de-risked in the event of any success in its three well program.

Mochamad Thamrin's unparalleled expertise in South Sumatran petroleum geology adds a key investment differentiating element to Quest.

This knowledge will go a long way towards understanding the Ranau PSC to both minimise risk and selection exploration targets.

Quest is also actively sourcing for additional oil and gas opportunities in Indonesia, which could add further to its value.

At current market valuation of $12.2 million, Quest is lightly rated given its significant exploration program gathering pace and the prospectivity of the South Sumatran Basin.

However, if there were a commercial discovery at Kayumanis, factoring in the Base Case project economics would see an IRR of 69.2% and an NPV of US$191 million. This is very heady given the current market valuation of Quest sitting at $12.2 million and demonstrates the risk/reward equation is very promising indeed.

At this level of valuation, Quest could be expected to gain a lift in valuation with the onset of exploration and spudding of its first well.

This provides significant upside potential for an investor from the current share price for those understanding the risk/return potential of oil and gas investment.

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