Hurricane Energy — GWA farm-in accelerates resource monetisation

We view Spirit Energy as an appropriate partner for Hurricane Energy, as it brings technical expertise in field development, operatorship capability and financial firepower. Spirit Energy was created in 2017 following the combination of Centrica’s exploration and production business (69% owned) and Bayerngas Norge (31% owned), and has a team of more than 800 people focused on assets in Europe, overseeing production of 50mmboe per year, with a reserves/resource base of over 600mmboe.

Spirit Energy’s farm-in to GWA can be broken down into five distinct phases. In the first, starting in 2019, Hurricane is to be fully carried up to a maximum of $180.6m gross, on its share of work programme including a three-well drilling programme. This will accelerate the exploration of Warwick and appraisal of Lincoln, including preparation works for the tie-in of one or more producers to the Aoka Mizu. The Transocean Leader semi-submersible has already been contracted, providing visibility on 2019 drilling catalysts.

Contingent on Phase 1 success, in 2020 Hurricane will be 50% carried for its share of an estimated $187.5m gross programme to tie back one GWA well to the Aoka Mizu, including tie-in to the West of Shetland Pipeline (WOSP) gas export system. The tie-in is a key requirement for enhancing Aoka Mizu throughput to 40kbod, as current flaring consents are unlikely to be extended to cover this level of production.

Phase 3 includes drilling three additional wells on GWA for further appraisal and providing well stock for the FFD. Phase 4 is front end engineering and design (FEED) and Phase 5 sanction of FFD targeting a 500mmboe resource. There will be a further contingent carry contribution by Spirit Energy of $150–250m for Hurricane’s share of GWA FFD costs dependent on the reserves included in the FID for the FFD. Hurricane is to remain operator until commencement of the FFD workstreams (including FEED), at which point operatorship will transfer to Spirit Energy.

The GWA encompasses Lincoln, discovered by Hurricane’s 2016 well, 205/26b-12, together with Warwick, which has yet to be drilled. 205/26b-12 established that Lincoln was a separate accumulation to Lancaster, based on the large differences (>500m) seen in the interpreted oil water contact depths of the two structures. Hurricane attributes the barrier effect between Lancaster and Lincoln to the Brynhild Fault Zone, and has also identified a splay system of large-scale faults that may further intersect the GWA.

Three horizontal wells will be drilled in the 2019 campaign, with one to appraise Lincoln and two to explore Warwick. Each well will have a 1km horizontal section through the reservoir and will be logged and tested. They are located so that one well will be drilled in each potential fault compartment, allowing drill stem test (DST) pressure data to be used to determine whether the large-scale faults are acting as pressure barriers. The wells will all be drilled at different reservoir depths, ranging between 1,770m and 1,900m, and this should also allow an oil gradient to be defined from DST pressures if no fault compartmentalisation is seen (Hurricane’s experience in collecting pressure data and samples using wireline tools in basement reservoirs is that it is challenging, and no such pressures or samples were recovered in 205/26b-12). One of the wells, 205/26b-C, will be drilled below structural closure to demonstrate oil flow from this deeper section.

In the event of success, each well will be suspended as a future producer, and management expects that the Lincoln well will be tied back to the Aoka Mizu to facilitate early production. This will provide data for planning the first phase of a GWA FFD, while attributing reserves and providing cash flows.

We had assumed a farmed-out 250mmboe development for Lincoln in our last published valuation. This has now been replaced by the terms of the Spirit Energy GWA farm-in, which envisages a larger FFD for the GWA (Lincoln/Warwick) at a targeted 500mmboe gross.

Other key changes to our valuation include an upgrade to our short-term oil price assumptions, which are based on EIA figures for 2018 and 2019, at $72.8/bbl and $73.7/bbl. This predominantly affects our valuation of the Lancaster EPS (+3% in dollar terms), assuming first oil in H119, as our long-term oil price assumption of $70/bbl Brent from 2022 remains unchanged.

Based on our model, we see potential for Hurricane to produce more than 100kboed net at peak, assuming a GLA and GWA resource base in line with company 2C estimates. As can be seen in Exhibit 4 below, the Spirit Energy farm-in adds a material leg to forecast net production and cash flow beyond the Lancaster EPS phase from 2024.

Our post-transaction valuation is detailed below. We believe the market is likely applying a higher risking to GWA/GLA full field development than our current estimates in anticipation of potential de-risking, as the Lancaster EPS provides data on well productivity and basement reservoir pressure response. Recoverable resource estimates for GLA and GWA remain key areas of uncertainty; current P10 to P90 ranges remain relatively wide but are expected to narrow post the Lancaster EPS phase and further appraisal. We use 2C or mid-case prospective estimates where provided.

We include the Spirit Energy farm-in terms in our valuation as per the announced transaction, but continue to assume a farm-in for Lancaster FFD and Halifax based on an assumed farm-in partner IRR of 20%. This assumption assumes that a farm-in partner fully carries Hurricane through the development phase in return for a working interest in the project. Under our base case, Hurricane would release 54% of its equity in the FFD under our modelled transaction. The value dilution through farm-out is significantly less than 54% given the assumed cost carry, which is reflected in our valuation of Hurricane’s retained equity stake. In this analysis, we assume that the farm-in partner retains the value of tax losses created from both its equity capex and carried capex, as is the case under the Spirit Energy transaction.

Our valuation of Hurricane is highly sensitive to our underlying oil price assumptions. In our base case, we use the EIA’s short-term forecasts ($72.8/bbl Brent in 2018 and $73.7/bbl in 2019) and a long-term oil price of $70/bbl (from 2022). Below we look at the oil price sensitivity of our total risked valuation. The market appears to be either taking a conservative view on asset risking and/or implying a lower long-term oil price than Edison.

Other key valuation sensitivities include WACC and, to a lesser extent, opex and capex assumptions. We note that our valuation is relatively insensitive to capex assumptions, as we assume Lancaster EPS capex is largely fixed and, under our Lancaster FFD farm-out scenario, Hurricane is fully carried.

Hurricane is subject to several sector-specific and company-specific risks. We highlight the key risks below.

Generic sector risks include:

Short-term cash flow and balance sheet items are driven by Hurricane’s investment in the Lancaster EPS ahead of first oil, which we model in H119.

Hurricane is fully funded for the EPS phase, with contingency based on current capex forecasts. GWA exploration and appraisal (three wells) are fully carried by Spirit Energy in 2019, and GLA drilling activity is likely to be funded through Lancaster EPS cash flows in 2021. Assuming successful de-bottlenecking of the Aoka Mizu FPSO to enable 40kbod of gross production, an option exists to tie back an additional GLA producer to the FPSO, accelerating monetisation of Hurricane’s GLA resource base. Indicatively, this could add c 10p/share to our valuation.

The recent rise in oil price increases the likelihood and value retained net to Hurricane should the company look to farm out GLA full field development or appraisal of its other assets.

Hurricane remains relatively unleveraged with the company’s only debt being a $230m convertible bond due in 2022 bearing interest of 7.5% and convertible at $0.52/share. We assume the bond converts in our RENAV, treating this debt instrument as equity.