SDX Energy — Sobhi sole risk delivered a commercial discovery

2019 was a year of significant operational progress for SDX, with an increase in production of 14% driven by the start of production at South Disouq, on time and within budget, and its accelerated ramp-up to full production ahead of expectations. In Morocco, the drilling campaign, which commenced in November 2019 and completed in March 2020, resulted in seven discoveries out of a total of 10 wells drilled. The tenth and final well, LMS-2, encountered gas but still requires testing to establish a commercial discovery. Testing is expected to take place once COVID-19 restrictions on the movement of equipment and crews are lifted. Operational performance in 2019 resulted in a year-end cash balance of $11.1m, no debt on the balance sheet, an undrawn $7.5m credit facility, and a cash flow-generative portfolio. As a result, the company is fully funded for all 2020 activities.

Management sees significant near-term challenges in the industry as result of the deterioration in both oil prices and equity valuations and the uncertainty caused by COVID-19. Notwithstanding, SDX’s business has strong downside protection fixed the recent decline in the oil price due to its portfolio of fixed-price gas assets in Egypt and Morocco. Management estimates that at a Brent planning price of $35/bbl, over 90% of 2020 and 2021 cash flows (76% and 82% respectively at Edison updated pricing) will come from the gas businesses, partially insulating SDX from lower oil prices. The uncertainty caused by the COVID-19 pandemic and associated partial shutdown of industries is causing temporary disruption to SDX’s customer base in Morocco, where three customers, representing 50% of total Morocco revenues and including SDX’s largest customer, gradually reduced their natural gas consumption to zero in the last two weeks of March. The remaining five customers have maintained consumption rates in line with historic norms. We take the temporary reduction in demand into consideration in our updated valuation. There is no disruption to date to operations in Egypt, but the pandemic is a serious and dynamic situation that management continues to monitor.

Gaffney, Cline & Associates carried out an independent technical and economic audit to assess SDX’s 2019 reserves at 31 December 2019. The revised 2P reserves were based on a better understanding of the structure and distribution of the reservoirs at the South Disouq and Ibn Yunus fields in Egypt, the discoveries made in Morocco and reclassification of reserves to contingent resources at West Gharib, which SDX expects to convert back to 2P on approval of the development plan for the wells required to produce them.

SDX recently announced a commercial discovery at the SD-12X well in the Sobhi prospect in Egypt, which justifies the company’s confidence in drilling the well on a sole risk basis after partner IPR’s decision not to participate in the well. The well was drilled to 7,245ft and encountered 108ft net of high-quality gas-bearing sands, with an average porosity of 20%, near the base of the Kafr El Sheikh (KES) formation. The top of the KES sand was encountered at a measured depth of 6,506ft. The drill stem test (DST) achieved a maximum rate of 25mmscfd for one hour on a 54/64” choke, followed by a three-hour stable flow of 15mmscfd on a 28/64” choke. Management anticipates that the well will produce at a stabilised rate of 10–12mmscfd, in line with the Ibn Yunus-1X well. The Sobhi well is expected to produce mostly dry gas. The well will be subject to a longer rig-less test in the coming weeks, which will provide more data to help determine recoverable volume in the discovery. Management's best estimate is that the well has encountered c 24bcf of recoverable resource, which is significantly in excess of the minimum commercial volume of c 8bcfe. The timing of the test will be dependent on the timing of the mobilisation of equipment, which may be affected by ongoing COVID-19 restrictions in the region.

Management expects the Sobhi well will be tied in during 2021 via a 5.8km connection line to the Ibn Yunus-1X location where an existing flow line connects to the South Disouq CPF. On a gross basis, the tie-in cost is estimated at $3.5m. The discovery will potentially only require one further development well to be drilled, although this will not be necessary for another two to three years. The Sobhi discovery has the potential to extend the current South Disouq fixed gas price contract plateau production of 50mmscfed through to 2023/24.

The company is guiding that oil and gas production will be 6,750–7,000boepd in 2020, an increase of 66–72% on the 2019 rate of 4,062boepd driven by production from South Disouq. Having delivered first gas from the field in November 2019, performance has exceeded management expectations and production was ramped up to 50mmscfed three months ahead of schedule. Continuing strong performance is reflected in the guidance, adjusted for CPF uptime. The late-life NW Gemsa field is also expected to continue its decline due to increased water cut and falling reservoir pressure. SDX may exit the concession this year if sufficient cost savings are not achieved by the operator. At the FY19 results, the company announced that most of its 2020 capex has already been completed.

We value SDX using an asset-by-asset NAV derived from detailed DCF modelling. The core value includes production, development and contingent resources that could be developed, while exploration is valued only if wells are planned and funded in the next 12 months. We apply a 12.5% discount rate given the geographical distribution of the assets and the size of the company. We have updated our short-term commodities prices based on EIA latest estimates and long-term price assumptions. Our short-term Brent assumptions move from $64.8/bbl to $33.0/bbl in FY20 and from $67.5/bbl to $45.6/bbl in FY21, based on EIA forecasts published in April 2020. We also reviewed our previous long-term oil price of $70/bbl Brent from 2022 inflated at 2.5% onwards to reflect the current oil price volatility. We present three scenarios with Brent in 2020 at $40/bbl in our low case scenario, $50/bbl in our mid-case scenario and $60/bbl in our high case scenario, escalated at 2.5% per year resulting in 2022 prices of $42.0/bbl, $52.5/bbl and $63.0/bbl respectively. We will be revisiting these assumptions to reflect further market changes as they occur. We continue to assume Moroccan gas prices of $10.85/mcf in 2020 inflated at 2.5%. In addition to the commodity prices, key changes to our updated valuation and estimates include the updated reserve numbers and capex and production guidance as above.

In Egypt, our updated valuation excludes the Salah prospect as it proved to be non-commercial and the Young prospect as the company is not planning to drill it in the near future. At the same time, the updated valuation includes the recent Sobhi discovery, added to the Core NAV since it is a simple tie-back to the CPF. In Morocco, we include the reserves reported at 31 December as per the FY19 annual report as well as the SAH-3 and OYF-2 wells, which were already completed as commercial discoveries during Q120. SAH-3 is close to infrastructure and OYF-2 is commercial as a standalone development to be tied back to existing infrastructure. For 2020 we assume the three customers in Morocco that are closed remain so for three months and therefore a gas production level of 5.95mmscfd for the year instead of the initial guidance of 6.7–6.9mmscfd. Risked exploration includes the BMK-1 discovery and the potential 10bcf located in close proximity to the BMK-1 well, and the LMS-2 discovery. The LMS-2 well indicates 10.6m of net gas reservoir with 30.9% porosity in the well, however, testing is required to determine its commercial potential once COVID-19 restrictions are eased and allow SDX to bring a testing crew into the country. All in all, our mid case RENAV moves from 53.9p/share to 40.7p/share (-24%), with our core value standing at 33.8p/share. We note that our valuation has a significant core value component at 83% of our RENAV. This is materially different from the current share price of 20p/share.

We forecast year-end 2020 net cash of $9.1m in addition to SDX’s European Bank for Reconstruction and Development (EBRD) loan facility of $7.5m which remains undrawn. Management intends to extend the tenor and re-establish the full availability of $10m credit facility. Based on the capex projections that underpin our production forecasts and SDX’s committed exploration programme, the company is fully funded for 2020 and we forecast positive free cash flow from 2020 with a 2020 FCF close to break-even. Since over 75% of cash flows in the coming years will come from the fixed price gas businesses, we currently do not foresee the need for further equity capital at this stage, unless incremental growth capex, over and above our forecasts, is dedicated to new projects or acquisitions.