Elk Petroleum — Acquires CO2 vertical integration and cash flow

In line with ELK’s strategy to become integrated along the CO2 EOR value chain to support the acquisition and development of further enhanced recovery projects, it has acquired Freeport-McMoRan’s c 14% interest in the Madden Gas Field for US$17.5m. In addition to being a prolific methane producer, Madden also produces a significant sour gas component, giving ELK access to material CO2 resource. The acquisition, which has an effective date of 1 January 2017, elevates ELK to producer status. ELK estimates attributable free cash flow of c US$7m in 2017 from Madden. ELK’s ramp-up in production post acquisition and first oil from Grieve have a material impact on group operational cash flow and earnings over the course of the next three years. The precise shape of the companies’ earnings growth profile will depend on the timing of Grieve first oil, commodity prices and plant uptime.

Given the substantial CO2 requirement to establish an EOR project and its importance to securing financing, ELK regards vertical integration and CO2 supply ownership as essential to underpin its future acquisition and development strategy and provide a long-term competitive advantage.

ELK believes the investment approach it took at the Grieve Enhanced Oil Recovery (EOR) project is highly repeatable. The Grieve project restructure, which involved raising debt and equity, generated widespread interest among US CO2 developers and operators, banks and other capital providers. ELK’s integration with its own CO2 is an enabler for repeating this acquisition and funding strategy.

ELK has acquired FCX’s c 14% non-operated interest in the Madden Gas Field in Wyoming, as well as the associated Lost Cabin Gas Plant. FCX’s sale is part of a broad, corporate-wide divestment strategy as the group looks to exit the oil and gas sector. The operator at Madden is oil major ConocoPhillips (COP:NYSE), which retains a 46% interest in the assets. The balance of the gas field and plant is owned by Moncrief Oil (30%) and various other private interest holders. The acquisition secures ELK a direct ownership position in the second most significant CO2 supply in the Northern Rockies.

Current proven developed reserves of CO2 in the Madden Gas Field are approximately 220bcf. The total recoverable resource potential of raw gas is over 1tcf. The raw gas stream has a CO2 content of c 20%, methane and ethane (68% combined) and hydrogen sulphide or H2S (12%). The Lost Cabin Gas Plant is designed to separate raw gas into pipeline specification methane, a purified CO2 stream, and elemental sulphur for sale to the fertiliser market. Operations began in 1995 and, after a number of major expansions, the plant consists of three gas processing trains with total capacity of 310mmscfd. The Madden Gas Field is the second largest supplier of CO2 into the Northern Rockies CO2 gas transmission and supply pipeline network.

As part of the CO2 supply arrangements, Denbury Resources (DNR:NYSE) constructed a CO2 receiving and compression facility adjacent to the Lost Cabin Gas Plant and the 373km Greencore CO2 gas pipeline. This has an ultimate capacity to transport 725mmscfd of CO2 for EOR projects in Wyoming and Montana. This implies total annual capacity of approximately 260bcf CO2. By way of comparison, ELK expects that a total of approximately 52bcf of CO2 will be injected into the Grieve field by the time first oil is produced.

Raw gas from the Madden Gas Field is currently processed at the approximate rate of 240mmscfd through the dedicated Lost Cabin Gas Plant (LCGP). Over the five years from 2017 to 2022, gross raw gas production from the Madden field is estimated to average 202mmscfd based on Proved Developed Producing (PDP) reserves.

Sales gas, mainly methane and ethane, accounts for about 68% of raw gas content. It is delivered from the gas plant into several inter-state sales gas transmission lines. These include the Lost Creek pipeline (for delivery to Colorado Interstate Gas, Wyoming Interstate Gas and Rockies Express) and Mountain Gas Resources (for delivery to Colorado Interstate Gas).

Based on projections for the 2017-22 period, ELK’s c 14% share of Madden net sales gas produced will be approximately 22.6mmscfd after taking into account the state ORRI royalty of 18-19% deducted from gross production (royalty credits drive a material reduction in the effective royalty rate at 9-11%). This projection is based solely on PDP reserves. This is equivalent to annual attributable gas sales of around 8.3bcf. ELK has estimated positive net free cash flow of approximately US$7m in 2017 based on January 2017 price consensus forecasts. To protect earnings and cash flow, ELK intends to instigate a natural gas hedging programme to support debt for the Grieve EOR project.

Exhibit 2 summarises historical production over the 2014-16 period. Due to the significant decline in US natural gas prices in the second half of 2016, the financial performance of the Madden Gas Field was clearly weaker.

The Madden Gas Field is a conventional gas field located in the Wind River Basin in Wyoming. It was discovered in 1968 and is one of the state’s largest gas fields. The field sits on the Madden anticline and covers an area of 518km2.

The field produces from multiple reservoir units ranging in depth from 1,500m to 7,600m.

The Madden Gas Field has an estimated original gas in place of over 5.5tcf. To date, it has produced over 2.42tcf of natural gas. This includes 1.1tcf from the deep Madden Formation wells.

Exhibit 3 shows a recent (January 2017) classification of Madden Deep Gas Reserves independently audited by NSAI. Gross PDP reserves were 524.3bcf (0.52tcf) on a methane only basis and post-royalty. We understand this audit was commissioned by Freeport-McMoRan as part of the sale process to divest its oil and gas interests.

Production forecasts by the operator, COP, provide for production over an estimated additional 10 years beyond the life implied by the NSAI PDP reserves; the NSAI PDP numbers may therefore be conservative.

We have valued ELK’s acquired c 14% interest on an NPV12.5 basis from cash flow estimates from the Madden Deep wells. We have calculated valuations over a range of reserve/resource scenarios and gas price scenarios (Exhibit 4). The gross reserves in the table below are on a raw gas (including sour gas components) and pre-royalty compared to methane only (sales gas) and post-royalty in the table above. In nearly all scenarios, our valuations are at premium to the US$17.5m consideration paid by ELK.

A comprehensive valuation for the whole company, including the Grieve project, is provided later in this report in Exhibit 5.

The Lost Cabin Gas Plant produces 1,200-1,400 t/day of sales-grade sulphur (gross). The majority is transported by rail to Tampa, Florida to supply the fertiliser market. The remainder is transported to a local fertiliser plant in south-west Wyoming.

The Lost Cabin Gas Plant is a sizeable and complex plant, which will incur a material decommissioning expense at the end of field life. We include estimates for the cost of mothballing train 1 (2033) and decommissioning the entire plant at the end of field life.

ELK is seeking to replicate elements of the restructuring and finance model used at Grieve for the acquisition of additional CO2 EOR projects.

ELK is targeting the acquisition of additional CO2 EOR assets with development or expansion upside. It is seeking unique project opportunities that may:

The advantage of the Rocky Mountains is the substantial opportunity for acquiring projects that can provide incremental valuation growth. The Nebraska DJ Basin may also provide an additional parallel path. In the longer term, the company plans to also screen opportunities in Australia and South-East Asia (including Indonesia and Malaysia) where it believes the opportunity set is virtually untapped.

ELK believes there is an oversupply of mature CO2 EOR assets in the Rocky Mountains. It has identified over 500 CO2 EOR projects in Wyoming alone. Wyoming’s regulatory environment is also supportive and it has some of the largest proven reserves of CO2, vital for CO2 EOR, in the US. Many companies with high-quality CO2 EOR and CO2 projects are capital constrained or undertaking balance sheet repair. Some are liquidating assets with current production and positive cash flow. We understand that a number of peer CO2 EOR operators have approached ELK as a potential partner for CO2 EOR expansion projects.

ELK’s objective is to take advantage of the current weak oil market and acquire attractive EOR projects at the bottom of the price cycle.

CO2 injection at 25-35mmscfd and water injection at approximately 4,650 barrels of water per day has continued. Field pressures have increased in line with expectations. At 31 December 2016, approximately 36bcf of CO2 had been injected into the Grieve field with an expected 40.5bcf by March 2017. Under the current development plan, it is expected that approximately 52bcf of CO2 will have been injected into the field by the time first oil is produced.

ELK expects field development well and construction work to commence in April/May 2017. The commencement of the remaining well workover projects and well testing is expected to be completed in August 2017.

Following the restructure of the Grieve Project JV, there has been an improved relationship with DNR as operator. ELK has reviewed, with DNR, an updated field development plan and project execution schedule. DNR has confirmed that the overall recoveries expected from the Grieve field are expected to be in line with ELK’s independent reserves assessment of 12.5mmbbl 2P gross recoverable oil from the project. First oil production continues to be expected in late 2017 or early 2018.

We have used our base case oil and gas prices (Exhibit 5) in our valuation of ELK’s 2P asset base, which stands at A$0.11/share. We see material upside in the event of higher commodity prices and/or resource recovery in excess of audited 2P estimates. In particular, we flag that ConocoPhillips holds significantly greater than estimates by NSAI of Madden 2P reserves as its own operator estimates. Our base case valuation breakdown is provided below.

Oil and gas prices: we have used Edison’s oil price forecasts to value the Grieve project. We have used the January 2017 EIA STEO gas price forecasts for 2017 and 2018, escalated at 2.5% pa from 2019, in valuing the Madden project.

To quantify commodity price sensitivity we provide a 2P NAV sensitivity to both long-term oil price and gas price assumptions. As can be seen in the table below, Elk is highly sensitive to both oil and gas pricing given the company’s operational and financial leverage. Our-long term assumptions are 70$/bbl WTI (real) and $3.4/mcf Henry Hub (real).

To reduce downside risk, a comprehensive oil price hedging programme was put in place at the same time as ELK’s term loan facility to underwrite the Grieve project. As such, 75% of forecast oil production from the Grieve project during calender years 2018 and 2019 has been hedged with put options at a floor of 45$/bbl – ELK retains oil price upside.

With the current share price implying that long-term commodity prices remain below current spot levels and with a significant amount of oil production hedged over the next two years, commodity price-driven downside is largely protected. Nevertheless, company-specific operational risks centre around ELK’s ability to recover reserves in line with audited 2P estimates, maintain high levels of operational uptime and minimise the NPV of decommissioning liabilities associated with large capital items such as the Lost Cabin Gas Plant.

To date, ELK has used a combination of debt and equity to fund growth. We expect operational cash flow from Madden and Grieve in late 2017/early 2018 to enable ELK to pay down debt and fund further growth.

The effective date for the Madden Gas Field acquisition is 1 January 2017. From this date, ELK becomes a producing oil and gas company and will begin to generate operating earnings from gas sales. Expected first oil production from the Grieve CO2 EOR project is expected in late 2017/early 2018.

The earnings forecasts in Exhibit 9 use Edison oil price forecasts and EIA gas price forecasts, as shown in Exhibit 6. Almost all the Madden gas is sourced from the Madden Deep Wells, where future capital expenditure requirements are low as no new wells are required to underpin the company’s 2P reserve profile.

Assuming January 2017 consensus gas prices, ELK has estimated positive attributable net free cash flow of approximately US$7m for CY17 from Madden. At the outset of production, our pre-tax cash flow forecasts for Madden are within this range.

The Benefit Street Partners facility was a US$58m conventional term loan for oil field development financing available to fund ELK’s outstanding capital requirements to first oil at Grieve. We expect the bulk of this to be drawn down over the course of FY17. In addition, ELK has completed a US$10m convertible loan to finance the closing payment of the Madden/Lost Cabin transaction. The remaining balance of $5.5m is due by 15 July 2017 and is expected to be paid out of cash flow and existing cash resources.

We expect to see a material increase in debt before year-end FY17 (June 2017) as ELK draws down of the Benefit Street Partners loan and takes on an additional US$10m of convertible debt to fund the Madden/Lost Cabin transaction. We expect this to be paid down rapidly from cash flow once Grieve is on-stream.