Elk Petroleum — Aneth adds another antler

Based on Edison commodity price assumptions (we use EIA short-term forecasts and 70$/bbl Brent in 2022), the acquisition of a 63% interest in the Aneth CO2 EOR project is materially accretive to our base case NAV. Our valuation increases from A$0.09/share to A$0.12/share as a result. The deal is also immediately accretive to production, reserves and NAV based on proved developed producing (PDP) projections. Production, resource and NAV upside exists, with several capital-light optimisation projects having been identified that would deliver returns in excess of 15% at current oil prices. Asset oil price leverage is somewhat muted in the short term through the inclusion of US$35m of oil price-contingent payments as part of the transaction. However, the downside is also protected through the use of hedging instruments. Financial close was achieved on 6 November 2017.

Unlike Grieve and Madden, Aneth is an ELK-operated asset. ELK has greater control and ownership over Aneth, with the addition of 100 contractors/employees at the asset level and certain Resolute Energy senior management joining ELK in senior executive roles. Key employees joining the ELK Denver-based operational team include James Piccone, a founder of Resolute Energy with intimate knowledge of the Aneth asset and relationships with key stakeholders.

Our NAV increases from A$0.09/share to A$0.12/share (+32%) as a result of the transaction, although we expect further value to be created as management optimises the asset and delivers on opex reduction targets (management sees potential to materially reduce the differential at which oil is sold versus WTI) and capital-light asset development opportunities. We expect our NAV to rise as ELK identifies, prioritises and commits capital to these opportunities.

The Greater Aneth Field is defined as a ‘giant’ oil field with 1.5bnbbls of light sweet oil initially in place (OIIP) and ranked by the EIA as the 86th biggest oil field in the US by proven reserves (March 2015). The field began producing in the late 1950s and tertiary oil recovery through the injection of CO2 began in the late 1980s. Production profiles highlight the benefit of CO2 injection on field decline rates with production close to 10mbopd gross over the last decade.

To date, oil recovery stands at 31% of in place volumes. However, a study carried out by Resolute Energy in December 2016 estimates that ultimate recovery of 49% of currently accessible in place volumes (1.15bnbbls gross) is achievable – this equates to 40mmbbls of net proven reserves and 112mmbbls of net development and contingent upside.

CO2 for tertiary oil recovery is supplied from Kinder Morgan’s McElmo Dome CO2 Field, which is one of the world’s largest CO2 accumulations with over 20tcf in place and a current production capacity of 1.23bcfd. A 28-mile pipeline connects McElmo Dome to the Aneth field, with capacity of 100mmscfd and CO2 is contracted via oil-indexed pricing through 2018. ELK sees potential for replacement CO2 supply sourced from the reservoir beneath the Greater Aneth Field, which may provide the opportunity to reduce operating costs and/or renegotiate existing CO2 supply contracts.

Oil recovered from the Aneth field is exported via established pipeline networks to end-markets and refineries. Oil is currently sold to Western Refining via the Running Horse Pipeline. However, offtake alternatives, which management now views as cost competitive, include trucking of crude or rail transport to Salt Lake City refineries. Resolute has estimated an average historic differential of $6.85/bbl versus WTI; however, ELK management sees the potential to halve this figure by optimising offtake agreements and routing. We currently assume a $6.85/bbl differential and see potential for a 13% increase from our base case NAV (A$0.12/share) once ELK enacts changes to reduce offtake costs.

Current Aneth operator, Resolute Energy, has identified numerous organic growth opportunities, which include additional compression, increased CO2 injection, waterflood expansion, accessing bypassed pay and CO2 flood expansion. These development projects offer access to net development resources of 63mmbbls and 0.5tcf of gas. Projects highlighted in Exhibit 4 show that a range in F&D cost from US$2.7/bbl to US$17/bbl and two-thirds of the highlighted projects generate an IRR of over 15% at the current oil price, and provide additional NAV gearing to the upside in the event that oil prices rise.

Our base case ELK valuation conservatively assumes a minimal capex case based on current PDP and proved developed non-producing (PDNP) (produced developed producing and produced developed non-producing) production projections. We intend to include engineered growth projects as and when ELK has the opportunity to high-grade development opportunities and commit capital. The production potential of the growth projects highlighted above is shown in Exhibit 5 below.

The total cash outlay for the Aneth acquisition, completed on 6 November 2017, stands at US$175m including financing and debt repayment costs and net of pre-close cash flow. This is to be funded through a combination of debt and new equity (raised in September 2017).

The key terms of ELK’s senior debt (US$98m) and preferred equity are highlighted in Exhibit 6. Preferred equity comes at a cost of 15%, which we see as relatively expensive capital, but is an enabler providing access to Aneth cash flows at a material discount to NAV. ELK’s intention is to refinance its debt in c 12 months, which should substantially reduce interest costs if it can access US PDP debt. ELK management estimates it could secure US PDP debt at 4-5% interest (currently), which, if successful, would bring the company’s weighted average interest rate down to around 7%.

In addition to debt and preferred equity, Elk has raised US$22m in new equity through the placement of 443m shares announced on 18 September 2017 with institutional and private investors at a price of A$0.062/share.

Incorporating the effect of equity dilution and the addition of Aneth proven reserve net cash flows to our NAV generates an increase from A$0.09/share to A$0.12/share. With ELK’s senior debt supporting the transaction priced at Libor plus 900bp and preferred equity at 15-18%, we have reviewed the use of a 10% discount rate to value the company’s producing US onshore assets. Based on current cash flow projections, debt will be rapidly paid down and refinancing of senior debt in two to three years’ time should lead to a significantly lower rate. We increase the discount rate used in our base case valuation from 10% to 12.5%, and intend to review this figure as and when financial leverage falls and current facilities are refinanced.

In Exhibit 8, we provide a valuation sensitivity to the long-term Henry Hub gas price and WTI. As can be seen, a combination of financial and operational leverage make our ELK valuation sensitive to oil and gas price assumptions (Henry Hub and WTI minus relevant differentials) despite short-term hedges.

Our valuation is also sensitive to the discount rate used over field life. In our base case we use a static rate of 12.5% over field life. The valuation sensitivity to WACC is shown below.

We discussed generic company risks and risks associated with the Grieve and Madden projects in our last published outlook note. Asset-specific risks relating to Aneth include:

The net result of the Aneth acquisition is a material increase in CFO and also net debt.

We expect cash flow to be used to pay down debt in the short term. Financial leverage may limit the ability to fund further transactions in the short term unless they reduce net debt/EBITDA. However, it is encouraging to see net debt falling rapidly over the next five years based on our forecasts and we would expect ELK to seek to refinance its debt once leverage starts to drop.