Elk Petroleum — Update 4 May 2016

ELK is targeting a niche area in oil production that targets the tertiary recovery of oil. The technology facilitates the acquisition of mature or life-expired oil fields, for which there are few alternative buyers. As these oil fields have already been defined, development can be very systematic, without the need for extensive further exploration.

ELK expects to commence production from the Grieve CO2 EOR project, where it is in a JV with DNR, in late 2017. ELK is in the final stages of raising debt finance to fund completion of the project. An equity raising is expected to follow. ELK also recently acquired assets in the DJ Basin in Nebraska, for a second CO2 EOR project. ELK has also identified a number of mature oil fields in the vicinity of Grieve that can likely be developed as satellite developments and benefit from the substantial infrastructure, power, water, CO2 supply already developed as part of the Grieve project.

We have carried out NPV10 valuations (Exhibit 10) for ELK’s share of Grieve for three different development scenarios that relate to different recovery efficiencies, oil recovery and production profiles. We have applied a book value for the early-stage DJ assets. Our valuation takes into account an assumed US$15-20m equity raising over a range of share prices and issued shares.

Under our base case, Case 1, we value ELK in a range of A$0.13-0.21/share. In Case 2, where a higher recovery efficiency is assumed, the range is A$0.18-0.29/share. For Case 3, where a greater quantity of CO2 is injected, the valuation range is A$0.20-0.33/share.

The Grieve CO2 EOR project is 75% complete. ELK is advanced in negotiations for a US$55m debt package to fund project completion as part of a fixed-price turnkey commitment from its JV partner DNR. An associated equity raising is assumed. DNR has developed c 25 CO2 EOR projects in the US, c 20% of the US total. Average DNR CY 2015 output was 41,602 BOPD with >164mmbbl oil reserves developed. DNR is operator of the Grieve project, which, in our opinion, is very bankable.

Grieve cash flow is expected to be very strong due to favourable CO2 supply arrangements with DNR and low sustaining capital requirements. Using Edison’s oil price forecasts, we estimate ELK’s Grieve-related debt could be repaid in less than four years from the start of production.

ELK earnings, cash flow and metrics related to the number of issued shares are sensitive to:

ELK is the only ASX-listed enhanced oil recovery (EOR) company. It is currently developing CO2 EOR projects in the US. Once the cash flow-generating platform of its US activities is established, ELK may seek global opportunities to apply its expertise in EOR technology.

ELK is focused on EOR techniques using CO2 injection to achieve tertiary recovery of oil from existing projects where primary and secondary recovery has already been achieved. EOR techniques can lift oil recovery by 10-20% of a field’s original oil in place (OOIP). The technique requires the ready availability of CO2, as an oil industry by-product or from industrial sources.

EOR projects are developed on an existing conventional oil extraction footprint. Additional exploration is small, with most of the oil development already well defined. In the most suitable CO2 project candidates, many of the existing historical production wells can be used either as oil production wells or converted into CO2 injection wells at relatively low capital costs. While upfront capital is required for an EOR project, operating costs can be low and sustaining capital minimal.

The process is readily scalable and repeatable. Projects are redevelopments of existing projects rather than projects that are dependent on lengthy exploration. While ELK’s existing activities are in the US, the technology can be applied to areas outside the US where applications of this technology are limited. These areas include Australia, Indonesia and Malaysia.

ELK believes there is a strong market opportunity for pursuing growth in EOR globally. Its interest in Grieve provides a platform for cost-effectively acquiring mature projects, suitable for EOR, which may be marginal in the current low oil price environment. With minimal exploration required and potential low acquisition costs, these projects have resources that are ready to be developed.

In 2014, ELK acquired the Singleton oil field in Nebraska and followed through in 2015 with the acquisition, from Devon Energy, of properties located immediately adjacent and contiguous to the Singleton oil field. They are located in the north-east part of the prolific DJ Basin. These will be developed as an EOR project in line with the strategy to grow the EOR business.

ELK has been focused on EOR for 10 years, with a track record of CO2 EOR field screening, selection and development, plus experience of water, chemical and thermal flood techniques.

At Grieve, ELK is in a JV with DNR, which is a recognised leader in CO2 EOR field redevelopment and operations. ELK is working closely with DNR at Grieve.

The MD and CEO of ELK, Brad Lingo, is a former MD and CEO of Drillsearch Energy (DLS), where he oversaw an eightfold increase in the share price, a 15-fold increase in market capitalisation, production from 12 new fields and 29 new conventional discoveries. He is also a former CEO of Sunshine Gas and has also worked for Tenneco Energy and El Paso Corporation.

The COO, David Evans, has 29 years of global oil and gas experience, including EOR projects. The CFO, Alexander Hunter, has particular expertise in mergers and acquisitions and capital raisings. He has over 10 years’ experience in the resources sector.

The president of Elk Petroleum USA, Scott Hornafius, has spent 16 years in various technical and management roles with Mobil in the US, Papua New Guinea and the UK. He founded MegaEnergy in 2000 and developed a 100,000-acre position over the Marcellus shale gas play in Appalachian Basin, where asset divestments and farm-out agreements realised US$100m.

EOR is a tertiary recovery method to target the substantial residual oil remaining in the reservoir after the primary and secondary recovery phases of the field.

EOR can achieve incremental recoveries of between 10% and 20% of OOIP depending on the characteristics of each individual reservoir (Exhibit 1). EOR currently accounts for c 3% of global crude oil production and is dominated by production from the US. This is expected to grow to around 9% by 2030.

By way of comparison, the primary and secondary phases of oil extraction recover only 20-40% of OOIP. This compares with 80-90% recoveries in gas reservoirs.

During the various phases of oil recovery, there are several mechanisms:

There are three distinct EOR methods used in the industry:

CO2 EOR is a proven technology that has been used for more than 40 years in the US, and now accounts for almost 60% of EOR production there. The technique was originally developed in the Permian Basin in Texas and into New Mexico, where activity grew rapidly in the 1970s and1980s due to the presence of suitable reservoirs and a readily available supply of CO2.

There are more than 120 successful CO2 EOR projects in the US, across multiple basins. They account for approximately 6% of US oil production. In statistics published by the Oil and Gas Journal (April 7, 2014), only 7 CO2 EOR projects in the US (approximately 5% of projects) have had disappointing results. We understand these were all in West Texas and hosted in fractured carbonate reservoirs, which allowed the CO2 to escape. All the CO2 EOR projects in Wyoming, which are hosted in sandstone, have been successful.

During a CO2 flood, CO2 is injected into the reservoir where, under the correct conditions, it will mix with the residual oil to become a single phase, ie, it becomes miscible. This allows the CO2 to displace the oil from the rock. As the CO2 dissolves in the oil, it swells the oil and reduces its viscosity. This improves the efficiency of the displacement process. The oil forms an oil bank, which is then swept towards the producing wells. Once recovered at surface, the produced fluids are separated, with the CO2 separated from the produced gas stream, recompressed and reinjected.

For maximum process effectiveness, it is important that the reservoir pressure is maintained above the minimum pressure at which the CO2 will remain miscible with the oil. This pressure is known as the minimum miscibility pressure (MMP). For this reason, reservoirs selected for CO2 EOR tend to be deeper than 900m, as the temperature and pressure at depth foster CO2 miscibility.

Grieve, ELK’s main project, is being developed with EOR technology using CO2 flood injection. The project is located 80km west of Casper, Wyoming in the US and within the Rocky Mountains (Exhibit 3). This area has a proven EOR production fairway with ready access to a CO2 supply. It is seen as a key growth area for the technology.

The ownership of the Grieve CO2 EOR Project JV was restructured in December 2015. ELK and its JV partner DNR entered into a non-binding letter of intent (LOI) (deadline extended to 31 May, 2016) outlining the basis for project completion, including funding and revised beneficial interests in oil reserves, resources and cash flows. Under the restructuring, certain prior claims including legal claims and prior JV funding provisions have been released through ELK funding the completion of the project. After formal agreements relating to the project restructuring have been signed, debt relating to ELK’s share of JV costs incurred (A$20.9m at 31 December 2015), will be eliminated. Subject to the execution of definitive agreements between ELK and DNR, indicative terms are:

ELK has received preliminary binding offers and expressions of interest from various sources, principally forms of senior and mezzanine debt, for more than U$50m to fund the completion of the Grieve project. ELK also anticipates raising additional equity.

The reservoir pressure had been depleted to under 600psi by historical production. Work has continued on the redevelopment of the field, with the necessity to repressurise the reservoir with CO2 injection supplemented by water injection. By April 2016, field pressure through CO2 and water injection reached the MMP of 2,256 PSI with field pressure reaching over 2,480 PSI.

Approximately 70% of capital expenditure has already been spent. Work completed includes:

Outstanding items, at a completion cost of US$55m, are:

CO2 is frequently sourced from existing natural fields with high CO2 contents (as for Grieve) or from man-made sources such as natural gas processing, ammonia, ethanol, fertiliser and power plants. In 2012, 62mt of CO2 was supplied to US operations with 15% from industrial sources.

The market price of CO2 is linked to the oil price at 1.3-2.5% of the WTI price. Hence, the CO2 component of costs would vary from US$2/bbl to US$11/bbl, depending on the CO2 flood efficiency.

Individual supply deals can be negotiated. DNR is supplying CO2 to Grieve at no cost to ELK during the pre-production ‘capital’ phase and at a reduced cost for the remaining life of the project.

Oil production using CO2 EOR stores more CO2 than is produced. For the Grieve project, approximately 59bcf CO2 is required for first production. Thereafter, the CO2 is recycled but some top-up is required. Once tertiary oil recovery is complete, the CO2 remains underground. Currently, CO2 EOR is believed to be the only profitable carbon capture and storage process that does not require a subsidy. If the carbon cost is priced, the economics of CO2 EOR are enhanced.

There is an existing c 55km oil pipeline from the Grieve project to Casper. This is 100% owned and operated by ELK. Use of the pipeline is currently suspended. Remedial works costing around US$2.5m are required, which includes the reconnection of the pipeline to the local oil haulage network. Commissioning works are scheduled for the first half of CY17.

The pipeline will enable Grieve production to be directly shipped to the Casper refinery. ELK is involved with ongoing discussions with prospective third parties, both other shippers and potential pipeline purchasers, with a view to generating haulage revenue from other oil producers (which may be currently trucking) or the sale of the pipeline.

The restructuring of the Grieve JV increased ELK’s share of the project’s 2P oil reserves by 51% and its share of 3P reserves and resources by 49%. The reserves shown in Exhibit 4 are after accounting for federal and state royalties.

In addition to production from existing reserves and resources, there is potential for the acquisition of satellite resources within a working radius (approximately 15-20km) of the Grieve processing facilities. These may be current or former resources where only primary production has taken place.

ELK believes the Grieve reservoir has suitable properties for EOR. It exhibits homogeneous qualities and has good permeability of 220md, which is expected to allow for good sweep efficiency. In addition the oil in Grieve is a light 37° API, which is beneficial as CO2 will dissolve more readily in oil that contains a significant proportion of lighter hydrocarbons. The MMP at Grieve is estimated to be 2,256psi. In early April 2016, ELK reported that MMP had been achieved.

CO2 injection commenced in March 2013 and approximately 30bcf CO2 has been injected to date at a rate of 50-60mmcfd. CO2 injection was supplemented by water injection to reach the MMP. ELK has been monitoring the subsequent pressure increase in the reservoir with pressure surveys. Repressurisation of the field is ahead of schedule. It should reach the 3000-3,100psi required for the reservoir to flow in 2017, with first oil scheduled for September 2017 (Exhibit 5).

ELK has developed a multi-layer dynamic reservoir simulation model that identifies oil location and how gas, water and oil contacts have changed over time. There have been around 30 simulations of reservoir behaviour to optimise the sweep of oil relative to costs to maximise the project NPV.

Compared to a model of primary production, an EOR model has access to a much more detailed database about the field with regard to the performance of individual reservoirs, and allows optimisation of the location of injector and producer wells. The pattern and spacing of the injector and producer wells can influence the efficiency of a flood.

The configurations of existing and new wells at Grieve and their function are shown in Exhibit 6.

All the wells in the field have been worked over and tied back to the central manifold. Each well can be operated remotely from the production control room. The operator has the flexibility to change from CO2 or a water injection well to a production well or vice versa. If a well configuration is not fully sweeping, adjacent wells can be rapidly converted to injectors. The objective is to obtain the desired flow rate and maintain efficiency of CO2 use. The well control system can be very dynamic.

The production control system also has the capability to respond to changes in oil prices by adjusting the production strategy.

The CO2 is supplied from a dedicated CO2 pipeline supply pipeline network that traverses the State of Wyoming. The CO2 from this pipeline is in a very clean form containing very little impurities or water. As CO2 is recycled through the Grieve oil field, the CO2 is continually recycled and reconditioned to maintain this low level of impurity. This ensures that the CO2 maintains its effective sweeping characteristics and minimises the scope for corrosion of equipment.

At Grieve, a 15-degree regional dip to the north-east created the oil trapping structure over a small geographical area. When CO2 is injected into this structure, it creates a very efficient injection front within the reservoir. This is more efficient than in a gentle sloping structure where the energy of the CO2 is widely distributed.

EOR projects generally have relatively high upfront capital costs, low sustaining capital and moderate operating costs. For ELK specifically, it has a major capital cost advantage because of its preferential CO2 supply arrangements and the fact that most of the processing plant has already been built. Its capital cost is restricted to the US$55m turnkey contract for completing the plant.

EOR ‘tertiary recovery’ projects have quite different characteristics from conventional ‘primary and secondary recovery’ projects. They have some of the characteristics of a manufacturing process and can be attractive in a low oil price environment.

ELK aims to develop its second EOR hub in the DJ Basin, Banner County, Nebraska. The DJ Basin has over 1,000 oil fields in Colorado and Nebraska, with more than 52,000 wells drilled. Most fields are nearing the end of secondary recovery efforts. In the absence of EOR, these fields will be abandoned. ELK’s Singleton and Devon properties are located in the north-east area of the basin.

In 2014, ELK acquired the Singleton Oil Field in Banner County, Nebraska, with the intention of developing a CO2 EOR project.

In late 2015, ELK acquired a 100% working interest in oil properties immediately adjacent and contiguous to the Singleton oil field from Devon Energy (DVN:NYSE). The acquisition included all of DVN’s oil and gas leasehold interests in Banner County, covering 9,738 gross acres (5,987 net acres). It also included two exploration wells, both of which have completed as oil producers – one vertical well, Opis 1P and one horizontal well, Opis 1H.

The acquisition also included all of the oil production, processing facilities, storage and oil truck load-out equipment. ELK’s acquisition cost was US$100,000. ELK estimates the total investment in the acquired properties is well in excess of US$5m. It believes the newly installed production facilities at the Opis 1H production well are well situated to support the Singleton EOR project.

The Singleton and DVN acquisitions offer substantial synergies for the development of the overall Singleton oil field and associated CO2 EOR project. Total combined reserves and resources are tabulated in Exhibit 7.

Both the Opis wells provide near-term production opportunities. A possible development scenario is as follows:

BCC Research (August 2013) projected the global EOR market to grow at an 8.8% CAGR.

ELK has observed that there are regions outside the US that are virtually untapped for EOR. These regions include Australia, Indonesia and Malaysia. In the current low oil price environment, ELK believes these regions may provide opportunities for EOR projects.

ELK has highlighted Indonesia as a country of EOR interest. In Australia, ELK has pointed to the Northern Cooper Basin as a potential EOR scheme target, with existing gas processing facilities in the region.

Our base valuation case (Case 1) is derived from ELK’s share of the development and recovery of oil from Grieve 2P reserves (12.2mmbl).

We have also valued two alternative scenarios for oil recovery from Grieve 3P probable and possible reserves (16.3mmbl) (Case 2) and Grieve 3C contingent resources (16.2mmbl) (Case 3).

Oil recovery scenarios and CO2 purchased for injection are tabulated in Exhibit 8.

A key factor that influences each valuation is the recovery efficiency. This determines the quantity of oil recovered, the volume of CO2 that needs to be purchased and injected to achieve that recovery, and the oil production profile. Recovery efficiency is defined as the CO2 required, in mcf, to recover one barrel of oil.

Grieve is expected to have a recovery efficiency of 7-9mcf/bbl. By way of comparison, a recovery efficiency of around 5mcf/bbl is considered to be very efficient. In contrast, a recovery efficiency of 15mcf/bbl is considered to be inefficient. Midrange is 10mcf/bbl.

When scheduling oil production in an EOR system, one of the objectives is to manage production so as to maximise the NPV. This can involve managing CO2 purchases and injection depending on the recovery efficiency being achieved, overall costs and oil prices. Some flexibility is possible.

The physical characteristics of the reservoir may be different from those assumed or may exhibit some variability. CO2 purchase requirements could vary from those assumed in Exhibit 8.

We model the cash flows from the Grieve project for each case to derive an NPV10 valuation. Wyoming oil prices generally trade at a 7% discount to WTI. We use Edison’s forecasts for WTI oil prices and then apply this discount for our earnings and cash flow forecasts and valuations.

Our valuations (Exhibit 10) assume zero net debt following the signing of formal agreements related to project restructuring and the notional impact of a possible future equity raising (we assume US$20m) to supplement subsequent debt financing for the project. For the purpose of our valuations, we factor in a range of possible share issue prices to determine potential increases in the number of issued shares. These valuations are sensitive to recovery efficiencies, which may vary, up or down.

ELK’s objective is to negotiate US$55m debt funding to complete the Grieve project. In the event of a lower or higher level of debt funding, we have carried out a sensitivity analysis (Exhibit 11) for various combinations of debt and equity for Case 1 at a notional share price of A$0.075.

ELK may also elect to raise higher levels of equity. Our sensitivity analysis is extended to include a range of possible equity raisings at the same notional share price of A$0.075.

Our earnings forecasts and cash flow and balance sheet projections are tabulated in Exhibit 12.

ELK does not have a current source of operating earnings. The Grieve CO2 EOR project is planned to start production in late 2017. The project is a JV between ELK and DNR. ELK will also derive oil haulage tariffs from the Grieve-Casper oil pipeline, which it owns. ELK is also focused on a second CO2 EOR project (which includes the Singleton project) in the DJ Basin, Nebraska.

ELK will not have a regular cash flow stream until the Grieve project commences production. Recent funds have been raised in equity issues.

On 11 January 2016, ELK issued 39.999m shares at A$0.063/share, raising a total of A$2.5m. This is being mainly applied to continued exploration and feasibility study expenditure for the company’s assets and general working capital.

On 1 April 2016, ELK completed a A$1m placement of 13.3m shares at A$0.075/share. Funds are being mainly applied to fund initial capital expenditures associated with the Grieve project JV restructuring. The intention is to maintain the Grieve project development schedule on the basis of imminent completion of definitive agreements for the JV restructure and the securing of financing.

ELK’s JV partner at Grieve, DNR, has worked to maintain a sound financial position despite lower oil prices. We believe DNR will be able its fund its share of costs to develop and operate Grieve. Cash flow from its operations was positive during CY15, including Q415, with DNR accomplishing a small reduction in debt. Most of its debt comprises senior subordinated notes with no near-term maturities. DNR achieved significant year-on-year capital and operating expenditure cuts in CY15. Its focus continues to be on reducing costs, increasing efficiencies and maximising cash flow.

At 31 December 2015, ELK had a cash balance of A$0.2m and total debt of A$24.8m. This included A$20.9m debt related to Elk Petroleum’s share of JV costs incurred at the Grieve project, which will be eliminated on the signing of formal agreements relating to the project restructuring. Since this balance date, funds have been replenished by equity raisings as above.

On 18 April 2016, all lenders under the A$3.6m Convertible Loan Facility converted the full principal balance and accrued interest into ordinary shares. The total outstanding balance of A$4.07m was converted to 107,145,743 new shares resulting in a total of 384,149,643 shares outstanding. We estimate ELK will have no debt once the agreement is signed and before drawdown of the anticipated debt financing (see below) to complete the project.

ELK has entered into letters of intent to provide funding of US$55m for capital expenditure to complete the Grieve project, as part of the project restructuring and an increase in ELK’s economic interest. ELK is in advanced negotiations with potential debt providers. We envisage funds will be drawn down as required to complete the project under the fixed price turnkey commitment.

In addition to US$55m of debt funding, we assume ELK will raise additional equity of US$15-20m for general and working capital purposes at Grieve and for the company’s other projects, particularly Singleton. In line with our valuations, we have assumed a notional capital raising of US$20m, equivalent to A$26.7m at US$0.75/A$. We assume this raising takes place in FY17.

For the purpose of our earnings model, we have similarly assumed the shares are issued at A$0.075/share, the same price as ELK’s last issue on 1 April 2016. In the financial summary (Exhibit 12), issued shares are calculated from the notional A$26.7m capital raising.

These assumptions are subject to variation. The achievement of further milestones such as the completion of debt financing could lead to a higher share price, reducing the number of shares issued. Alternatively, the company could choose to have a larger equity raising. We have provided a reasonable scenario to accompany our earnings forecasts. A range of outcomes is possible.