Petro Matad — Four exploration wells planned for 2019

Petro Matad offers investors exposure to an active exploration programme targeting multiple basins and play types onshore Mongolia. A combination of low well costs (just c $2m for a development well), attractive production sharing contract (PSC) terms that enable cost recovery, and a sizeable prospective resource provide for an attractive risk/reward. PetroChina’s current production at c 19kbod from Blocks XIX and XXI helps demonstrate that domestic logistical and infrastructure constraints can be overcome, enabling commercial oil production. Petro Matad’s conceptual development studies suggest significant flexibility in engineering design such that small discoveries can be commercialised – we estimate a minimum economic volume of c 10mmbbl for Blocks IV/V (less than 1mmbbl for Block XX) based on a long-term Brent oil price of $70/bbl (2022). 2018’s exploration programme did not result in a commercial discovery, but Snow Leopard-1 provided some encouragement of a working petroleum system in the Taats Basin.

Our valuation is based on the expected monetary value (EMV) of four prospects: Heron, Gazelle, Red Deer and either a Raptor prospect or Fox in Block V. Applying suitable risking, we reach a risked valuation of 41.3p/share (prior to 50% value dilution through farm-out) at $70/bbl long-term (NPV12.5) on the assumption that the company’s four-well programme ($18m excluding overhead and PSC costs) is funded through our forecast $23m year-end 2018 cash balance. We estimate development project IRRs in the 50–120% range depending on discovery size, which we believe should attract farminee interest considering the exploration running room. Our updated base case valuation of 20.4p/share assumes $70/bbl Brent (2022) and a conservative 50% value dilution through farm-out (see Appendix A for further details). However, we note that if Petro Matad can debt finance development, this would be potentially less dilutive. Equity funding at the current share price would significantly reduce our per share valuation.

Key components of risk include fiscal/country risk given Petro Matad’s single country exposure, geological/subsurface risk inherent in an exploration-led strategy in a frontier basin, and funding risk. Key sensitivities include commodity price realisations and differentials, uncertainty over offtake costs/capital costs and the timing of development.

Petro Matad’s acreage is spread across multiple basins with varying risk profiles, from high-impact frontier exploration with near-term drilling in Block V in the west, to low-cost targets close to existing production in Block XX to the east. The company drilled two frontier wells in Block IV and V in 2018. The Snow Leopard-1 well in Block V provided evidence of a working petroleum system in the Taats Basin, and post-well evaluation has highlighted three new prospects on the southern flank of the basin. The Wild Horse-1 well encountered sands with no oil shows. In Block XX, initial work will focus on targeting the extensions of producing trends and fields from the PetroChina-operated Block XIX, and could provide a low-risk route to early cash flow.

Petro Matad differentiates itself relative to its small-cap E&P peers through its focus on a low-cost, multi-well exploration strategy with material upside/running room in the event of success. Low costs, attractive fiscal terms and the scalability of development can make Block IV/V discoveries as small as 10mmbbl commercial based on a $70/bbl long-term oil price. The break-even (NPV12.5 = zero) oil price for larger developments (>150mmbbl) stands at sub-$40/bbl Brent.

The Petro Matad team is chaired by Enkhmaa Davaanyam, the CEO of Petrovis Group, Mongolia’s largest fuel supplier. Ms Davaanyam provides a wealth of connections in Mongolia and board oversight. Petro Matad’s management team includes CEO Mike Buck and CFO John Henriksen, both of whom worked for oil major Eni and held senior positions at Salamander Energy. Mike Buck has a geological/geophysical background, while John Henriksen is a qualified accountant, and provides experience in financial management and business development.

During 2018, Petro Matad drilled Snow Leopard-1 and Wild Horse-1, the first ever exploration wells in the frontier Blocks IV and V in Western Mongolia. Neither well resulted in a discovery, but the data gathered are now being used to re-evaluate the prospectivity of these blocks. In particular, the results of Snow Leopard-1 will be incorporated with existing seismic data to determine the drilling target and schedule for drilling in Block V in 2019, where the company has highlighted three new structures with sizeable resource potential in the Taats Basin, in addition to the existing Fox prospect in the neighbouring Tugrug Basin.

Snow Leopard-1 is located in the Taats Basin in the west of Block V and was targeting mid-case recoverable resources of 90mmbbl across two separate reservoirs. Reservoir sands were not encountered in the shallow target, but C1 to C5 gases were observed across the interval, together with the presence of an oil sheen in the drilling mud. Petro Matad believes that the gas is indicative of an active petroleum system and that the light oil has migrated from a mature source rock. The deeper target found good sand development, with an interval of over 400m, but the sands here were interpreted as being water bearing. The new data led to the high-grading of three, four-way dip closed structures, the Raptors, with a total prospective resource potential of 400mmbbl, of which 200mmbbl sits in the Velociraptor prospect. A further well is planned in Block V in Q419 and work is ongoing to determine whether to drill one of the Raptor prospects, or to select the 206mmbbl Fox prospect in the Tugrug Basin.

Wild Horse-1 sits in the Baatsagaan Basin in Block IV, about 450km to the west of Snow Leopard-1. The well was drilled in October and November 2018 and was targeting mid-case recoverable prospective resources of 480mmbbl across three stacked targets. The first objective encountered c 250m of porous sands and interbedded claystones. C1 to C4 background gases were observed across this interval, but there were no oil shows. The second target encountered only thin sands, although the presence of carbonaceous material and thin coals could be indicative of the presence of potential source rock material here. The third and deepest objective was not present due to the shallower than prognosed penetration of basement. As the well was the first well tie to the seismic database in the block, the seismic can now be reinterpreted to better understand the basement configuration. Post well evaluation will now commence and will initially focus on determining the ages of the formations drilled, and the reservoir and source rock potential.

Petro Matad is fully funded for its 2019 drilling programme, which will combine one high-risk, high-impact well in Block V with three low-risk, low-cost exploration wells in Block XX in eastern Mongolia and adjacent to the country’s producing oil fields. Work is progressing to identify priority targets for the Block V well and is likely to be one of the Raptor prospects located on the southern flank of the Taats Basin or the Fox prospect in the neighbouring Tugrug Basin. Drilling is planned to commence during Q219 in Block XX followed by the Block V well in Q419. Drilling permits for the northern Block XX prospects and Fox have been secured, while those for the Raptor trend and Red Deer are progressing.

The Velociraptor prospect is one of a trend of three four-way dip closed inversion anticlines that sit 6km to the south of Snow Leopard.

The prospects are located over a thick depocentre and Petro Matad believes that the source intervals seen in Snow Leopard-1 (SL-1) thicken into this depocentre and there are short vertical migration pathways into the Raptor trend. Management expect the prospects to be well located for the presence of thick reservoir units, based on the shallow, good-quality sandstone reservoirs seen in SL-1 and sourced from basin bounding fault scarp. Velociraptor is the largest of the structural closures with potential mean prospective resources 201mmbbl, and can be drilled with a low-cost, shallow well. The total resource potential of the Raptor trend is estimated at c 400mmbbl.

The Fox prospect sits in the Tugrug Basin in the east of Block V and is estimated to hold mean recoverable resources of 206mmbbl (P50 188mmbbl) across interbedded Jurassic and Cretaceous reservoir and shale source rock. The prospect is a tilted fault block (a proven model in the region) and is a three-way dip closure against a fault. The structure is defined on new, high-quality 3D seismic (from 2017) and the prospect is located in the centre of the basin, making it ideally located to receive charge from the Tugrug source kitchen. The well will target a stacked reservoir system consisting of six pay intervals and there is a large offset on the bounding faults, which the company believes will promote sealing (the key geological risk has been identified as trap effectiveness).

The prospect is located 8km south-east of a stratigraphic core hole drilled to 1,600m, which encountered live oil staining in the reservoir section, porous sands (10–30% porosity), good permeability and source rock with total organic content of 2–5%. Tests on extracted oil showed that it was not biodegraded and was lacustrine source derived. In the success case, Petro Matad has identified seven prospects and leads within a 10km radius of Fox that would be partially de-risked by success in the Fox-1 well. We recognise that there will be geological risk interdependency between mapped reservoir sections/targets at Fox, thereby increasing the probability of either a highly successful (multiple discoveries) or low success outcome (no discoveries).

The well is expected to cost c $7–8m and will be drilled to a depth of 4,000m, making it one of the deepest wells to be drilled in Mongolia. Management is currently reviewing Snow Leopard-1 vertical seismic profile (VSP) data to formulate a view on reservoir development at Fox and expects to have taken a view on Block V well location by the middle of 2019. The current exploration phase for the blocks expires in mid-2019, although a further two-year exploration extension is available.

A three-well programme is planned in Block XX in 2019, consisting of two near-field exploration and appraisal targets close to the PetroChina-producing fields in Block XIX, and one play opening well, Red Deer 1, in the south of the block and around 140km from the Block XIX facilities. Located in basins that are either a continuation of proven producing areas or adjacent to proven basins provides the targets with a good chance of success and the possibility of rapid commercialisation if successful.

The first well will be Heron-1, less than1km south of the PetroChina L19/46-3 discovery. Petro Matad has mapped Heron as an extension of the L19/46 structure that spills updip into Block XX and so Heron-1 will be an appraisal well. The well will target mean prospective resources of 16mmbbl. In the case of success, the proximity of existing infrastructure will facilitate quick development. In addition, the company estimates an upside STOOIP in the greater Heron trap of 75mmbbl and plans to follow any success quickly with additional wells. Management estimate a high chance of geological success at c 75%, with key risks being closure up-dip, sand thickness and porosity.

Gazelle-1 will target a lookalike structure to PetroChina’s best producing field, L19-30, 12km to the north-east in Block XIX. Gazelle-1 sits in the west of the block where reservoir quality and well productivity is observed to improve in the producing fields, and is estimated to contain mid-case recoverable resources of 13mmbbl. The Gazelle-1 well will be drilled to a total depth of c 2,100m, at an estimated cost of c $2.5–3m. Due to the proximity to existing discoveries, Petro Matad estimates a high chance of geological success.

Red Deer-1 is located 100km from Block XIX in the south-west area of the licence and will be a basin opening well in Asgat Sag. The well is targeting a three-way dip fault bounded closure in the basin centre, which is analogous to proven Cretaceous structures in the Tamsag Basin in Block XIX and is predicted to encounter stacked pay potential. Outcrop and shallow borehole data confirm the presence of oil-prone source rocks in the area. Management estimates the prospect to contain mean-case prospective resources of 48mmbbls and expects it to be drilled at a cost of c $3m. In the event of success, the well is located around 1km from the existing east-to-west trucking route. The exploration licence for Block XX has been extended and expires in July 2020. Success here would open up further potential in the same and surrounding basins. We view Red Deer as slightly higher risk than Heron and Gazelle as it is located over 100km from known oil.

Our valuation of Petro Matad is on the basis of risked value for the company’s drill-ready and committed prospects in Block V, and Block XX (Gazelle, Heron and Red Deer). Details of these prospects are provided above. We calculate economics per unit volume ($/boe) using modelled company development plans for Block V and Block XX. Our Block V unit values are shown below and are driven by discovery size (more details are available in our initiation report).

For Block XX, we believe that economics will to some extent be driven by opex sharing or tariff agreements with PetroChina for the processing, storage and onward transport of crude. In our base case, we now assume Petro Matad generates a 50% IRR at $70/bbl, which implies a relatively high absolute tariff, as can be seen in Exhibit 12. This could prove to be conservative, but the cost recovery of tariff suggests that Petro Matad can absorb relatively high operational/tariff costs while continuing to generate a high IRR. Exhibit 13 shows the IRR sensitivities to different tariffs in Block XX economics, ranging from $5/bbl to $22/bbl.

As with many E&Ps, the unfunded risked value for prospects can be significant, and this is also the case for Petro Matad. In our base case valuation, shown in Exhibit 14 below, we typically include elements of dilution, of which investors need to be cognisant when investing in the small-cap E&P sector: 1) while we do not currently include equity dilution through a future fund-raise, this has potential to be significantly dilutive to our per-share NAV valuation; and 2) asset-level working interest dilution through the farm-out of discoveries made during the exploration phase. We include the $23m estimated year-end 2018 cash balance to fund the company’s 2019 exploration campaign, contingency and SG&A. We also assume at this stage that Petro Matad retains 50% of asset value post farm-out (please see Appendix A for further details on our farm-out framework).

Our valuation is sensitive to several key assumptions such as oil price, WACC, farm-out dilution and development costs. The valuation waterfall below, Exhibit 15, provides a breakdown of our risked valuation prior to farm-down at 41.3p/share, followed by what this could look like post farm-down at a range of oil prices, Exhibit 16. Our updated base case valuation of 20.4p/share (-34%) is on the basis of a $70/bbl Brent long-term oil price and 50% asset-level value dilution. The main reason for the decrease in our valuation is the result of the 2018 drilling campaign, which was targeting a high resource base with Snow Leopard and Wild Horse, but did not result in a commercial discovery. We note that the market is currently assuming a lower oil price assumption and/or a higher risking/asset-level dilution than our base case valuation.

We note that Petro Matad benefits from high IRR development projects based on our long-term oil price assumption of $70/bbl Brent (2022) and as such our base case assumption of 50% value dilution through farm-out is conservative. Actual farm-out terms will depend on several factors, including farminee risk appetite, planning assumptions and internal analysis of development returns. Alternatively, if Petro Matad was to fund development through equity, a fund-raise at the current share price would be significantly dilutive to our per-share valuation.

Below we provide a RENAV valuation sensitivity to our long-term Brent oil price assumption and value dilution through farm-out.

We see the risks below as representative of all of the independent E&Ps focused on exploration and appraisal.

Enkhmaa Davaanyam (non-executive chairperson): Ms Davaanyam is the CEO of Petrovis Group, Mongolia’s largest fuel supplier. She has over 19 years’ international experience in financing and risk management of mining, infrastructure and energy projects and commodities trading. She has served as deputy chair of the board of directors of Petrovis Group since 2011 and was appointed as the CEO in August 2013. Prior to joining Petrovis Group, Ms Davaanyam worked as a managing director at Macquarie Group for over 10 years, responsible for risk management in the energy sector in the US. She was appointed as Petro Matad’s chairperson in 2015.

Michael Buck (CEO): Mike Buck is an explorer by background and spent the first 20 years of his career with UK independent E&P company, LASMO, rising from graduate geophysicist to exploration manager and to managing director of overseas business units. Following the acquisition of LASMO by Eni he was appointed managing director of Eni's Pakistan geographic unit and thereafter of the Iran geographic unit. Mr Buck has been directly involved in the discovery of over 1bnboe of recoverable reserves, including Indonesia – Kurau, Selatan, W. Kerendan, MDBD; Colombia – Juncal, El Palmar, Los Trompillos, Guepaje, Venganza, Purificacion; and Libya – Elephant.

Mr Buck joined Salamander Energy in August 2006, was appointed to the board as an executive director in October 2006 and was Salamander's chief operating officer until March 2015 when Salamander was acquired by Ophir Energy. He was retained by Ophir until end 2015 to help with the integration of the two businesses. He subsequently worked as a consultant to numerous operating E&P companies in Asia before joining Petro Matad in October 2017.

John Henriksen (CFO): Mr Henriksen has 35 years’ experience in the international oil industry and in April 2012 assumed the role of CFO for the Petro Matad group, based in Ulaanbaatar. Prior to this, he was the country manager for Salamander Energy’s Indonesian operations. Before Salamander, Mr Henriksen worked in senior financial roles for VICO, Eni, LASMO and Hudson’s Bay Oil and Gas, ultimately being responsible for all aspects of financial management, reporting and internal control. A substantial portion of Mr Henriksen’s career has been spent overseas in developing countries, and as a result he has a full understanding of cultural sensitivities and working with local governments and partners. He is a qualified accountant and holds a Bachelor of Commerce degree from the University of Alberta in Canada.

Tim Bushell (technical non-executive director): Tim Bushell is a geologist by training with over 35 years’ experience in the international upstream oil and gas industry. For 10 years he was CEO of Falkland Oil and Gas. During his career he has been directly involved in the discovery of over 700mmboe of recoverable reserves. These include Falklands – Zebedee, Elaine/Isobel; and Norway – Hyme, Snilehorn, Brasse and others. Mr Bushell joined the board of Petro Matad in April 2017. He is also on the boards of Rockhopper, Genel and Wentworth Resources, and is a founder and advisor to Point Resources, a private equity-backed, Norway-focused E&P company.

Shinezaya Batbold (non-executive director): Ms Shinezaya is the CEO of Petrovis Venture Capital LLC, one of the first local venture capital funds investing in multiple SME sectors in Mongolia. She was a VP of Petrovis from 2010 to 2012, and currently holds a number of board and chair positions in diversified business sectors in Mongolia, including as board member of Petrovis and chairperson of UNIGAS, a gas distribution company in Ulaanbaatar. She is a graduate of Northeastern University, Boston, MA.

Petro Matad is an early-stage E&P, hence current earnings and short-term P&L projections have little relevance. The company’s income statement as it stands simply reflects the ongoing cost of running the company’s Mongolian operations and corporate functions. The positive cash flow impact of an oil development is unlikely to be a material driver of earnings and cash flow until 2021 at the earliest, in our view.

There is potential for earlier cash flows if Petro Matad can unitise oil fields that straddle Block XX and Block XIX with PetroChina, or if the company pursues an early production system based on discoveries made in Block IV/V. We intend to update our forecasts if and when there is more visibility on short-term production and cash flow.

Key elements of short-term cash flow include: