Hurricane Energy — Hurricane hoping for a storm-less 2018

In recent weeks, Hurricane has released several updates relating to contractual and development progress at the Lancaster EPS. First oil remains on track for H119; however, with several weather-dependent components of work scheduled for the summer of 2018, there is inevitably a risk that supply chain interruptions or extraordinary weather could lead to a delay, despite planned contingencies. Below, we look at EPS progress to date, schedule and cost risk and potential impact on valuation (we cover EPS subsurface and operational risks in our note published on 16 May 2017).

Key milestones delivered to date:

Hurricane has mitigated capex risk through contractual arrangement with over 75% of capex spend committed on a lump sum basis, and the remainder being largely reimbursable. A key component of the fixed price, lump-sum contract with Bluewater is for the Aoka Mizu FPSO vessel upgrade, buoy fabrication and pre-operational work prior to final project acceptance. To date, there have been limited variation orders, giving us some comfort that the lump-sum order is suitably specified.

Some reimbursable contract risk remains ($98m of the total capex budget of $467m) and largely comprises day-rate-linked items, including the completion of the two producers and installation work (diver vessels, support vessels and heavy-lift vessels). Hurricane includes some weather-related contingency in its $467m capex cost estimate – we include an additional 10% capex cost contingency to reflect potential weather-related delays and scope variations in light of recent North Sea execution mishaps.

Hurricane’s EPS project schedule (Exhibit 1) highlights several critical items planned for the 2018 summer weather window (March through to early October 2018). Management remains confident in the development plan, and have built-in weather contingencies such that only extreme weather patterns in summer 2018 would have schedule impact. Nevertheless, we believe an extended period of adverse weather, including seasonally anomalous wave heights during the summer weather window, could potentially lead to a start-up delay. Summer 2018 weather critical items include the items below:

In our base valuation, we include an additional 10% capex cost contingency above Hurricane’s forecast of $467m and assume first oil in Q120, relative to Hurricane guidance of Q219. If management continues to track internal forecasts of time and cost schedule, we expect to release this additional contingency built in to our NAV estimate and forecasts.

Edison’s base case Lancaster EPS standalone valuation (including cash and net of overheads) stands at 64p/share. On release of the additional contingency built in to our forecasts, this has the potential to rise to 69p/share.

Hurricane currently has flaring approvals in place to cover the EPS phase; however, if gas to oil ratio is higher than predicted, or if application for extended flaring consents are not approved beyond management may elect to drill a gas injection well. We conservatively now include gas injection in our base case EPS valuation (in 2022) at a cost of $60m to cover well costs and compression capex.

We expect further details to be released on GLA/GWA resource upside once Hurricane publishes an updated CPR at the end of 2017. Ahead of CPR publication, management is looking at options to appraise the company’s wider asset base in order to reduce resource uncertainty.

Management estimates that a further five appraisal wells could be required in order to define the GLA/GWA resource base; assuming similar costs to the 2016 well programme, we estimate that the total appraisal programme would have an approximate gross cost of US$350m.

Hurricane’s options for funding this appraisal programme include a combination of the below:

In our view, a farm-out is the most likely source of capital and this could be structured in several forms, including multiple farm-outs, a combined appraisal and development farm-down or a farm-out with payments contingent on appraisal/EPS success.

We currently model full field development of Lancaster, making the assumption that Hurricane farms down in exchange for a full cost carry through to first oil in 2026. In this scenario, the modelled farm-down implies a 20% cost of capital (ie the farminee generates an IRR of 20%) with Hurricane releasing 58% equity interest in the asset. Our farm-out calculations assume our base case oil price assumptions, which follow EIA oil price projections for the next two years ($50.8/bbl 2017 and $51.6/bbl 2018 rising to $70/bbl by 2022). The implied cost of capital from the farm-in is broadly in line with historical sector E&P farm-in transactions, which typically range from 15% to 25%.

We also assume similar equity dilution and funding terms for the development of Halifax and Lincoln (including appraisal costs) in our analysis, leaving Hurricane with a reduced working interest across the entire asset base of 42% (from 100%). We have left these underlying assumptions unchanged in our latest valuation; however, we expect to update these once we have more clarity on GLA/GWA resources, development concepts and costs or an agreed farm-out scenario.

Our valuation below is updated to reflect our latest oil price assumptions, which use EIA short-term forecasts (last published $50.8/bbl in 2017 and $51.6/bbl in 2018) trending to $70/bbl Brent by 2022. A lower long-term (2022 onwards) oil price assumption (reduced from $80/bbl long term) has a negative impact on our asset cash flow forecasts, as well as the impact of working interest dilution through farm-out. Under our new commodity price scenario, we estimate that Hurricane would retain just 42% of GLA full field development post farm-down (compared to a previously estimated 49%).

A breakdown of our valuation is shown in the table below. Core valuation (Lancaster EPS plus cash and net of SG&A) stands at 33p/share. This rises to 64p/share when including Lancaster FFD and 79p/share including risked value for GLA and GWA upside.

Our valuation remains highly sensitive to key inputs such as oil price and cost of capital and suggests that the market is valuing the Lancaster EPS phase based on a $65-70/bbl long-term oil price assuming Edison capex/schedule assumptions, excluding any value for further phases of development. In the short term, the focus is likely to remain on EPS project execution prior to further detail on GLA and GWA resource upside in a CPR to publish towards the end of 2017. A catalyst for a re-rating could include a GLA/GWA appraisal or development farm-out.

Short-term cash flow and balance sheet items are driven by investment in the Lancaster EPS prior to first oil, which Edison models in 2020. Hurricane is fully funded for the EPS phase with contingency based on current capex forecasts; however, further funding would be required in order to accelerate the appraisal of GLA in 2018/2019. The total gross cost of a five-well programme could be c $350m and is yet to be funded.