SDX Energy — In an enviable position in the sector

At its capital markets day, SDX provided an update on its strong production, reiterating guidance for 2020 at 6,000–6,250boed (which includes North West Gemsa and South Ramadan production) and strong cash generation. The presentation focused on detailing the prospectivity around the South Disouq field in Egypt and the BMK area and the newly identified prospectivity in the Top Nappe play in Morocco.

In Egypt, the company is focusing on six primary prospects amounting to a total prospective recoverable resource of 233bcf. Hanut is the most material prospect, with a management estimated prospective recoverable resource of 139bcf, followed by Mohsen with 26bcf, El Deeb 22bcf, Warda 14bcf, Ibn Newton and Newton (a dual prospect) 16bcf, and the Shikabala cluster with 16bcf.

In Morocco, the successful wells at BMK-1 and OYF-2 drilled in Q120 have extended the existing production and development area to the north of Sebou. Management estimates that these wells de-risked more than 18bcf of recoverable resource in the BMK area. SDX is seeking to accelerate a four-well exploration campaign to H121 that will develop the potential of the area, and confirm the potential of the extension to the core area. There is also potential in the new Top Nappe play below SDX’s core area, and the company will seek to test this play with a dual target well during the next drilling campaign. Future discoveries would allow SDX to expand the infrastructure incrementally so that future connection costs are managed sustainably.

In 2021, SDX will drill one exploration well in South Disouq, on the potentially high-impact Hanut prospect, which management estimates holds 139bcf recoverable volumes. The prospect was identified after the company had reviewed the remaining prospectivity of the area, particularly in the basal Kafr El Sheikh (KES) horizon, which had been de-risked by the Ibn Yunus and Sobhi discoveries.

Hanut sits 4.5km to the south-east of the South Disouq field on the eastern margin of the South Disouq concession. Terms to extend the exploration period by two years for the area covering Hanut and Mohsen are required, given the exploration licence expired in 2020. The terms of the extension have been agreed between SDX and EGAS, but are pending on final ministerial and parliamentary ratification, expected in H121. SDX will operate the well and is in discussions with partner IPR (WI 45%) regarding its participation.

The Hanut prospect is a basal KES formation turbidite sand deposit, defined by a high-amplitude response (shown in bright blue in Exhibit 2) on 3D seismic, which shares the same seismic response characteristics seen in the proven basal KES gas accumulations in Ibn Yunus and SD-12X. Hanut is a stratigraphic prospect, relying on the overlying shales to provide a trap. SDX has assigned a 33% chance of success (CoS), reflecting the fact that the eastern closure is not fully imaged (cf the nearby smaller Mohsen prospect, to be drilled in 2022, which has a 51% CoS and is fully covered by 3D seismic).

In the event of success, a discovery of 139bcf would be a step change for South Disouq, given the existing dry gas 2P reserves for South Disouq and Ibn Yunus is 84bcf (based on end-2019 reserves audit). SDX plans to drill Mohsen and Warda, two further prospects similar to Ibn Yunus and SD-12X, in 2022, targeting P50 prospective recoverable resources of 26bcf and 14bcf respectively.

We value SDX using an asset-by-asset net asset value (NAV) derived from detailed discounted cash flow modelling. The core value includes production, development and contingent resources that could be developed, while exploration is valued only if wells are planned and funded in the next 12 months. We apply a 12.5% discount rate given the geographical distribution of the assets and the size of the company. We have updated our short-term commodity prices based on the latest EIA estimates. Our short-term Brent assumptions move from $41.9/bbl to $40.6/bbl in FY20 and from $49.1/bbl to $46.6.1/bbl in FY21, based on EIA forecasts published in November 2020. Our long-term price assumptions remain in line with our previous note, where we presented three scenarios with Brent in 2020 at $40/bbl in our low case scenario, $50/bbl in our mid-case scenario and $60/bbl in our high case scenario, escalated at 2.5% per year resulting in 2022 prices of $42.0/bbl, $52.5/bbl and $63.0/bbl, respectively. We continue to assume Moroccan gas prices of $10.85/mcf in 2020 inflated at 2.5%. In addition to commodity prices, key changes to our updated valuation and estimates include updated FY21 capex based on the company’s proposed work programme.

In Egypt, our updated valuation includes net proceeds for the disposal of North West Gemsa and South Ramadan as the company successfully disposed of the assets in July 2020 and November 2020, respectively, for a total of $2.1m. The updated valuation includes a second producer well at Ibn Yunus, to be added in Q2/Q321 to maximise recovery from the field. In Morocco, we continue to include the reserves reported at 31 December according to the FY19 annual report as well as the SAH-3 and OYF-2 wells, which were already completed as commercial discoveries during Q120. For 2020, we maintain our estimates in Morocco with a gas production level of 5.95mmscfd for the year, in line with guidance of 5.3–6.0mmscfd. Risked exploration includes the BMK-1 discovery and the potential 18bcf located in close proximity to the BMK-1 well in what the company calls the BMK area, and the LMS-2 discovery. The LMS-2 well indicates 10.6m of net gas reservoir with 30.9% porosity in the well. However, testing is required to determine its commercial potential once COVID-19 restrictions are eased, allowing SDX to bring a testing crew into the country.

We highlight that at this point we are not taking into consideration the 233bcf prospective resources of potential additional upside that is currently being evaluated by the company in the South Disouq area. However, as these projects develop and the exploration licence extension is granted, we will update our valuation accordingly. All in all, our mid-case risked exploration net asset value (RENAV) remains in line with our last note at 45.0p/share, with our core value standing at 36.2p/share, equivalent to 80% of our RENAV, and materially different from the current share price of 18.0p/share. Overall, our core net risked valuation remains broadly in line with our previous note at $94m, reflecting the lower near-term oil price estimates, offset by the net proceeds from South Ramadan disposal.

We forecast year-end 2020 net cash of $16.6m and note that SDX’s European Bank for Reconstruction and Development (EBRD) loan facility of $2.5m remains undrawn. Management intends to extend the tenor and re-establish the full availability of the $10m credit facility, subject to the customary satisfaction of conditions precedent in early 2021. Based on the capex projections that underpin our production forecasts and SDX’s committed exploration programme, the company is fully funded for 2020 and 2021 and we forecast positive free cash flow (FCF) from 2021. We do not yet take into consideration capex for the Hanut and Mohsen wells given these are still contingent on final ministerial and parliamentary approval for the two-year extension to the South Disouq exploration area. We expect FCF in the coming years to be material, giving the company headroom for additional investments. As more than 90% of cash flows in the coming years will come from the fixed-price contracts gas businesses, we do not currently foresee the need for further equity capital, unless incremental growth capex, over and above our forecasts, is dedicated to new projects or acquisitions. Management’s stated strategy is to grow the company both organically and inorganically.

South Disouq and Sebou are cash-generative assets, with low operating costs and fixed gas price contracts. Given SDX’s market cap, and organic and inorganic growth opportunities, we would expect management to direct cash to extend its reserve life index – either through the drill bit or via acquisitions. Hanut, Warda and Mohsen could extend the South Disouq plateau with low investment required, given the central processing facility (CPF) is already in place. In Morocco, SDX is the only operator, other than ONHYM, that produces gas in country and is the main supplier in its area of operations, hence any discoveries around its facilities would also add value at a low investment cost. If no capital is allocated to growth opportunities, operations would cease once South Disouq had completed operations by 2030.

While we expect SDX to continue to recycle much of its FCF to grow both organically and inorganically, over time we see the potential for the company to also distribute some FCF back to shareholders as dividends. The company has not yet established a dividend policy, but based on SDX’s firm exploration and development commitments (shown in Exhibit 4), including Hanut, Warda and Mohsen, we see the potential for the company to pay a dividend of c $10m pa, based on a 40% FCF payout assumption (Exhibit 10). This unrisked FCF projection and associated dividend is the equivalent of a c 20% yield at the current share price and could be payable from 2022/23.

In the event the company does not drill Hanut, Warda and Mohsen (given they are still contingent on final ministerial and parliamentary approvals), the company could still pay a dividend, based on the above assumptions (Exhibit 9). Note that such dividend projections do not include additional exploration and development capex beyond the company’s current plans, however with rapid monetisation of discoveries, there is clear scope for an evolving dividend policy over time.