Rockhopper Exploration — Market heavily discounting Sea Lion

At the current share price, it appears the market has substantially discounted Sea Lion despite operator Premier Oil’s apparent commitment to the project. Below we outline what we feel are the key risks and uncertainties in relation to the development of Sea Lion, and we take a view on what the market is implying in terms of oil price expectations and chances of the project progressing.

Premier has signed LOIs with the Sea Lion FPSO provider, drilling contractor, subsea equipment provider, well services, subsea installation contractor and for helicopter services alongside building a development team of more than 60 people. In our view, Premier is committed to progressing Sea Lion through to first oil; delivery of FPSO development, Catcher, on time and 30% below budget will provide Premier’s management with comfort in its execution capabilities.

Premier’s unlevered returns on Sea Lion Phase 1 will be to a large extent driven by oil the price, assuming cost to first oil can be maintained at $1.5bn gross. Below we provide our calculation of Premier’s point-forward returns at various long-term oil price expectations. We note that the project delivers unlevered IRRs over 20% to Premier at oil prices above $60/bbl in the long term (levered IRRs will depend on the cost of debt but are likely to be materially higher). In our view, our modelled levered returns should enable Premier Oil to justify investment at current spot oil prices.

A key investment consideration has been Premier Oil’s ability to fund the development of Sea Lion given its existing net debt and associated debt covenants. Funding for the project is expected to be split into vendor financing (c $375m), export credit/bank finance (c $750m) and upstream partner equity (c $375m). With Premier estimating end-FY18 net debt at $2.3bn and a year-end leverage ratio of 3x net/EBITDA, it remains well within its 5x covenant. Premier has committed to further reductions in covenant ratio (targeting net debt/EBITDA at 2.7x by end Q119) and this can be achieved by several means including a covenant-accretive transaction (Premier has said it continues to look at North Sea assets – we expect producing asset packages that can accelerate the monetisation of Premier’s tax loss position) or, alternatively, a sizeable asset divestment.

In our view, Premier’s 25% equity interest in Mexico Block 7, containing the Zama discovery, makes an attractive divestment opportunity post appraisal. We see equity in Zama as a liquid asset, demonstrated by the recent sale of Sierra Oil and Gas’s stake in the discovery.

DEA recently acquired Sierra Oil and Gas for c $500m (according to press reports). DEA has a 40% interest in the Zama discovery, which contains a Premier estimated 400–800mmbbls (P90-P10) recoverable. Although it is unclear exactly how much of the deal value is for Sierra’s net stake in Zama and/or cash held in the company, it does suggest there is sufficient industry interest in the discovery to enable Premier to transact.

On the other hand, we see Sea Lion as a less-liquid asset for Premier, largely due to jurisdiction. Nevertheless, risked returns for operator Premier Oil remain compelling at current oil prices. We estimate that Premier will generate a point-forward, unlevered 23% IRR based on its 60% working interest, based on a $70/bbl long-term oil price and after Rockhopper’s (RKH) cost-carry for Phase 1. This return is highly geared to underlying oil price assumptions, as can be seen in Exhibit 1. Rockhopper is funded for Phase 1 development of Sea Lion through existing cost-carry arrangements with Premier Oil.

We see some risk and uncertainty around the availability and timing of export credit/debt financing given the political backdrop. This is a key component of our project risking.

Sub-surface technical risks that can derail Sea Lion Phase 1 have been largely mitigated through an extensive appraisal programme. Operational risks remain, as with any development project, but existential risks are within the normal bounds expected for an offshore project of this nature.

The Falkland Islands government (FIG) is fully behind the development of Sea Lion and has shown its support in providing the required exploration, appraisal and development consent. We see the risk of FIG objecting to the project as minimal. The project FDP is substantially agreed and a final update is expected on project sanction. The Environmental Impact Statement (EIS) public consultation process has been completed.

Geopolitical risks are hard to dismiss completely, especially with varying views on the sovereignty of the Falklands among senior political figures on both sides of the Atlantic. Relationships have improved in recent months with the introduction of a second flight a week from South America (Sao Paulo via Cordoba in Argentina to Mount Pleasant in the Falklands) to the Falklands.

Assuming Sea Lion is sanctioned and reaches final investment decision (FID) in H219, it is possible for first oil to be achieved in 2023 (assuming a 3.5-year project timeline). We add an additional element of conservatism in our base, assuming first oil in mid-2024. Slippage beyond this would likely be driven by funding/political delays rather than project execution.

We assume a $70/bbl long-term oil price in our base case and provide valuation sensitivities to commodity price. The oil price is a key driver of net project economics. Premier estimates total life of field opex and capex per barrel at $35/bbl and the full-cycle project break-even oil price varies between Premier and Rockhopper due to existing cost-carry arrangements. Gearing to the oil price is similar to that expected for North Sea FPSO developments.

LOIs with key service companies provide a basis for capex cost estimates of $1.5bn gross before first oil. Higher oil prices and an inflationary environment could lead to cost creep. At our base case $70/bbl long-term oil price and with spot prices remaining below this level, we do not expect a significant change to Premier’s current cost estimate.

Reservoir-related uncertainty is relatively constrained given that Sea Lion has been extensively appraised. We do not see this as outside the normal range for a project moving into development.

Other key uncertainties are within the normal range we would expect for a project of this nature.

Egypt and Italy are relatively small components in our overall Rockhopper valuation, at 3% and 4% respectively. Recent operational updates highlight a couple of recent positive developments in relation to both.

Rockhopper commenced international arbitration proceedings against the Republic of Italy in relation to the Ombrina Mare field it acquired from Mediterranean Oil & Gas in 2017. Rockhopper believes it has strong prospects of recovering ‘significant monetary damages’ based on lost profits as a result of the Republic of Italy’s breaches of the Energy Charter Treaty. We estimate this will be recoverable at c $16m on a risked basis in our valuation but press reports suggest it could be materially higher with the claim running up to several hundreds of millions of euros. The hearing is scheduled for early February 2019.

Average production rates for Abu Sennan in FY18 were 840boed net and Rockhopper expects to sustain current production levels in FY19, on inclusion of recent success at Al Jahraa-10. We forecast 840boed in FY19, a 6% increase on previous forecasts, and a slightly higher liquids yield than in FY18 (on inclusion of production from Abu Roash-C, which flowed at 130bopd gross). Rockhopper has joint venture approval for an active 2019 drilling programme which includes one exploration well, two development wells and a water injector. Drilling is expected to commence in Q119. Rockhopper’s Egyptian receivables position has reduced materially over the course of FY18, from $7.5m at the end FY17 to $1.5m at end FY18.

Our base case valuation increases by 11.7% from 73.6p/share to 82.2p/share (+5.0% in dollar terms). Sterling foreign exchange rates remain volatile ahead of Brexit (our FX assumption moves from £/$0.75 to 0.77 based on recent sterling weakness). Other key moving parts in our valuation are described below.

Oil pricing: we move our short-term oil price deck from $70.6/bbl to $60.5/bbl for FY19, which affects Egyptian oil realisations, but our long-term oil price expectation of $70/bbl Brent in 2022 remains unchanged. We upgrade our Abu Sennan production profile, increasing our FY19 production expectation by 6% with a higher liquids yield, offsetting our lower FY19 oil price assumption.

FX: moves from £/$0.75 to 0.77 based on recent sterling weakness.

First oil: we move Sea Lion Phase 1 first oil from mid-2023 to mid-2024, essentially including a one-year contingency over and above management guidance. We also move subsequent phases back by one year.

Rolling forward of NAV: we roll forward our discount date for future cash flows from 1 January 2018 to 1 January 2019, largely offset by the one-year delay to first oil included in our update.

A full breakdown of our valuation by asset is provided in the exhibit below, including a sensitivity to our underlying cost of capital assumption of 12.5%.

With Rockhopper currently trading at 23p/share, the market is much more pessimistic on Sea Lion Phase 1 progression or oil price expectations than our base case 55% commercial chance of success (CoS) based on a long-term price expectation of $70/bbl Brent. The current share price suggests an implied chance of success of c 20% for Phase 1 at $70/bbl or c 39% at $60/bbl (see Exhibit 3), implying that the project is unlikely to proceed. Based on our analysis of the key risks and assuming a long-term oil price of $70/bbl, we believe the project is more likely to proceed than not. However, timeline uncertainty remains with funding on the critical path.

Rockhopper expects to end FY18 with c $40m of cash on the balance sheet and no debt (in line with our forecasts). With SG&A running at c $4.5m pa and non-Sea Lion capital costs covered by c $3–$4m of positive cash flow from operations, Rockhopper should be funded through to Sea Lion Phase 1 first oil given current operator estimates of the project’s debt capacity. In addition, Rockhopper retains outstanding cost-carry balances for Phase 2 Sea Lion development and, depending on the precise capex schedule to this development phase, is likely to fund its share of development through a combination of existing carries and cash flows from Phase 1. Alternatively, equity in a producing Phase 1 Sea Lion development will provide the company with access to a borrowing base if Rockhopper looks to debt fund further phases.