SDX Energy — Morocco – a simple, low-cost operation with growth

Kenitra is the fourth largest industrial city in Morocco and is a significant consumer of liquid fuels, LPG and natural gas. Imported liquid fuels and LPG dominate supply (94% of total), despite significant price and operational benefits of using piped natural gas. The key constraint on pipeline gas market penetration has been supply and, to a lesser extent, the time required to connect new customers.

Edison’s recent site visit to Kenitra provided us with an appreciation of the depth of the thermal gas market in Kenitra and the relative ease at which gas can be supplied to customers within key industrial areas including the regions new Atlantic Free Zone (AFZ) - a regional hub offering significant tax incentives for exporters located within its boundary.

SDX’s current gas customer base is dominated by three large customers: Super Cerame, CMCP, and Peugeot (located within the AFZ) which combined are forecast to consume approximately 6mmscfd of natural gas. Incremental demand is set to come from smaller thermal offtakers with the potential for a significant step-up in demand if SDX was to enter the power generation market and supply the Kenitra-based, state-owned ONEE power plant.

We base our market demand forecasts on company analysis of identified natural gas customers and SDX’s connection goals for 2018. Combined, these act as the basis for the company’s 2018 Moroccan sales guidance of an 8-10mmscfd exit rate. Demand analysis suggests that piped gas sales have the potential to increase dramatically over the next two to three years, especially if SDX is able to penetrate the power generation sector.

We see risk around this step-up in gas demand, as it is unlikely that every identified customer would necessarily switch to gas whilst some may already have existing long-term fuel supply arrangements. In addition, negotiating with large-scale state-owned entities adds additional risks and complexity. We have risked SDX’s projected market demand forecasts using a simplistic approach applying a 75% risk to existing customer Super Cerame’s second plant, a 50% risk to new thermal customers and a 20% risk to power plant consumers. Our risked demand profile is shown in Exhibit 1, which implies a 2018 exit rate of just over 10mmscfd, growing to 17.5mmscfd over the medium term. This is materially ahead of the production profile implied by our base case 2P reserves and risked volumes from the current nine well campaign. In other words, further gas supply, from incremental discoveries or externally sourced gas, would be required to meet our projected risked demand.

As of December 2017, SDX Energy had a Moroccan 2P gas reserve base of 7.1bcf backed by 10 producing wells connected to pipeline infrastructure. The company’s current nine-well drilling campaign is targeting 15bcf of resource, with four discoveries out of five wells drilled to date.

To meet growing gas demand, SDX is incentivised to de-risk further gas resource across its Gharb Basin asset base. Much of the early success in the basin was on larger structures delineated on multi-trace 2D seismic, while more recent exploration has relied on high-resolution 3D seismic in order to define smaller pockets of trapped gas. SDX has refined its exploration strategy to focus on bright amplitudes in the basin which are indicative of reservoir sand, which this is then combined with inversion datasets in order to differentiate between fluid phases. The company’s current campaign has had an 80% success rate, or 100% success rate with wells drilled on high-resolution 3D. Three E&A wells remain to be drilled in 2018:

In addition to the wells described above, SDX is to begin a high-resolution 3D seismic survey over the Gharb centre permit in order to build a prospect inventory to the north of existing production and south-east of Lalla Mimouna. SDX Energy estimates the basin-wide unrisked prospective resource to be 50bcf.

In order to contract new gas supply, SDX is obliged to provide visibility of reserves which is the intention of the company’s 2018 exploration campaign. We estimate that SDX ended FY17 with c 5.2bcf of 2P gas reserves (excluding 2017 discoveries) which we forecast would rise to c12.7bcf including existing discoveries and risked 2018 campaign resource (2P + nine-well campaign) .

Our risked five-year demand forecast in Exhibit 1 consumes 24.6bcf of gas, implying further gas will need to be discovered in 2018/19 in order for this to be met. Based on an average discovery size of 1.5bcf and a GCOS of 75%, we estimate that an incremental 10-11 wells are required in order to meet this demand forecast. SDX sees the remaining unrisked exploration potential at over 50bcf, and as such we do not see this as a limiting factor. We note that our valuation only includes value for 2P reserves and the nine-well campaign and excludes incremental value from future Moroccan drilling activity.

A key take-away from our site visit was the simplicity of the company’s above ground operations. Gas is virtually export quality at the wellhead and land access for well-sites and pipe laying is straightforward. SDX has not experienced any pipeline-related integrity issues, which is a testament to the quality of the recovered gas and the effectiveness of the relatively simplistic cathodic protection system employed. Pipeline gas thefts are so far unheard of. The pictures below show the simplicity of the company’s well sites, top-side separation facilities and pipe-laying operations.

We have updated our valuation to reflect our latest assumptions of gas sales growth in Morocco, and updated our asset models to reflect SDX’s latest guidance for its 2018 production and capital spend. Other material changes to our NAV include an increase in short-term oil price assumptions and a mark-to-market for recent fx movements. We reflect the EIA’s latest forecasts for Brent and WTI crude in 2018 and 2019, with our 2018 Brent crude price assumption rising from 50.0$/bbl to 59.7$/bbl. Our long-term oil price remains unchanged at $70/bbl in 2022. We continue to use an average Moroccan gas price of $10/mcf in 2018 rising to $12.5/mcf by 2022.

We base our valuation of SDX’s Moroccan asset on the exploitation of the company’s 2P reserve and committed nine-well campaign – an estimated 12.7bcf of gas. Our base case production profile is shown in Exhibit 1 of this note. We clearly see longer-term upside within the company’s Moroccan asset portfolio given our estimates of market risked gas demand, remaining Gharb Basin resource potential and historical exploration success rates. Our valuation of this future potential is sensitive to a number of risks and uncertainties including:

We see material value over and above our base case to reflect future gas sales, which would be based on yet to be discovered/acquired gas resource which we have chosen to reflect as residual value in the company’s installed pipelined network and customer connections. This residual value component is based on a US pipeline norm of $100,000 per inch mile of installed pipeline, discounted at 50% to reflect depreciated service life. This equates to $16m or 5.7p/share in our NAV valuation. This approach reflects the optionality that SDX retains in supplying future demand in existing Kenitra industrial zones and the AFZ. Supplied gas could come from future exploration, or through a JV with a CNG/LNG importer.

Key changes in our NAV include an increase in our Morocco valuation, and oil levered assets base on our higher oil price assumption for 2018/19. We only include the Kelvin and Ibn Yunus prospects in our South Disouq exploration valuation (which previously included incremental risked prospective upside) with modified risking to reflect the latest guidance from management.

We forecast SDX Energy ended 2017 with just over $25m of cash and no debt as well as a net working capital position of c $27m which continues to unwind after the Circle Oil acquisition. The company remains fully funded for anticipated spend in 2018, with flexibility to consider bolt-on acquisition opportunities. Our 2019 and 2020 forecast free cash flow will, to a large extent, be driven by asset production performance, prevailing commodity prices and committed capex. In our base case, we anticipate a material build up in cash available for NAV accretive investment or distribution to shareholders.