Rockhopper Exploration — Update 24 January 2016

On 13 January, RKH and PMO announced a revised development plan for Phase 1a, increasing the recoverable barrels to 220mmbbl and the peak production to 85kbd with unchanged capex (pre-first oil). This should result in a large increase in Phase 1a's NPV and greater cash flows, which could fund further developments.

The reduced break even is obviously good news for the project, but is well above the current spot price. The oil investing environment will have to improve substantially from its current state (as measured by the spot price) if the project is going to be sanctioned in mid-2017. Due to the importance of the oil price to the company valuation, we refer investors to the sensitivities section to examine the valuation at varying long-term oil prices.

We expect the company to publish the results of a competent persons report (CPR) on Sea Lion in H116. Now that 10 wells have been drilled in the Falklands, the company has a much stronger understanding of the assets, which is reflected in the evolving development plan. We have already seen additional barrels exploited in the northern flank of Sea Lion in Phase 1a, meaning a further 60mmbbl will be extracted versus previous plans. We also expect the CPR to include the results of the drilling at Isobel (both wells).

On the same day, RKH/PMO also announced the amended commercial terms of the farm-out deal for Sea Lion, but it also included details of an amended deal on Sea Lion. The changes are summarised below.

Now that ownership of Sea Lion has been clarified and Isobel-2 has been successful, we expect PMO/RKH to actively seek a partner to help develop Sea Lion. Given the difficult macro environment, we do not expect an imminent resolution, although we note that with many hundreds of millions of barrels discovered in the North Falklands basin, this would represent a major project (and reserve additions) for even large companies.

Isobel-2 was spudded on 21 November 2015 and reported results on 11 January. It was designed to re-drill the Isobel-1 well, which had penetrated the first 24m of the Isobel Deep reservoir. After encountering higher pressure, Isobel-1 failed to reach total depth so was unable to drill, though the total estimated thickness of the interval was 80m.

Isobel-2 was designed to re-drill the Isobel-1 well to properly explore the Isobel Deep/Elaine complex. Although the primary objective remained the Isobel Deep fan, it also intercepted four other fans in an ambitious 4.2km step-out. The well intercepted 27m of net pay in the Isobel Deep reservoir 350m down-dip of the original well, and the company believes the result indicates the total oil column to be over 480m. The company concludes that the Isobel/Elaine complex is “highly likely to contain a commercially viable quantity of recoverable oil”.

Management estimates that the full Isobel Deep/Elaine complex could be more than 500mmbbl, above the 400mmbbl resources at Sea Lion. A number of appraisal wells are required to progress the discovery towards development status (Rockhopper has drilled nine wells on Sea Lion with seven being successful). As a result, it will take some time before Isobel Deep and other reservoirs are developed.

We do not expect any further drilling of Isobel in 2016 as RKH/PMO concentrate on developing Sea Lion and attempt to farm-down the blocks to a third party if possible. This farm-down has been helped by two recent developments: (i) the merger of RKH and FOGL (announced in December 2015, closed in January 2016); and (ii) the clean-up of the Premier/Rockhopper ownership balance announced in January 2016. Appraisal drilling at Isobel/Elaine is more likely to happen when a rig returns for development drilling on Sea Lion.

The large interest that FOGL held in PL04 (and no interest in PL32) meant that the Sea Lion development (and possible Isobel development) was split between three parties. The fact that FOGL was an unfunded player, and held interests in acreage that would only see first production in Phase 1b at the earliest, meant discussions on a farm-out deal with third parties were difficult before the merger. The post-merger Rockhopper should allow interested parties to reach a deal more easily – the key reason we believe the merger was executed.

Rockhopper issued approximately 160m shares in exchange for FOGL’s share capital, representing a c 65:35% merger between the two. The new entity will continue to be run by RKH management, although two FOGL board members have joined the RKH board as NEDs.

On the day of the announcement, FOGL was effectively valued at $80m. Given its 85mmboe 2C resource, the deal valued it at $0.9/boe of contingent resource. This compared to RKH’s EV of $33m and $0.18/boe contingent resource. On the surface, RKH’s management was therefore paying a significant premium to the RKH valuation for FOGL. This leads to a material dilution in the value of the core business (adding 54% to the share count, but adding a smaller percentage of contingent resources).

In light of the Isobel-2 success, these metrics have become more favourable for RKH. However, we believe the over-riding consideration of the merger was to enable a farm-down and development of the assets.

It is clear from the chart below that deals executed in recent years have generally been completed at a significantly higher $/boe figure than achieved by the RKH/FOGL merger. Indeed, if we examine the deal on a global basis (rather than by a comparison of RKH/FOGL standalone figures), this deal has enabled RKH to buy 2C contingent resources at a very low cost. Of course, the deals executed in the past were at materially higher oil prices.

After a government ruling on 13 December, it is possible that drilling at Ombrina Mare will not be able to go ahead, as drilling less than 12 miles from the coast has been stopped – a reinstatement of the moratorium brought in after the Macondo disaster. When the moratorium was reintroduced, the company was given a 12-month extension to the licence at the same time, meaning that there is still some uncertainty over the final resolution to the issue (we note that original ban was repealed 18 months later). The prospect has estimated resources of 25mmboe and is presently 100% owned by RKH.

Given the high value of discovered resource under Italian fiscal rules, this is a setback for RKH’s long-term value, albeit that we had not included the prospect in our valuation due to uncertainty over drill timing.

The company has indicated in its most recent presentation that it is looking to rationalise its asset portfolio. We would expect current production at Civita and Guendalina to remain. The materiality of Ombrina Mare and Monte Grosso, and optionality of Croatia and Malta could also remain as key components in the portfolio.

Following the completion of the deal, we now formally include the FOGL merger in our valuation. We have made a number of adjustments to NAV, as follows:

The net effect of these changes moves the core NAV to 104p/share (previously 147p/share). RENAV moves to 133p/share. A significant uncertainty in this valuation is the value that Rockhopper will be able to retain/extract from a farm-out deal. The companies are likely to give away a material percentage of any development, although cash/carry component will likely increase the value per barrel of any remaining stake.

Sea Lion will not be sanctioned unless the partners are happy that it will make a sufficient return, and as we discussed earlier, we calculate the break even (NPV=0) of Sea Lion to be at around $40/bbl (2016 real price inflating at 2.5% pa). In the sensitivities below, we are not adjusting the guarantee fee payable by RKH to PMO (to even up the NPVs for each partner), leaving it as c $16m per quarter regardless of the oil price. We also assume that Rockhopper uses the $750m loan facility at an interest rate of 15%. Despite these differences to how things may actually play out, the table below should give investors a broad idea of the sensitivity of the value of the project to the long-term oil price.

The merger with FOGL brings no cash to RKH and adds to the cash requirements for Sea Lion full field development (not to mention at Isobel/Elaine) – though not to requirements pre-first oil at Phase 1a due to the existing carry from PMO.

However, if we assume there is a significant gap between first oil from Phase 1a and Phase 2, the enlarged entity should have enough cash flow and/or ability to raise debt from its production to fund the development without further need to source equity. If the developments are closer together, funding for Phase 2 may become more of an issue. However, the cash generation from earlier phases and development carry means this likelihood is reduced.

Our financial forecasts have changed to reflect the removal of the Beach Energy assets acquisition, the inclusion of FOGL assets and a number of other adjustments.

We currently assume a long-term oil price of $80/bbl (2016 real). Given the current macro environment and falling cost base, investors may want to look at the cash flows at lower oil prices, below, where we present the cash flows at $50/bbl and $65/bbl. These indicate that in more depressed oil prices, the company will need to raise further external finance, and the ease at which it can do that will depend on the overriding macro environment at that point.