Rockhopper Exploration — Update 25 May 2016

The release of the CPR into RKH’s Falkland Island assets confirms management guidance that Sea Lion could produce more than 500mmboe (across multiple phases). This should give further comfort to investors as FEED progresses and decisions are made on farm-downs and FID.

The recent drilling operations on the Isobel/Elaine complex opened up a new play in the southern part of the PL04 licence and established a total oil column likely to be in excess of 480m.

However, during the drilling of 14/20-1 and its redrill (14/20-2), the acquisition of a full suite of data was compromised due to operational issues (the rig was forced to move off site prematurely). As a result, ERCE had a limited data set on which to work for Isobel/Elaine and could only attribute contingent resources to the F3H Isobel Deep fan encountered in 14/20-1, as this formation demonstrated the ability to flow when reservoir fluids were recovered at surface as part of well control operations. Recoverable volumes could not be assessed for the oil-bearing fans encountered in 14/20-2, F3D Emily, F3G Isobel and F3J Isobel Deep, so ERCE has reported discovered STOIIP figures for these fans.

Prospective resources have also been estimated as part of the audit and include figures for the Irene and Elaine South fans which, although technically discovered with oil shows in 14/20-2, cannot be included under discovered STOIIP as the reservoir quality encountered at this location was not sufficient to meet the net pay criteria.

Under these constraints, ERCE has allocated 2C recoverable resources of 20mmstb for Isobel Deep, with management estimating an additional 49mmstb 2C resources for the 14/20-2 sands by applying a recovery factor of 25% to the audited discovered STOIIP.

The evaluation of the complex is still at a very early stage and management remains confident that, with further appraisal, Isobel/Elaine has the potential to contain 400-500mmbbls. This would place Isobel/Elaine much closer to the current 3C estimate, including prospective resources. However, in our view, this could be achievable given that management believes the 2C recovery factor of 25% is conservative and that the majority of prospective resources are contained in the Irene and Elaine South fans. This can only be confirmed with further drilling, which will be carried out once a rig returns to the area for development drilling on Sea Lion.

Phase 1a: the CPR confirms the resources we had modelled for Sea Lion (Phases 1 and 2) and we therefore leave volumes for Phase 1a unchanged. We have made slight adjustments to capex (for example net FEED costs of $20m in 2016 and a tweak to the guarantee payments).

Phase 2: using the CPR, we can back-calculate the percentage of resources in Sea Lion in PL32/PL04 (see Exhibit 1). This indicates that 59% of the 2C contingent resource is in PL32 (where RKH holds a 40% WI). This is quite different from our previous estimate (where we had assumed that Phase 1 was entirely in PL32 and 50% of Phase 2 was in PL32). We have therefore adjusted the modelled splits so that Phase 1 remains within PL32, but alter Phase 2 volumes so that the entire development sees 59% of volumes in PL32. At this stage we are comfortable keeping to this split, but expect to update it in time as the development plan is finalised. For example, we note that if we include all possible resources (including prospective volumes), this falls to a more even split of 53:47. These changes increase the value of Sea Lion by 4% over previous estimates. We note that any move of Phase 1a volumes into PL04 would likely increase NAV net to RKH further.

Isobel/Elaine complex: following our research principles, we prefer to use independent resource estimates where available. As a result, the incomplete data set on Isobel/Elaine means we are unable to keep it in our RENAV. This is because a standalone development of 139mmboe, as defined by the CPR 2C resource, is not likely (and we do not believe that 139mmboe is actually the extent of the resource). Instead, we choose to show the value of the development of a larger resource base (500mmbbls), split by what can currently be accounted for by the CPR and the remainder. It is unfortunate that the amount of data on Isobel/Elaine is not enough to give greater certainty at this stage, but management remains confident that the size of the discovery (so far proving an oil column of 480m and not yet finding an OWC) is far larger.

Other changes: we have made slight adjustments to the model to reflect the company guidance in the AGM presentation, which leads to a movement in the 2016 year-end cash estimate. We expect this to be affected by the Egyptian acquisition and will review again when the deal closes and we know whether RKH will hold 22% or 17%.

The result of the above factors increases the core NAV to 93p/share. Until the Egyptian acquisition closes (expected in H216), we keep the value outside the core NAV.

We continue to note that PMO would prefer to farm down an interest in Sea Lion and RKH management has indicated that it may reduce its holding as part of a deal to facilitate development. Given that the company is essentially fully funded (including the PMO financing arrangement) for the development, it is not clear how much value would be gained/lost in such a transaction, but we do note that RKH is in a strong position, holding 50% of the contingent Sea Lion 2C volumes and 64% of volumes at Isobel/Elaine.

As can be seen in Exhibit 2, RKH’s value is quite sensitive to the discount rate. This is not surprising given the long period of time before positive cash flows are expected from Sea Lion. The analysis indicates that the current share price implies a discount rate of 20%.

The market continues to see downward pressure on services, and it is very possible that the current estimate of pre-first oil capex of $1.8bn may fall. Reductions in costs would boost returns for the project and reduce the break-even oil price required. Currently, we model that Phase 1a reaches break-even on an NPV10 basis at a long-term price of slightly above $45/bbl. A reduction in capex to $1.5bn (pre-first oil), would see the NPV10 break-even fall by around $5/bbl – not insignificant.

Rockhopper remains financially robust (with $110m of cash at end December 2015) and the company estimates end-2016 cash of $60-70m (we model $68m). It benefits from the $337m development carry on Phase 1, a further $337m on Phase 2 and a backstop financing arrangement with PMO to provide required capital at a 15% interest rate if required.

In these times of low oil prices and uncertain sentiment, we believe that management will seek to conserve cash. As oil prices rise and Sea Lion moves from FEED to FID, investors should have more confidence in the value in the development and the company can look to use its resources more freely.