Elk Petroleum — Rockies CO2 EOR consolidation

Elk Petroleum (ELK) is an ASX-listed oil and gas producer and developer with a focus on enhanced oil recovery (EOR) from mature oil fields using established technology. Its current projects involve CO2 EOR, where CO2 is injected into a mature oil field at pressure and temperature conditions at which it becomes miscible with oil, enabling previously immobile oil to be recovered. The company’s first project, Grieve, is close to delivering first oil and ELK recently acquired a 14% interest in the Madden Gas Field and Lost Cabin Gas Plant (LCGP) in Wyoming from Freeport-McMoRan, affording it access to a prolific CO2 source. Net cash flow from Madden and the near-to-completion Grieve project will have a material impact on group operational cash flow and earnings in calendar year 2018. The precise shape of the company’s earnings growth profile will depend on the timing of Grieve first oil, commodity prices and plant uptime.

The Denbury-operated Grieve project is rapidly approaching first oil, with the operator targeting late 2017 or early 2018. 41.2bcf of CO2 has been injected at Grieve and the field is now fully repressured, with average reservoir pressure well above the minimum miscible pressure required for CO2 to go into phase with the remaining oil in the field. Critical items at Grieve include transport of larger pieces of process equipment and the workover of remaining injection and production wells prior to site access potentially becoming restricted in the winter. ELK expects the planned well programme to be complete by the end of August 2017 and major equipment on site before end September 2017. Given the substantial CO2 requirement to establish an EOR project and its importance in securing financing, ELK regards vertical integration and CO2 supply ownership as essential to underpin its future acquisition and development strategy and provide a long-term competitive advantage. ELK believes the investment approach it took at the Grieve EOR project is highly repeatable and is actively looking at further oil field CO2 EOR candidates, CO2 sources and compression/ transportation infrastructure. Across the Rockies, the CO2 EOR opportunity is estimated at 2-6bnbbls by the Department of Energy (DoE).

Alongside field operators Denbury and ConocoPhillips, ELK management has identified numerous field optimisation opportunities with high risk-adjusted returns (many in the 50-100% IRR range). These include shooting 3D seismic over the Grieve to better define the structural/stratigraphic closure in order to identify volumetric upside. Material resource upside exist if ConocoPhillips is able to extend plant life beyond current NSAI 2P assumptions, helped by recent operational data that suggest a shallower decline rate than previous operator forecasts. Risks to our assumptions include timing slippage at Grieve and/or well or facility integrity issues at Madden. We address these risks later in this note.

Our NAV-based valuation for ELK is split A$0.17/share for Grieve, A$0.06/share for Madden and a total NAV of A$0.09/share after deducting net debt and admin costs. Gross production from Grieve is expected to be c 3-4kbod in calendar year 2018, with ELK owning a 49% interest. Combined revenues from Grieve and Madden in FY18 (July 2018 to June 2019) are estimated at US$31m, generating operating cash flow of US$3.9m before working capital movements. We forecast net debt to reduce rapidly even at spot oil prices once Grieve is in production.

ELK is close to delivery on its first CO2 EOR development at Grieve and with the acquisition of Madden CO2 resource is looking to pursue further EOR projects in Wyoming. Grieve and Madden cash flows should enable ELK to pay down project debt (last reported net debt of US$65.4m at 30 June 2017) and pursue inorganic growth. We expect management to continue to pursue acquisitions such as incremental CO2 source gas and associated infrastructure, as well as EOR opportunities in close proximity to the company’s Wyoming asset base. ELK has identified a number of opportunities including infrastructure assets being divested by majors and EOR opportunities that lie below the radar of larger peers.

CO2 EOR has been used as a method of tertiary oil recovery for over 40 years, and the prevalence of suitable reservoirs as well as CO2 supply has driven utilisation of the technique across the US. There are over 120 successful CO2 EOR projects in the US across multiple basins – the application of CO2 tertiary recovery is generally viewed as low risk. During a CO2 flood, CO2 is injected into the reservoir where, under the correct conditions, it will mix with the residual oil to become a single phase, ie it becomes miscible. This allows the CO2 to displace the oil from the rock. As the CO2 dissolves in the oil, it swells the oil and reduces its viscosity. This improves the efficiency of the displacement process. The oil forms an oil bank, which is then swept towards the producing wells. Once recovered at surface, the produced fluids are separated, with the CO2 separated from the produced gas stream, recompressed and reinjected.

ELK is on the verge of completing its first EOR development project at Grieve and over the last three years has gained considerable experience in CO2 EOR project management and execution from operator Denbury. ELK’s strategic goal is to source CO2, which it has done successfully through the acquisition of the Madden field. The company’s immediate strategy is to focus on short-term asset optimisation opportunities and incremental inorganic growth.

ELK’s management team is formed of a number of former Drillsearch Energy directors. ELK’s managing director and CEO, Bradley Lingo, was CEO of Drillsearch where he oversaw a more than eightfold increase in market cap over a six-year period. Alexander Hunter, CFO, was previously general manager of business development at Drillsearch and David Evans, COO, was formerly Drillsearch’s chief technical officer. The company’s Denver-based US management team has extensive US onshore development experience. J Scott Hornafius, president of ELK’s US subsidiary, was formerly president of Mega Energy where he developed a Marcelles shale gas play. Brian Dolan, COO of ELK’s US subsidiary, has over 26 years of engineering, management and operations experience including the development of US shale resources across four different plays.

ELK has a 49% working interest in the Grieve CO2 EOR project located in the Wind River Basin, Northern Rockies, Wyoming. Denbury Resources operates the development with a 51% operated interest, and a fixed time and cost construction contract with ELK minimising ELK’s exposure to cost or time overruns.

The Grieve project is now over 80% complete and first oil is expected in late 2017/early 2018. We visited the Grieve project in early July 2017 and were able to view site progress, and discuss schedule and project expectations with senior management. We highlight some of the key construction milestones that have been met and the remaining construction scope below.

Denbury is making good process on site and the operator appeared to be comfortable with a late 2017/early 2018 first oil based on the current project schedule. In our view, critical items include ensuring delivery of all larger outstanding process equipment and tank storage to site as well as completion of well work ahead of winter weather potentially restricting site access from late September 2017. Denbury is currently in the process of enclosing new process buildings around newly installed equipment in order to weather proof the project in order to mitigate against weather restrictions. Our forecasts assume an early 2018 start-up broadly in line with management guidance. We note that while there would be a time value impact of delays as ELK net cash flows are deferred, the direct cost of delays is minimised through ELK’s contractual arrangements with operator Denbury.

A site layout of the Grieve project is provided below, showing key newbuild facilities highlighted in yellow. This can be compared against an aerial photo of the Grieve site taken at the time of our site visit on 10 July 2017.

Our Grieve oil recovery and production profile forecasts are in line with management’s 2P projections, assuming incremental recovery of 12.3mmbbls taking total recovery of original oil in place to 63% from 50%. We note that Denbury has publically disclosed a slightly lower gross recoverable figure of 10mmbbls (5mmbbls net). Elk management believes there is material upside beyond current projections of 2P reserves through the optimisation of the CO2 EOR and potentially through shooting a 3D seismic survey (cost estimated at $1.5m) to fully delineate the Grieve field and to position future producers/injectors to target volumetric upside. Given the sunk capex, the economics of incremental oil recovery are likely to be extremely attractive.

The exhibits below outline our projections of production and net cash flow from Grieve (calendar years) based on current 2P production profiles and assuming first oil in early 2018.

ELK has a 100% operated interest in the Grieve pipeline, which transports crude from Grieve to the Spectra oil storage tank farm and connection to the Enbridge-operated Platte River Crude Oil Pipeline, a 933-mile interstate crude oil transportation pipeline that currently transports c 150kbod. Recently acquired intelligent pigging data confirmed the pipeline to be within operational wall thickness tolerances and cathodic protection has been installed in order to maintain pipeline integrity. Enbridge is now installing the reconnection of the crude oil pipeline to the North Platte Interstate Transmission crude oil pipeline. The only pipeline works remaining are the Denbury connection of the Grieve production facility to the Grieve pipeline, followed by packing the line with crude oil ahead of first oil export.

In line with ELK’s strategy to become integrated along the CO2 EOR value chain supporting the acquisition and development of further enhanced recovery projects, it acquired Freeport-McMoRan’s 13.6% interest in the Madden Gas Field for US$17.5m. In addition to being a prolific methane producer, Madden also produces a significant sour gas component, giving ELK access to a material CO2 resource. The acquisition, which had an effective date of 1 January 2017, elevates ELK to producer status. ELK estimates attributable free cash flow of US$7m in 2017 from Madden.

Current proven developed reserves of CO2 in the Madden Gas Field are approximately 220bcf. The total recoverable resource potential of raw gas is over 1tcf. The raw gas stream has a CO2 content of 20%, methane and ethane (68% combined) and hydrogen sulphide or H2S (12%). The LCGP is designed to separate raw gas into pipeline specification methane, a purified CO2 stream, and elemental sulphur for sale to the fertiliser market. Operations began in 1995 and, after a number of major expansions, the plant consists of three gas processing trains with total capacity of 310mmscfd. The Madden Gas Field is the second largest supplier of CO2 into the Northern Rockies CO2 gas transmission and supply pipeline network.

The Madden Gas Field is a conventional gas field located in the Wind River Basin in Wyoming. It was discovered in 1968 and is one of the state’s largest gas fields. The field sits on the Madden anticline and covers an area of 518km2.

The field produces from multiple reservoir units ranging in depth from 1,500m to 7,600m.

As part of the CO2 supply arrangements, Denbury Resources (DNR:NYSE) constructed a CO2 receiving and compression facility adjacent to the LCGP and the 373km Greencore CO2 gas pipeline. This has an ultimate capacity to transport 725mmscfd of CO2 for EOR projects in Wyoming and Montana. This implies total annual capacity of approximately 260bcf CO2. By way of comparison, ELK expects that a total of approximately 52bcf of CO2 will be injected into the Grieve field within the first 12 months of first oil production.

ELK is looking at options of using Madden CO2, which is currently being vented and is unutilised. Short-term options include the reinjection of CO2 into the Madden reservoir to improve methane recovery and capture tax credits. Longer term, the expectation is that CO2 will be sold to Denbury under an existing long-term contract for export into the Greencore pipeline.

Due to the sour gas nature of the Madden gas field and the acid gasses process at the LCGP, facility integrity and maintenance is an important consideration when considering plant life and ultimate gas recovery. ELK’s and Edison’s production forecasts assume regular plant turnarounds (every 18-24months) and maintenance spend to ensure asset integrity. In our view, our key considerations include monitoring and maintenance of Madden deep production tubing, casing strings and field pipelines to ensure integrity of the field’s valuable well stock (deep wells can cost up to $120m to drill and complete due to the exotic metallurgy used for sour gas service) over field life. ConocoPhillips began a well integrity programme in 2016, and a total of three of the eight producing wells have been inspected to date with corrosion evaluation work ongoing.

Maintenance of the LCGP sour gas processing facilities, in particular the sulphur recovery train, is also an important consideration in ensuring the facility meets regulated and permitted emissions targets. Facility integrity and uptime is optimised through regular plant turnarounds that include cleaning out process equipment and equipment repairs. The EPA has set a stringent one-hour SO2 standard and the LCGP has a monitoring station immediately south of the plant operational since 1 January 2017. The plant operator is working to identify operating and mechanical modification to reduce the risk of emissions exceeding regulated levels.

Neale Taylor, Chairman: Dr Taylor has extensive technical, operating and commercial experience in oil and gas exploration and production with Esso Australia, Nexus Energy and Cambrian Oil & Gas. He is a former non-executive director of Terra Gas Trader, former non-executive chairman of Tap Oil, a former managing director of Cambrian Oil & Gas and director of various subsidiaries of Xtract Energy. He is a member of the Society of Petroleum Engineers and a Fellow of the Australian Institute of Company Directors.

Bradley Lingo, Managing Director and CEO: Mr Lingo is an experienced international resource and energy executive with a proven track record of successfully building companies in the upstream and midstream oil and gas energy sectors. Recently, Mr Lingo was MD and CEO of Drillsearch Energy, where he oversaw a more than eightfold increase in the share price and market cap over a period of six years, helping build that company into one of Australia’s leading onshore oil and gas producers. He held previous roles in business development, new ventures, mergers and acquisitions and corporate finance with Tenneco Energy and El Paso Corporation in the US and Australia, and was senior VP and head of oil & gas at the Commonwealth Bank of Australia. His skills include leadership, ability to build market confidence, financial and technical skills, organisation building, business development and funding capability, and entrepreneurship. His experience also includes equity and debt capital raising, project and transaction financing and structuring to achieve attractive financial, tax, accounting and legal treatment for complex commercial, project and financing transactions, similar to ELK’s current needs.

Alexander Hunter, CFO: Mr Hunter has over 10 years’ experience in resources sector M&A and capital raising, and previously worked for 10 years in construction and infrastructure project management. He was most recently general manager of business development at Drillsearch Energy, where he helped to rationalise and grow the business leading various successful takeovers, divestments and capital raisings. He holds an MBA from the University of Southern California Marshall School of Business, a Bachelor of Engineering and postgraduate qualifications in corporate finance and business law.

David Evans, COO: Mr Evans is a geologist with 30 years’ upstream global oil and gas development, production and exploration experience, with significant exposure to Brownfield redevelopments and EOR projects. He joins ELK from Drillsearch, where over a six-year period he held the positions of chief technical officer and acting chief operating officer.

Our valuation of ELK and its core assets, Grieve and Madden, is based on discounted cash flows (NPV10) adjusted for group net debt and administration costs. At this stage, we do not include incremental value for potential value-accretive inorganic growth. Our base case assumptions and commodity price sensitivity are provided below.

The Lost Cabin Gas Plant produces 1,200-1,400t/day of sales-grade sulphur (gross). The majority is transported by rail to Tampa, Florida to supply the fertiliser market. The remainder is transported to a local fertiliser plant in south-west Wyoming.

The Lost Cabin Gas Plant is a sizeable and complex plant, which will incur a material decommissioning expense at the end of field life. We include estimates for the cost of mothballing Train 1 (2033) and decommissioning the entire plant at the end of field life in line with NSAI 2P projections.

We have used our base case oil and gas prices (Exhibit 12) in our valuation of ELK’s 2P asset base, which stands at A$0.09/share. We see material upside in the event of higher commodity prices and/or resource recovery in excess of audited 2P estimates. In particular, we flag that ConocoPhillips holds significantly greater estimates than NSAI for Madden 2P reserves within its own operator estimates. Our base case valuation breakdown is provided below.

To quantify commodity price sensitivity we provide a 2P NAV sensitivity to both long-term oil price and gas price assumptions. As can be seen in the table below, ELK is highly sensitive to both oil and gas pricing given its operational and financial leverage. Our-long term assumptions are assumptions are $70/bbl WTI (2022) and $3.85/mcf Henry Hub (2022).

With the current share price implying that long-term commodity prices remain below current spot levels and with a significant amount of oil production hedged over the next two years, commodity price-driven downside is largely protected. Nevertheless, company-specific operational risks centre around ELK’s ability to recover reserves in line with audited 2P estimates, maintain high levels of operational uptime/plant integrity and minimise the NPV of decommissioning liabilities associated with large capital items such as the Lost Cabin Gas Plant.

ELK’s current asset base is concentrated in the state of Wyoming, US and as such lacks a suitable comparable peer group on the ASX. In this section, we compare ELK to a number of US onshore conventional and unconventional producers that operate similar US onshore assets in comparable basins. These comparisons are based on data available in company SEC filings, Bloomberg and publicly available data. We focus on metrics commonly used in US equity markets for the mid-cap onshore exploration and production sector.

ELK currently trades at a distinct discount to US onshore peers on an EV/1P $/boe basis at just 7.0$/boe.

ELK also stands out when looking at valuation on a flowing barrel basis (EV/bbd) despite leverage (net debt/EBITDA) close to the peer group average, however $/acre multiples remain substantially higher than US peers. Elk focuses on production rather than exploration assets and we would expect the company’s developed acre multiple to fall once behind-pipe resource at Madden shallow (90mmbbls gross) is included.

ELK’s realisations per barrel are towards the lower end of the peer group given its gas bias on a volume basis. However, realisations are robust given the hydrocarbon mix. Lifting costs and finding and development (F&D) costs are among the lowest in the peer group. Operating costs at Grieve are c US$10-13/bbl and Madden at c 10$/boe.

To date, ELK has used a combination of debt and equity to fund growth. We expect operational cash flow from Madden and Grieve in late 2017/early 2018 to enable ELK to significantly pay down debt over the course of 2018-2020 and fund further expansion. We discuss the company’s balance sheet in further detail below.

The effective date for the Madden gas field acquisition is 1 January 2017. From this date, ELK became a producing oil and gas company and begins to generate operating earnings from gas sales. Expected first oil production from the Grieve CO2 EOR project is expected in late 2017/early 2018.

The earnings forecasts in Exhibit 23 use Edison oil price forecasts and EIA gas price forecasts, as shown in Exhibit 12. Almost all the Madden gas is sourced from the Madden Deep wells, where future capital expenditure requirements are low as no new wells are required to underpin the company’s 2P reserve profile.

Assuming January 2017 consensus gas price forecasts, ELK has estimated positive attributable net free cash flow of approximately US$7m for CY17 from Madden. At the outset of production, our pre-tax cash flow forecasts for Madden are broadly in line with this figure.

ELK’s capital structure consists of several debt lines ranging in cost and asset security. Key elements are highlighted below:

FY17 saw a material increase in debt as ELK drew down on the Benefit Street Partners loan and took on an additional US$10m of convertible debt to fund the Madden/Lost Cabin transaction. We expect this to be paid down rapidly from cash flow once Grieve is on stream even at spot oil prices.