Deutsche Rohstoff — Track record of value creation

Deutsche Rohstoff’s (DRAG) business strategy involves the identification, development and monetisation of attractive resource projects in North America, Australia and Europe. The company’s current focus is on the development of oil and gas opportunities in the US. As it stands, its US unconventional resource base makes up the bulk of DRAG’s valuation and the company retains less significant positions in gold, copper, rare earth minerals, tungsten and tin through equity investments in six mining companies.

The exhibit below outlines DRAG’s equity investments and the resource focus of each of its holding companies.

To date, DRAG has a track record of creating value for shareholders through successful development and monetisation of its equity holdings. Since IPO in May 2010, equity and debt raised has totalled €108.2m, and proceeds from the sale of four investments amount to $250m. The most material divestment was that of the Tekton Energy, which was sold for $230m in 2014, generating a return on equity of 365% over three years.

Management is focused on delivering capital growth and income for shareholders (FY16 dividend yield is 2.9%) and after recent equity divestments, DRAG maintains a strong balance sheet with €24.6m of cash (€35.6m including marketable securities) and €75.2m debt. Excess capital is likely to fund organic growth with existing holding companies, in-organic growth and returns to shareholders. Key historical investment returns are shown in the table below:

DRAG’s revenues by resource segment have shifted towards oil and gas in recent years with the company active in two prolific onshore shale plays: the Williston Basin (Bakken) and Wattenberg field (Niobrara/Codell).

The major assets of Tekton Energy, including all of the producing wells and wells drilled, together with the majority of areas in the Wattenberg field, were sold to the former cooperation partner, Extraction Oil & Gas, in May 2014 at a price of $200m plus a $30m asset carve out. The sale proceeds were used to repay $39m in debt with the remainder distributed to Tekton shareholders including Deutsche Rohstoff USA (a 100% subsidiary of Deutsche Rohstoff AG).

Invested capital in Tekton was $30m of equity capital, and returns on investment include a dividend payout of $129m, equating to a 365% return on equity in less than four years.

The remaining assets within Tekton formed new company Elster Oil & Gas (EOG), of which DRAG is a 93.04% shareholder. A key retained asset is the Magpie area, which is south of the Windsor assets sold to Extraction Oil & Gas. Elster has a 50% non-operated interest in Magpie – over 50 wells are planned for this area at net cost of $2m to $4m per well with all-in break-evens estimated at $35/bbl WTI.

DRAG holds a multi-commodity reserve and resource base. Net proven and probable reserves are dominated by the company’s oil and gas position onshore US. Outside oil and gas DRAG has reserves and resources of zinc, copper, tin, lead, tungsten and molybdenum. From a value perspective the company’s oil and gas equity interests dominate.

Key valuation drivers and sensitivities are described below:

DRAG’s multi-asset and resource strategy has been built around management’s ability to identify investment opportunities, and development of these opportunities to the point of exit.

Management is not constrained by target returns or holding periods, and has an opportunistic view to both acquisition and divestment timing. Historically, this has generated significant value for shareholders and management has been able to attract blue-chip shareholders, such as BASF, as a result. Another testament to DRAG’s capital discipline and investment strategy is the company’s bond (8% due July 2018), which has consistently traded above par (currently a 6% premium). Growth within holding companies is expected to be funded through the use of existing cash, cash flow and debt, as well as asset sales, as opposed to new DRAG equity, limiting shareholder dilution.

Management believes that it has developed expertise in identifying small US onshore asset packages, as the market at this scale is not as efficient as that for larger acreage positions. Internally, the operating companies have mapped out well productivity, identifying play sweet-spots, providing strong insight ahead of negotiating for leases.

DRAG’s US onshore asset base extends across the Williston Basin (Bakken) and Wattenberg field (Niobrara) and management expected per-well investment returns to range from 20-40% IRR at spot oil prices. The company is highly leveraged to the oil price given its asset base, with NPV10 operational break-even at c $35-40/bbl according to management estimates.

We note that DRAG’s estimates of per well returns, highlighted in Exhibit 7, are relatively conservative compared to those presented by peers active in the same plays/basins. For example, PDC Energy, a peer in the Wattenberg field, suggests that significantly higher returns are feasible through the use of modern completion techniques and longer laterals, even at relatively low oil prices. Publically available data suggests that returns in the 60-90% range can be generated by low gas oil ratio (GOR) wells using modern drilling and completion techniques even at $40/bbl WTI.

As shale activity levels ramp-up in the US onshore, driven by the recent oil price recovery, we see potential for an increase in service sector pricing (rig rates, pressure pumping and labour rates), which could have an impact on realisable margins. The impact of service cost inflation is hard to quantify, but should be an investment consideration.

DRAG is exposed to the price of multiple commodities, with greatest leverage to oil and gas prices in the US and regional discounts to the WTI crude benchmark. Prices have been volatile, driven by commodity-specific supply/demand dynamics, but as can be seen in the exhibits below a number of commodities have seen price strength in recent months, driven by positive emerging market PMI data and GDP growth revisions.

German listed companies typically have three corporate bodies – an annual general meeting of shareholders, a board of management (Vorstand) and a supervisory board (Aufsichtsrat). There is clear separation between management and supervisory functions in the two-tier board. The purpose of the supervisory board is to support the interests of shareholders, but also the interests of other parties including the company’s employees, and public interest. The supervisory board oversees the company’s board of management and appoints its members.

The supervisory board members are:

The management board members are:

Cub Creek Energy and Elster Oil & Gas CEO/President – Robert A Gardner

Robert Gardner has 23 years of oil and gas experience in reserves, operations and project management. He has extensive Rocky Mountain experience, having served as engineering manager for Ute Energy, LLC from 2010 to 2012, while being responsible for the drilling and completion of over 150 wells and reserve determination in excess of 400mmboe in the Uintah Basin, resulting in a successful divestment value of $790m at the end of 2012. Recently, Mr Gardner served as VP of engineering at Tekton Energy, LLC where had direct responsibility for drilling and completing 31 horizontal Codell and Niobrara wells leading to a successful $220m divestment of the company. During his career, Mr Gardner has worked at a variety of positions in well-known oil and gas companies.

Salt Creek Oil & Gas CEO/President – Timothy M Sulser

Tim Sulser founded Salt Creek Oil and Gas, LLC with Jerry Sommer and Earl Norris in 2015, after five years as an investment banker with Tudor, Pickering, Holt & Co (TPH), most recently heading its Denver office. While at TPH, Tim advised upstream clients on acquisitions, divestitures and energy capital markets. Prior to joining TPH he worked as a reservoir engineer for reserve engineering consultant Netherland, Sewell, and Associates in Houston, Texas. He started his career with Marathon Oil Company in Lafayette.

As described above, German listed companies are required to maintain a dual board – a management board and a supervisory board – in order to ensure the management decisions are in the interest of both shareholders and employees.

DRAG’s largest shareholders include management and BASF. With a free float of c 81.2%, trading remains liquid, with average daily volume of 21.7k shares.

DRAG produces consolidated financial accounts in line with German GAAP. DRAG’s P&L is representative of the company’s business model with revenues falling substantially in 2015 after the sale of Tekton Energy. DRAG’s cash flow statement reflects this significant divestment with a substantial increase in shareholder equity and cash/cash equivalents. Investors should expect financial metrics to remain volatile as management continues to acquire and divest assets, but should instead focus on cash returns on investment. A table of historical returns on investment is provided earlier in this note (Exhibit 2).

We note that Bloomberg consensus currently does not reflect company guidance of an increase in dividend to €0.6/share proposed by management and the supervisory board. In addition, management expects 2017 group sales of €55-65m and EBITDA of €40m. This forecast is made on the basis that existing producing wells continue to produce in line with management forecast production profiles, and a fraction of wells under development contribute to 2017 sales and an average oil price assumption of $50/bbl. Q117 figures show that the company generated revenues of €20.7m in the quarter and EBITDA of €17.2m.

DRAG’s cash flow statement should be viewed in light of the company’s major acquisitions and divestments. These are likely to be lumpy in nature. As it stands, DRAG has a robust balance sheet given its projected EBITDA profile, with €24.6m of cash and €75.2m of coporate debt. Investors should focus on the company’s free cash flow generation, and cash returns on investment, given the company’s business model.

The market value of DRAG appears to be at a discount to the NPV10 (Ryder Scott CPR) of its net oil and gas investments plus book value of mining assets minus net debt. We believe asset value is an appropriate basis for valuation of DRAG over above traditional P&L metrics such as P/E or EV/EBITDA due to the nature of its investments. We would expect DRAG’s P&L to remain volatile due to asset acquisitions, divestments and asset impairments. Over a longer time horizon, investors may wish to consider return metrics such as ROACE, ROIC and ROE in order to formulate a view on management’s ability to create value through its ‘acquire, develop and divest strategy’.

With the bulk of DRAG’s value driven by US onshore shale assets we have analysed the company’s peer group base on metrics typically used to value US onshore E&P plays. Typical comparable valuation metrics include EV/acre, EV/flowing barrel and EV/reserves. We note that DRAG’s peer group contains a varied mix of companies in terms of market cap, play diversity, resource phase mix and financial leverage therefore ‘comparable’ companies shown in the table below should not be considered in isolation.

In the comparison table below we adjust DRAG’s EV for the book value of mining assets, tax receivable and net debt in order to be able to compare the company’s US onshore business with a number of pure plays. As mentioned above, the peer group is diverse; nevertheless, based on headline metrics, DRAG trades at discount to the group below on an EV/1P, EV/flowing barrel and EV/NPV10 (1P) basis. We also note that DRAG has significantly less financial leverage than a number of peers including Bonanza Creek and Bill Barret.

DRAG’s US onshore Williston and Wattenberg peers (excluding the large/mid-cap E&Ps) are a diverse group with varying levels of reserves, acreage, production and financial leverage. We have looked at DRAG versus its immediate peer group on several valuation metrics and have looked for relationships between financial and operational metrics.

DRAG trades at a discount to the peer group on a number of metrics including enterprise value per flowing barrel (EV/bbld). We have included EV/NPV10 as a valuation metric to compare the company’s enterprise value to the SEC standardised measure of discounted cash flows. It is worth noting that DRAG’s audited assessment NPV10 for Salt Creek, Elster and Cub Creek utilise marginally different price decks to those prescribed by the SEC, so some caution is required when using this metric as a comparative.

On consensus estimates, DRAG appears to trade at a discount to the peer group when considering the relationship between financial leverage and EV/1P reserves and a slight premium on a EV/developed acre basis. In our view, the company appears to be relatively undervalued and modestly leveraged compared to peers.

DRAG also appears to trade at a discount when considering 2017 EBITDA consensus forecasts and production growth. DRAG trades at on a relatively low EV/EBITDA multiple given its financial leverage.

Definitions of proved reserves (1P) and probable reserves (proved + probable equates to 2P) are provided below using Society of Petroleum Engineers (SPE) definitions.

Proved reserves: proved reserves are those quantities of petroleum, which by analysis of geoscience and engineering data, can be estimated with reasonable certainty to be commercially recoverable, from a given date forward, from known reservoirs and under defined economic conditions, operating methods and government regulations. If deterministic methods are used, the term ‘reasonable certainty’ is intended to express a high degree of confidence that the quantities will be recovered. If probabilistic methods are used, there should be at least a 90% probability that the quantities actually recovered will equal to or exceed the estimate.

Probable reserves: probable reserves are those additional reserves, which analysis of geoscience and engineering data indicate are less likely to be recovered than proved reserves but more certain to be recovered than possible reserves. It is equally likely that actual remaining quantities recovered will be greater than or less than the sum of the estimated proved plus probable reserves (2P). In this context, when probabilistic methods are used, there should be at least a 50% probability that the actual quantities recovered will equal to or exceed the 2P estimate.