Elk Petroleum — Transition to organic growth: Low hanging fruit

ELK petroleum is an ASX-listed oil and gas producer with assets in the northern Rocky Mountains. The company is focused on applying the established EOR technique of CO2 injection to mature oil fields to enhance oil recovery. Key assets include the Denbury-operated Grieve CO2 EOR project, which was commissioned in April 2018, a c 14% interest in the ConocoPhillips-operated Madden sour gas field and Lost Cabin gas plant (LCGP) as well as operatorship of the Aneth oil field. June 2018 1P reserves stood at 94.4mmboe with Edison forecast production of c 9.1kboed in CY18.

ELK recently reviewed its development programme for Aneth, un-locking numerous growth projects with the potential to double production and drive a 200% increase in proven reserves over the next five years. Management estimates Aneth development projects generate returns from 22% to 87% based on US$60/bbl WTI. Our latest valuation includes this development potential risked at 75% COS, contingent on a successful ELK re-financing. Our risked NAV rises from A$0.12/share to A$0.19/share (+61%) on inclusion of this growth pipeline. Incremental production growth is entirely leveraged to oil with a US$10/bbl increase in our WTI assumption increasing valuation by 37% and a US$10/bbl decrease driving a drop of 38% (after hedge protection). Management estimates CY18 production of just over 9kboed (excluding Grieve) and EBITDA of c US$50m; this compares to Edison forecasts of 9.1kboed (post-overriding royalty (ORRI) and excluding CO2 volumes) and EBITDA of US$34.4m in FY18 and US$90.8m in FY19 (after settled derivative contracts).

Recent acquisitions have driven material growth in production, revenues and cash flow. However, inorganic growth has been equity/debt funded on a piece-meal basis, leading to a complex and costly capital structure. ELK’s refinancing discussions are well advanced and management expects to be able to deliver a material reduction in the cost of debt, gentler debt amortisation and simplification before the end of CY18. As discussed in ELK’s half-year report, management expects banks to lend at 50-65% of proved developed producing (PDP) reserves, which were independently valued at US$363m on 29 December 2017 at strip. In addition, a further 25% is expected to be made available at a higher interest charge secured against proved undeveloped (PUD) reserves. This would imply debt capacity of c US$272m to US$323m, which would more than cover current absolute debt of US$225m with excess capacity to fund organic investment.

Company-specific risks include ELK’s ability to invest in organic growth in the absence of a comprehensive re-financing and a key sensitivity for our valuation is the underlying oil price assumption. Based on our long-term US$70/bbl WTI (from 2022) assumption, we believe ELK is well placed to access reserve-based lending (RBL)/corporate debt and generate material FCF post investment capex from 2021 onwards. Short-term operational cash flow continues to be re-invested in identified high-return and short-payback development projects at Aneth.

ELK completed the acquisitions of Madden and Aneth during CY17, two material transactions that have transformed the company into one of the largest producers on the ASX. Management expects net production in CY18 will be just over 9kboed (post-overriding royalty and excluding Grieve).

Bolt-on acquisitions remain an opportunity for ELK, including the consolidation of minority equity interests at Madden. However, we expect management’s focus to shift towards organic growth opportunities and financial re-structuring in CY18. High IRR, quick payback projects are likely to rank highly as uses of free cash flow in addition to debt reduction. Identified projects at Aneth are expected to generate management estimated IRRs ranging from 22% to 87% at US$60/bbl WTI and 29% to 124% at US$70/bbl. In this note, we look at current production and cash flow projections for the company’s three main assets and the development opportunities within the asset portfolio. Limited capital is required to produce current reserves with over 50% of 2P reserves fully developed and booked as 1P PDP. However, the acceleration of growth projects and of the reserve base will require funding from cash flow, equity or debt based on our forecasts. A proportion of Grieve 2P reserves are to be reclassified as 1P PDP once stabilised production has been established.

The addition of Aneth to the company’s asset portfolio is significant, not only due to the size of the field (1.5bnbbls original oil in place), but also from a standpoint of control. ELK operates Aneth with a 63.7% working interest alongside one JV partner, NNOGC. ELK has highlighted several NAV-accretive development opportunities at Aneth in the company’s ‘roadmap to 100mmbbls and beyond’. We include these near-term growth opportunities in our updated valuation. ELK’s partner, NNOGC, has secured debt funding to participate in its share on Aneth investment and ELK’s re-financing plans are expected to conclude in Q318. As operator, ELK is looking to double Greater Aneth field (GAF) production through a series of identified project opportunities including longer-term CO2 EOR expansion. In simplistic terms, management believes that c 50% of the 1.5bnbbl oil in place (OIP) at GAF can be recovered implying a further c 300mmls of gross recoverable oil (c 190mmbbls net to ELK). At this point in time, we limit our valuation to PDP reserves and identified near-term growth opportunities (net 80.8mmboe post overriding royalties).

In our updated valuation, we include the near-term growth opportunities (highlighted below) in addition to PDP reserves. The addition of these projects is a key driver of our NAV upgrade to A$0.19/share.

Management believes that the acquisition of Aneth provides the company with visibility on a proven reserve base over 100mmboe (from current proven 47.8mmboe) and a near doubling in production from the current 9kboed to over 18kboed. This estimate is based on low risk PUD projects at Aneth, as highlighted in Exhibit 1, and excludes an additional 50mmbbls of low risk, engineered technical resources that would become economic at higher oil prices.

Our forecast production and cash flow profiles for Aneth are provided below on a net basis. These profiles include identified development upside as detailed in Exhibit 3. ELK has reported initial success from the company’s McElmo Creek well deepening project, which is targeting the deepening and recompletion of 43 poor performing or inactive wells. At current oil prices management estimates that each well deepening will payback within six months, each increasing ultimate oil recovery by approximately 140kbbls.

The Madden asset continues to perform in line with management’s expectations, with recent operational focus on the planned retirement of the Train 1 gas processing plant. The Madden/Lost Cabin operator, ConocoPhillips, plans to operate the field well beyond the 2034 economic cut-off implied by current NSAI 2P reserve estimates, with field life potentially extended to 2060. We assume this extension of productive life in our base case valuation, reflecting the operator’s latest success in field life extension pilots. A recent pilot project to extend the economic threshold of a well was recently completed, adding incremental reserves at just US$0.14/mcf, and a strongly positive rate of return on investment. In the short term, ELK’s net profit interest in Madden is diluted by the royalties under its Tranche B preference shares. However, we expect redemption of preference shares in H2 CY18.

Madden remains a strategic asset for ELK, as the second-largest producer of CO2 in the Northern Rockies and with net CO2 recoverable of c 600bcf. Current CO2 supply is contracted to Denbury, the operator of several large Rockies CO2 EOR projects including Grieve.

ELK announced first oil at Grieve on 18 April 2018: a material driver of FY19 results and group cash generation. Management expects production to ramp-up to over 2,100bopd by end CY18.

Our Grieve production and cash flow forecasts are shown below. Given limited further capex requirements, Grieve is a cash cow for ELK, providing capital for investment in Aneth and debt reduction. In the short term, operator focus is likely to be on commissioning and asset optimisation ahead of considering further CO2 EOR opportunities, which can leverage installed topside facilities at Grieve.

Our group-level production and operational cash flow forecasts are shown below. Growth in operational cash flow significantly exceeds production growth as our oil price assumptions rise from US$66/bbl WTI in 2018 to US$70/bbl long term (2022). Growth in high margin oil production from Aneth is a key driver of this evolution in operating cash flow.

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.

James Piccone, CEO Denver: Mr. Piccone has 39 years of experience in the US oil and gas industry. He has extensive experience with oil and gas financial transactions and financing, most recently as a director of Resolute Energy Corporation. As the CEO of Elk Petroleum Inc. and a non-executive director of Elk Petroleum Ltd. he oversees the Denver Colorado based US subsidiary of Elk Petroleum Ltd.

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.

We discussed generic company risks and risks associated with the Grieve and Madden projects in our last published outlook note. Asset-specific risks relating to Aneth include:

Our updated NAV is provided below. Key changes from our last published valuation include:

Based on the current share price the market is heavily discounting Aneth and its growth potential, which are key constituents of our group RENAV. We believe ELK’s upcoming re-financing will provide greater visibility of Aneth’s growth project funding potentially unlocking this upside. In addition, ELK remains highly leveraged to oil price assumptions given the company’s financial and operational gearing – sustained higher oil prices will also be a catalyst for a re-rating.

Key components of our NAV based valuation are highlighted in Exhibit 11 and as mentioned above, Aneth PDP reserves and risked near term growth make up 70% or our risked asset valuation (excluding net debt and admin expense).

Below we provide a valuation sensitivity to our long-term WTI crude and Henry Hub gas price assumptions. Our equity valuation remains highly leveraged to movements in commodity price given ELK’s combination of operational and financial leverage. ELK has hedged a proportion of Aneth and Grieve oil volumes over the next three years, which we include in our commodity price sensitivity. We note that Aneth growth volumes remain completely unhedged providing investors with full exposure to prevailing oil prices.

Management estimates consolidated EBITDA (before realised hedge losses) of US$50-55m in CY18. This compares to our financial year (June year end) forecasts of US$34.4m in FY18 and US$90.8m in FY19 incorporating the Aneth acquisition and including the impact of settled derivatives under existing hedge arrangements. FY19 financials will largely be driven by Grieve and pace of production ramp-up. Sustainable cash flow from operations (CFO) will depend on underlying price assumptions but as can be seen in Exhibit 14 we expect annual cash flows in the US$30-100m range out to 2025.

We expect cash flow to be used to pay down debt in the short-term, in addition to organic investment. It is encouraging to see net debt falling rapidly over the five years from 2020 based on our forecasts and we would expect ELK to seek to refinance its debt and reduce capital structure complexity as described in the section below. As operator of Aneth, ELK retains the ability to adjust capital investment to match debt availability.

ELK’s capital structure is complex due to a range of debt structures that have been used to support historical acquisitions. These are outlined below:

The recent rise in oil price and shift in strategy from acquisitions to organic growth is expected to provide management with the opportunity to reduce debt and restructure existing facilities to simplify capital structure and reduce cost of capital. Management is in discussions with a syndicate of banks with regard to rolling up existing debt in to a single RBL/first lien facility. Management’s key objectives through the refinancing process include:

As mentioned in the company’s half yearly accounts, management expects banks to lend at 50-65% of PDP reserves, which were independently valued at US$363m on 29 December 2017 at strip. In addition, a further 25% is expected to be made available at a higher interest charge secured against PUD reserves. This would imply debt capacity of c US$272m to US$323m, which would more than cover current absolute debt of total US$225m including preferred stock as of end December 2017.

Our NAV-based valuation remains sensitive to assumptions of cost of capital. We assume a base case 12.5% life-of-field WACC; however, we provide a sensitivity to higher and lower WACC assumptions in the table below.

NNOGC announced that a US$80m first lien oil and gas term loan credit facility was closed on 14 June 2018 with clients of Guggenheim Investments. Funds have been explicitly earmarked for the retirement of NNOGC’s Wells Fargo-led credit facility and of anticipating funding of Aneth capital expenditure.