EGY : The $7 bet on the next Persian Gulf
(Feb 14th, 2012) Every so often it’s important to review one’s own biggest trading mistakes. My second worst trading error of the past six months occurred in January, when I got long an expensive, controversial oil name, Cobalt Energy (NYSE: CIE). Cobalt started out life as a Goldman Sachs’ backed driller in the Gulf of Mexico, and built a tidy portfolio of value-added offshore drilling. In late December of last year, Cobalt’s stock took off, moving from $10 a share to around $15, on word that its’ holdings in offshore Angola, where it was completing the Cameia-1 appraisal well, had potentially struck a a monstrous find.
I quickly ran the numbers. It was possible that the pre-salt opportunity in Angola mirrored that of offshore Brazil, where finds like the Tupi field where Petrobras (NYSE: PBY) confirmed a multi-billion barrel potential find. Petrobras and others were committing themselves to spending tens of billions of dollars over the next decade to build out these offshore pre-salt fields in what has the potential down the road to rival the current production numbers emanating from the Persian Gulf.
Geologically, most scientists believe that Africa and South America were once connected, and separated over millions of years in a process knows as ‘continental drift’. If true, it is highly possible that the stratospheric finds in offshore Brazil would be ‘mirrored’ in similarly situated West African pre-salt deposits.
What made Cobalt’s stock continue to climb is that Maersk, owner of an adjacent Angolan block, hit big on its’ pre-salt appraisal well. When that news came out in early January, I bought a fairly large stake in Cobalt at around $15.50 and hoped for the best.
As the stock kept creeping up on me, I sold against my long position, first the 17.5 calls and then the 20 calls. Fairly quickly, I was up almost 30%. Wowzers, I told myself. Who knew investing in Angola oil could be so profitable, so quickly? By the time February rolled around, I was fully hedged and called away on my Cobalt stock at $20/share.
What seemed to be such a smart investment turned into a disaster, as I watched Cobalt last Friday announce a mammoth, 1,180 foot “gross continuous oil column” in its Block 21 Cameia-1 appraisal well. The stock closed the night before at $23.90 and promptly opened the next day at $33.98. I watched in horror as all my homework on Cobalt was realized, staring at me on my screen, except I wasn’t participating in the profits one iota. I left the equivalent of a years’ worth of profit pass by without me because I was too myopic in taking the quick money.
Fast forward to this week. I’ve reviewed in depth the maps encompassing the Kwanza Basin, which is the area offshore Angola that both Maersk & Cobalt hit their respective pre-salt targets. Most of the offshore blocks are controlled by large international oil companies such as Conoco Phillips (NYSE: COP) and Total. However,93 miles north from the Cobalt discovery and within the Kwanza basin, sits block 5, owned by a small, well run outfit called Vaalco Energy (NYSE: EGY).
Vaalco was founded in 1985 and brought its first offshore well online in 1992. It began development in Gabon in 1995 with the Etame field permit and started production in 2002. Since then, its daily production, currently running around 4,000 barrels and solidly in the black, has come mainly from its Gabon assets. With cash as of September 2011 of $112m and net property/equipment of $102m, EGY (with 57 million shares outstanding and trading around $7/sh) has more than half its’ value in cash and tangible assets. Throw in the value of its Etame and other Gabon fields, (Vaalco has 7m barrels of proved reserves and plenty more in the probable column) and the current stock price is attractive on the basis of those items alone. But the real kicker that could propel this stock forward in a meaningful way comes from its 40% ownership of Angolan Block 5.
Block 5 is operated by Vaalco and is made up of 5,700 km or 1.4 million acres of offshore drilling opportunities. 12 wells were drilled by prior operators, and 5 of them reported oil and/or oil shows. Two seismic runs were performed, one in 1997 and another in 2008 (both 3D surveys comprising over 1700 sq km) and a number of promising prospects were identified. Of those, one stands out the most : The Loengo Prospect.
Loengo sits at the southern end of the block, is situated in 510′ feet of water, and has an exciting pre-salt prospect. The company estimates a well would cost $35m to drill the 11,000 feet to the pre-salt formation. Over the past year and a half it has struggled to identify a new partner (Norweigen Interoil walked away from its’ 40% stake around 2 years ago) with which to split the drilling costs. Although there are multiple prospects throughout the mammoth 1.4 million acre field, to date no one has stepped forward. But all that has changed now that Cobalt announced the results of Cameia-1.
Industry players I reached out to told me that since Block 5 lies within the Kwanza basin, Vaalco should have little trouble finding a major oil company to step into Interoil’s shoes. I spoke with Vaalco’s CFO, Gregory Hullinger, last night, who reviewed the numbers with me. Drilling costs are estimated at around $35 million, and any new partner would have to pick up a few million of accrued costs as well as a permit/transfer fee to Sonangol (The Angola state oil company, which holds a 20% carried interest in the block) that could range from 3-5 million dollars to something approaching 10-12 million. (Offshore Angolan blocks have jumped in demand overall since the Cameia-1 results with the Angolan government being the immediate beneficiaries.)
Mr. Hullinger confirmed to me that, in concert with what I’ve heard from others, his phone has been “ringing off the hook”. From what I’ve gathered, its probably a 2-5 month process to weed through the inquiries and nail down the terms for bringing on board a new partner. Vaalco has established a data room and put Sonangol on notice that it intends to move forward expeditiously. In fact, it seemed to me after my phone call that a potential hiccup in moving forward would lay with Sonangol not moving fast enough for Vaalco and its’ new partner in approving the deal.
Stephan Berman, an analyst at Pritchard Capital, has, from my vantage point, done the best research on this company (If you are in the hedge fund world and don’t do business with Pritchard you are missing out on some great oil calls). He downgraded the stock sometime last year due to what he described to me as his “frustration” with the pace of Block 5 development. That is clearly about to change. Even without the excitment surrounding Block 5, Berman has an $8 target on the stock. The potential for Loengo could be anywhere from 10-50 million barrels of oil, and for a company with less than 10 million proven barrels under reserve, this is clearly a game changer for shareholders. As for the entire block, Sonangol themselves estimated that there is a potential 350 million barrels of retrievable oil, and again, that was before Cameia-1.
I’d expect Pritchard and others to pick up the pace of coverage and start highlighting the value inherent in Vaalco over the next few weeks. The company will report earnings on March 12th and host a conference call on the 13th. Expect management to ‘bang the table’ with regards to Block 5 and highlight its increased value. I also wouldn’t rule out strategic talks with other players. Its an open secret that Vaalco has evaluated potential mergers in the past year. Vaalco is an offshore driller with a $400 million market cap and its’ really too small over the long haul to continue to build up drilling opportunities without taking risks too large for any one dry hole to sink the company – if it had to fund Loengo by itself it would cost 25% of Vaalco’s cash position. I wouldn’t be surprised based upon the potential size of Loengo and other Block 5 prospects for these talks to turn to an outright sale of Vaalco.
At the current price of $7 and change the value here is too significant to ignore. I’m a buyer of the stock right here, right now, with what I see as a $1 and change of downside. If the Angola pre-salt opportunities continue to develop as the Cameia-1 has, with literally billions of barrels in extractable oil, this slice of West Africa may very well turn out to be the next Persian Gulf (as the decade long built out of Brazilian fields such as the Tupi discovery are rapidly turning out to be). If that is the case, small Vaalco would certainly be in play.
The bottom line here is that Cobalt Energy tacked on over 8 billion in market cap due to the overwhelming success of its Angola drilling to date. At a market cap 1/30th the size of Cobalt, Vaalco’s stock has a long ways to go if Loengo is successful. Over the past few trading days Vaalco has gone from $6 to $7. This train is leaving the station – count me on board.
At the time of publication of this report, I am long Vaalco Energy common stock
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