Harvesting Venezuelan Oil – The Bull Case for HNR
(April 4th, 2012) With crude sitting at $105 and change, oil & gas exploration companies with undervalued prospects have been all the rage. Therefore, its not often you find the stock of an oil company in the midst of an M&A transaction sitting squarely in the 50% off bin. Yet that is exactly the case with Harvest Natural Resources (NYSE: HNR).
Harvest is an independant energy company with exploration programs in Oman, Indonesia & Gabon. While those projects may or may not pan out, Harvest has the vast majority of its existing capital tied up in a 32% stake of PetroDelta, a large Venezuelan oil producer currently pumping out over 31,000 barrels a day near the prolific Orinoco / Faja heavy oil belt (The Venezuelan government indirectly owns a majority 60% stake).
On March 6th of this year Harvest dropped a bombshell : A few days earlier it had entered into exclusive negotiations with a third party for the sale of Harvest’s entire stake in PetroDelta. The most recent audited, present value analysis of the proved plus probable oil reserves at PetroDelta puts the value at over $1.05 billion. Throw in the possible (3P) reserves – in the Orinoco belt possible oil reserves are almost always bankable – and you get an additional $860 million of value.
With approximately 37 and a half million shares outstanding (adjusted for a recent debt conversion) and the stock changing hands for $6 an change, something is clearly amiss. The market price is telling you that either (a) management is on the verge of selling PetroDelta at a price far far less than its intrinsic value, or (b) chances of any sale are slim to none given the Venezuelan’s propensity towards injuring its’ US-based oil investors.
It’s my belief that both risks are extremely overblown, and that a rational investor will rejoice at the opportunity to participate in the extreme upside / limited downside that currently exists in the common stock of HNR. In fact, if I’m right about this, Harvest’s stock could easily double in a short period of time as a possible sale moves forward. Here’s why :
The History of PetroDelta
The story of how this US-listed small-cap oil company got into bed with the Venezuelan national oil company PDVSA is a fascinating one and worth, for the uninitiated, reviewing . Harvest has been operating in Venezuela since 1992, when it signed a 20 year operating agreement with an affiliate of PDVSA to develop the Uracoa, Tucupita and Bombal fields. These three Orinoco belt fields were developed from 1937 through 1962 and abandoned in 1987 (when oil prices averaged $17.75 a barrel). Harvest’s pitch to the Venezuelans – let us come in with American technology and know how, and get the cost of the production down and throughout up such that the fields could be produced at a profit. The pitch was persuasive; or else at an average crude price of $19.25 ($31 in inflation adjusted dollars) that year there wasn’t much competition. Either way, Harvest ended up becoming the first American company since 1976 to be granted an oil field development contract in Venezuela.
The agreement called for the Venezuelan government to maintain full ownership of all hydrocarbons in the fields, as well as the equipment and capital infrastructure. Harvest received an operating fee for each barrel of crude oil delivered, as well as getting reimbursed for most of its capital expenditures.
Things worked well for a decade. When oil prices jumped 50% from 2002 – 2004 (going from an average of $22.81 to $37.66) Harvest’s stock price jumped from around $4 to over $15 as oil production from these once-barren fields gushed to 28,000 barrels a day. But with the rise to power of Hugo Chavez the good times were about to end.
In early 2005, PDVSA began to disapprove of Harvest’s capital budgets (PDVSA approval was a necessary component for all foreign operators in Venezuela looking to recoup their expenditures exclusive of the operating fee). At first this was odd to Harvest given the success they had in increasing production. Without certainty on what to spend in drilling new wells, Harvest’s production naturally declined over the year to 22,000 barrels a day.
It seemed very odd that the Venezuelans would want to throw a moneky wrench into production that generated substantial revenues for the government. But within months, it became perfectly clear what Chavez was up to – namely to nationalize the industry and whack the ‘obscene’ (in Socialist-speak) profits being generated by American gringos.
PDVSA proposed that, in place of the existing operating agreement, the three fields would be placed into a joint operating company (“JV”) to be owned 60% by PDVSA. Harvest would need to completely waive its operating fee, and instead be compensated through dividends declared by the JV. Along with bumping up the local income taxes from 34% to 50% (applied retroactively for a number of years!) the net effect was to steal a significant percentage of the net present value of the Uracoa, Tucupita and Bombal fields in the name of the Venezuelan people.
Under threats to have all three fields taken away unilaterally, Harvest attempted to hammer out an operating agreement for the new JV (ultimately named PetroDelta) while in a parallel action threatening to litigate the ‘theft’ of its existing license in international court. Harvest spent much of 2005 & 2006 threatening such litigation while hammering out an improvement to the structure of PetroDelta that would partially compensate Harvest for its losses in the nationalization.
Harvest wasn’t the only company effected by this nationalization attempt. Eighteen other international oil companies operating in Venezuela were given the same ultimatum. Exxon and Conoco balked at the terms, sued in international court (Exxon alone demanded $12 billion; after a 5 year legal slugfest they were recently awarded a paltry $255m, retroactively validating the decision by the management of Harvest to negotiate a better JV agreement in the first place) while the rest knuckled under and signed new agreements converting old operating service agreements to new majority PDVSA-owned mixed operating JVs.
After an extended set of negotiations, which included the intervention of the Venezuelan ambassador to the United States, the Venezuelan Ministry of Energy and Petroleum (“MEP”) offered up a sweetener to Harvest in exchange for voluntarily agreeing to contribute its rights to operate the three fields to the newly-formed PetroDelta. MEP agreed to transfer to PetroDelta the exclusive rights to three new oil fields, the Isleño, Temblador and El Salto fields (A link to a useful map of the fields can be found here). These new fields were located in the same geographic area as the first three and seem to share the same geology and productive formations. Also like the first three, Isleño, Temblador and El Salto had undergone minimal development in the past and would require Harvest’s expertise to develop a drilling program suitable for its’ particular geology.
In September 2007 Harvest and Venezuelan government signed all the necessary agreements and PetroDelta came into being. So in short, while Harvest gave up a lucrative cash flow business from operating its existing 3 fields, the company played ball with the nationalist crowd in Venezuela and picked up a 32% interest in 3 additional fields for its trouble.
PetroDelta ended 2007 producing 13,100/bopd due to the lack of capital investment over the prior two years. With Harvest back in charge and on the ground agressively drilling new wells, production steadily increased to 20,000/bopd in 2008. More importantly, Harvest drilled its first two wells in the Temblador Field (one of the three additional fields granted to PetroDelta) and both initially produced (“IP”) in excess of 2,000 bopd. Clearly Harvest had chosen its new fields well.
With the increase in production, relations with PDVSA improved. The Board of PetroDelta began declaring dividends of its’ excess cash (there was enough profit at existing oil prices for PetroDelta to internally fund its drilling program with excess cash flow) and by 2010 production inched up to 24,000 bopd while the Proved reserves (“P1”) net to Harvest in Venezuela increased to 50.0 MMBOE and Probable reserves (“P2”) climbed to 103.6 MMBOE. On a net present value pre-tax, proved plus probable reserves had an audited value (discounted at 10%) of over $2.3 billion dollars.
In 2011 production at PetroDelta continued to improve; however relations with PDVSA turned cold. In April the Venezuelan government approved a new round of ‘windfall’ taxes. The tax on revenue was pegged to the price of oil, and called for companies operating in Venezuela to hand over 80% of revenue above$70/bbl, 90% when prices rise above $90, and 95% above $100/bbl. This confiscatory policy had the effect pitching the excess acash flow necessary to both pay dividends and fund a robust drilling program. Opting for the latter, PDVSA declined to pay Harvest its’ share of previously stated dividends and diverted what cash it could to a 2-drilling rig program with 2 more coming on in late 2011. In spite of the financial difficulties, the fields continue to outperform, and both Temblador and El Salto saw new wells IP at approx. 3,200 BOPD; these were the highest IP rates recorded by Harvest since the beginning of the 2008 drilling program. But without access to its profits, Harvest shares tumbled, eventually bottoming out at $6 and change in Dec ’11 / Jan ’12.
Throughout the Chavez-induced difficulties Harvest has gone through, there has been a number of opportunistic buyers that approached the company regarding a bid for PetroDelta. Management has stated numerous times that the PetroDelta asset has significant value and would not be sold in a “fire-side” sale. These comments were not made without good reason; according to one source of mine, some time last year a Canadian firm made an informal offer in the mid-200 million dollar range for the asset only to be rebuffed by management without further discussion.
Harvest’s Other Assets
PetroDelta is the crown jewel of Harvest, but it does own a slate of international development projects. In the last 12 months Harvest has turned up disappointing drilling results in Oman and Indonesia. However, Harvest does own a 66.667% of an offshore block in Gabon, called the Dussafu PSC. The Dussafu is located in a few hundred feet of water, and is South East of the well known Etame field, operated with much success by Little Bear favorite Vaalco Energy (NYSE: EGY).
Appraisal well activity, completed in 2011, has shown positive results. To date Harvest has made three oil discoveries in the block, totalling an estimated (gross unrisked) 26 million barrels of oil. While nowhere near the opportunity of other off-shore African finds, this block does has significant value. Pritchard E&P analyst John Abbott, whom I think does the best work on this name, pegged the value of the Dussafu PSC at $3/share. Given that the structures of the three finds are direct analogues to the existing Vaalco Etame production its a good bet that value exists.
Harvest recently sold a large portfolio of US assets and paid down virtually all its’ debt with the proceeds. After doing so Harvest has approximately $1.50/share in cash, after adjusting for ongoing overhead and existing payables.
Who Would Want to Buy INTO Venezuelan Oil?
The market is clearly skeptical that Harvest could find a buyer with the necessary patience, never mind deep pockets, to take a 9 figure gamble on buying a minority stake in a Venezuelan oil company in the grips of Chavez’ socialist-stealing hoodlums. Under normal circumstances, no large cap oil company would throw its shareholder’s wealth at such a gamble. But there is one set of buyers eager to do business with Chavez : the Chinese.
Pushed into locking up oil supplies worldwide to feed a domestic demand for crude that has already topped 10 million barrels a day, China has spent a good part of the last decade investing large sums of money abroad in emerging oil fields. China’s strategy can be summed up rather simply – find cash poor, resource rich countries on the outs with the West, preferably those with autocratic govenments, and offer cash on the barrel in exchange for long term supply agreements. China agrees to turn a blind eye to any human rights ‘issues’, couldn’t care less how onerous the socialist tax regime is, and doesn’t worry about any anti-bribery niceties such as the US’ Foreign Corrupt Practices Act. The number one goal is to secure long term access to oil, preferably in places that the West can’t interfere with.
China has pulled off its oil land grab with remarkable success. The results have been most spectacular in five countries where Chinese state-owned firms deployed the majority of their cash : Sudan, Kazakhstan, Angola, Iran, and of course, Venezuela. (A full review of the Chinese invstment in the overseas energy industry is beyond the scope of this article. If the reader is interested in exploring this admittedly fascinating subject, the easiest and best way to go about it is to read this 52 page report by the IEA written in February of last year.)
In the past two years, Chinese state-owned companies have signed in excess of $14 billion in various development and long-term purchasing deals with PDVSA affiliated entities. It’s not as if the Venezuelans had much of a choice; the existing operators are loathe to commit additional capital to a country that steals, uh, taxes 80-90% of your revenue. Without new investment, existing wells mature and decline, and as such overall production has been declining over the past few years to where current output is around 2 million barrels a day. For a country estimated to possess anywhere from 100 billion to 900 billion barrels of oil this is nothing short of an embarrassment.
In my discussions with a number of industry contacts close to the situation both inside Venezuela and in the US, the two oil companies most frequently bandied about as being the likely acquiror for PetroDelta are Sinopec and CNOOC. Both oil companies are significantly state-owned and have invested tens of billions of dollars in securing oil deposits overseas. Just recently Sinopec agreed to invest billions to develop the Orinoco Junin 1 and Junin 8 blocks, which could each produce up to 200,000 barrels a day of crude. CNOOC has also been active, signing a number of joint venture agreements with PDVSA to develop various new fields within the Orinoco belt. At every turn, officials at PDVSA and both Chinese companies have made it clear that existing deals are only the beginning as all parties intend to work even more closely developing the multi-billion barrel opportunities that abound in the Orinoco.
What is PetroDelta REALLY Worth to the Chinese?
A number of analysts I spoke to who follow Harvest say that the convential wisdom amounst oil & gas investors is that Harvest could reap $200-$300 million in any sale. Most observors of Harvest get this number by looking solely at the 1P value – namely the proven oil reserves from wells already in production, and ignore everything else. Harvest has 38.6 million barrels of proven oil attributable to its share of PetroDelta and at $6-7 per barrel you get a 200-300 million dollar range. Even the bulls at this point would be happy with such proceeds, as the entire market capitalization of Harvest is under $300 million – and that’s before adding in the value of Gabon and existing cash reserves.
I think its highly unlikely management would go through the legnthy process of selling an asset it has developed over 20 years for solely its 1P value. In fact, in a telling exchange I had with James Edmiston, CEO of Harvest, on the latest conference call March 15th, he said exactly that (a link to the transcript can be found here)
Zachary Prensky : I think what would be helpful, (…)
is to give us a little more color as to what metric
you find the most compellinginternally as you strike your own
valuation on the Petrodelta asset.What I mean is, (you said) there will
be no fire sale of the asset (….) But as you define
a fireside sale, what is the single-most important metric
that you look at, at valuing it, and then comparing your own internal
valuation to what you would accept in the sale process?
James Edmiston : What I can point to, though, what I’m allowed to point to are
things like the reserve report where the after-tax PV-10 in the reserve report this year
for the 2 PKs is a little over $1 billion for the one, a little over $1 billion.
So it’s a pretty big chunk of money.The other thing you can point to is just
classical metrics, I guess. I mean, in the last year I believe Steve pointed
out we had $57.7 million in earnings from Petrodelta at the Petrodelta level.
So, you’d have to tell me what’s the appropriate multiple
for a business that grew at 33%, that has a reserve-to-production
ratio of well in excess of 20 (…) to well in excess of 30 if you count the 2P…
So there’s a broad range of metrics you can throw at this thing and obviously
we have our own internal view (…)
I’ll be honest with you, I don’t think anybody in our business is trading
on a 1P metric in the first place I know the analysts like to use
1P, and they show it as a metric, but as a buyer and
a seller of assets, I can’t — nobody does that.
I think it’s clear from the above exchange that management would never have entered into exclusive negotiations to sell PetroDelta if it didn’t have a range of values closer to the $1.1 billion dollar after-tax PV10 reserve value. Of course they know that the onerous tax regime in Venezuela makes such reserves less valuable. The flip side to that is that the confiscatory tax policy have made it increasingly difficult for anyone without a side deal with Chavez to justify investing fresh capital into drilling wells and growing production. Chavez will not live forever, and if his well-publicised recurring bouts cancer take a turn for the worse then his abilities to steal oil revenue over the long term are limited. PV10 reserve valautions take into acccount a decade or more of production – its important to note that less than 10% of PetroDelta’s six fields have been developed. Put another way, there are thousands of potential low-risk drilling oppotunities to be developed in the coming decades at PetroDelta – fields like these are the ultimate in long lived assets. Its a virtual certainty that at some point in its’ development PetroDelta’s owners will be paying less in confiscatory taxes than it is now (and again, important to note, even with the existing taxes PetroDelta is fully funded in its existing, admittedly low, capital development plan).
My contacts I’ve reached out to say that James Edmiston would take a number around 50% of the PV-10, or a range of $450-$600 million. Before you laugh, remember that such a price tag gives zero value to the 3P, or possible reserves, currently pegged at over 100 millions barrels of oil. And one thing we know about the Orinoco is that possible reserves have a funny habit of becoming probable reserves (remember that at one point not to long ago all six fields were abandoned and thought to be non-commercially relevant)
In fact, you could make the argument that the Chinese have additional non-commercial reasons for locking down PetroDelta, namely to secure long term oil supplies, and they would be more inclined to pay a number closer to PV-10 just for the exclusive rights to buy the oil. But I don’t think you need to get there to come to the conclusion that the Chinese would gladly pay $500 million, 50% of PV-10, 25% of P3, in order to own this underdeveloped asset.
What Would a Sale of PetroDelta Look Like?
As I discussed earlier, Harvest needed to get its’ shareholders to approve the original deal with PDVSA that formed PetroDelta, and under any sale agreement would have to likewise proxy its shareholders for approval to sell the asset. Under its’ agreement with PDVSA (which you can read as part of Harvest’s 2006 proxy, located here. The relevant section is located on page 40) Harvest has the right to solicit offers for its’ ownership stake in PetroDelta. PDVSA has a 30-day right of first refusal, after which Harvest has 180 days to close the sale.
People have a long memory down in Venezuela, and I’m sure there’s more than a few people who remember how Harvest outmaneuvered PDVSA in getting the Isleño, Temblador and El Salto fields thrown into the PetroDelta JV. I am assuming the socialists in power will want to let the door hit Harvest on the way out, and threatening behind the scenes to drag out any potential deal with the right of first refusal is the best way to go about it. You can be sure any sale will include the obligatory payoff to those in power, most likely by shaving off 10-20 million in the purchase price, with said funds finding there way back into the right pockets. But ultimately its all about dollars and cents; the Chinese have it in spades, and the Venezuelans don’t.
Both the Venezuelan government and PDVSA in particular have been perenially short of funds. Government bond yields are some of the highest in the world outside of Greece (although, interestingly enough, Venezuelan bond prices have recently rallied sharply- is the market sending a signal as to the results of the upcoming elections?). Chavez’s socialism has led to significant budget deficits which have been filled with more and more petrodollars being skimmed off the top of PDVSA and its’ local operators. In recent years the Chinese have offered to fill part of the funding gap by structuring loans-for-oil (again, more deeply discussed in the abovementioned IEA paper, see page 12 in particular). Again, my contacts have led me to believe that any deal to sell Harvest’s stake to a Chinese firm will come alongside additional capital injections into either PDVSA or PetroDelta itself using some variant of loans-for-oil. Some of the additional cash will most likely find its way into increasing the existing 4 rig development crew into a world class drilling plan more appropriate for a set of fields that can easily produce 40, 50 or 60 thousand barrels a day.
However the Chinese and the Venezuelans cut their deal, its clear they both need each other. And absent Chavez out and out stealing Harvest’s stake in PetroDelta, there’s not much to do except pay Harvest off. (One important note is that while Chavez has nationalized the oil industry, anyone who has gone along with the plan and agreed to operate under the rubric of a 60% PDVSA owned joint venture company has been allowed to continue unimpeaded. And why not? Between PDVSA’s cut and the windfall taxes the government ends up with the vast majority of the revenue. Why steal 100 cents when your oil ‘partners’ hand over 85 cents voluntarily?)
In short, if Harvest was going to sell out at the bottom, they would’ve taken one of the lowball offers pitched to them over the past two years. My best guess is that a deal will be worked out as a three way agreement, whereby PDVSA waives its rights of first refusal (Given how strapped they are by the windfall taxes, PDVSA has had difficulties in even paying its vendors) in exchange for the Chinese agreeing to either lend or invest cash to grow production and help PDVSA out with its’ bills. After all, if the Chinese are able to front a few billion dollars in what is essentially pre-paid oil deliveries why shouldn’t the Venzuelan government be pleased to have them as the new owners of Harvest’s minority stake in PetroDelta?
What If I’m Wrong?
Making a binary event bet is always fraught with risk. While my contacts on the ground are optimistic a sale goes through, there is no guarantee of any successful conclusion. In a situation like this, both the risk must be worth the reward and the downside must be limited. I believe both are true in this case.
On the upside equation, again I would refer the reader to John Abbot’s work on Harvest. (Pritchard Capital is a dedicated O&G shop, and in my experience has had a lot of success in covering these names. If you work at a hedge fund, trade and/or invest in the energy space, and don’t have a relationship with Pritchard you are doing yourself a disservice!) In his updated model published on March 19th he gets to approximately 50% of the $1 billion after tax PV-10 for the P1 and P2 reserves – or $15 a share before ascribing any value to the Gabon assets – and as I’ve described above that’s around where I expect management to be a willing seller.
On the downside, if a sale ultimately falls through its hard to see Harvest’s stock going much lower. Remember that Harvest will still own 32% of PetroDelta, and the fortunes of that investment can only improve if either Chavez’ cancer gets worse, or if the market perceives that he will lose the upcoming October 2012 elections. All the opposition parties have rallied around one candidate, former Governor Henrique Capriles Radonski. While I am no expert in Venezuelan politics, when Chavez-friendly outlets such as Pravda admit he may lose the election the race is tighter than it seems on the surface (Also worth noting that Chavez’s Anti-Semitic smears smack as a bit desperate given that Capriles is a highly noted, rosary-wearing Catholic, who headed straight to a Catholic shrine to give thanks after winning the Presidential primaries). And lastly, voters can’t be amused that Chavez seems to fly off to Cuba every other week for radiation treatments – not the best confidence in a leader you are electing to a new six year term.
So, in a way, Harvest is a low-cost option on the future of Chavez. Its clear from the out-of-control violence to the punishing inflation, Venezuela is a Latin America country falling apart with only the cult-of-personality that Chavez maintains keeping his socialistic vision in power. Like taxes, death is certain to end his reign. With PetroDelta self-funding itself in spite of the windfall taxes, and 90% of its’ acrage still undeveloped, the smart money says that its’ Orinoco oil will still be pumping long after Chavez’s heart isn’t. Therefore, I don’t see much downside from here – actually a case could be made that shareholders are better off if the sale falls apart in a few months if Chavez’s numbers in the polls continue to underwhelm.
As someone who focuses most of my time seeking out binary events where the payoff is skewed, I cannot find too many opportunities better than Harvest Natural Resources. I believe the recet weakness in the stock is due to (a) skepticism over Venezuelan politics allowing for a sale of the asset; (b) doubt over management’s resolve at not accepting a low-ball bid; (c) selling from recent holders of the convertible bonds (the company recently saw a $16m tranche of convertible debt exchanged for approx. 3,000,000 shares at $5.56/share, a low enough price to incentivize those sellers to hit the bid); (d) worries over a recent ATM shelf filing (which cannot be sold into the market currently due to the continuing blackout period surrounding the sale process) which, according to a contact of mine that spoke recently to the company, was put in place to give the company financial flexibility should the sale talks collapse.
None of the reasons, in my opinion, for the relative weakness in the stock price, are indicative of the relative merits of a sale of PetroDelta happening. In my mind, the inherent value of this asset is too great for all parties not to find a way forward. For a management team that has operated in Venezuela for over 20 years I simply cannot believe that they are taking a flyer on feeling out a lukewarm buyer. While I certainly do not know anything more than the market does, all my conversations with people heavily involved in the Venezuelan energy sector lead me to believe the talks are for real. And therefore, this is one special situation worth taking a bold gamble on.
At the time of publication of this research, I am long shares of Harvest Natural Resources, Inc. (“HNR”)