Dana Novakovic of LB Capital: Risks & Rewards of Caspian Exploration & Production

An M&A Energy Advisor’s perspective - The Oil Council's Drake Lawhead (DL) interviews Dana Novakovic (DN) of LB Capital.

DL: What does 2011 hold for Oil & Gas emerging markets M&A?

DN: Whilst most of our mandated work since 2009, through 2010, has been in Canada and North and West Africa, at the start of 2011 we see renewed interest, and opportunity to grow shareholder value, in the Caspian – places such as Kazakhstan, where the deal count has been limited and where most deals have been of a local or a private nature over the past 3 years. Only in January we accepted two mandates in the Caspian, a cross-border buy-side, and a sell-side in Kazakhstan. From a Macroeconomic perspective, according to projections put together by the IEA, Caspian oil and gas output will approximately double by 2030. Whilst the quickest output growth will come from Turkmenistan, the quickest growth in export quantities will still come from Kazakhstan, requiring that the country expands its oil export capacity from 1.5m bbl/d to as much as 3.5 m bbl/d. On the microeconomic level companies are carefully scrutinising technical, “soft” and financial consideration, and the risk envelope of the Caspian is recovering relative to the alternatives, as well.

DL: How is this affecting acquisition multiples and expected level of deal flow?

DN: Kazakhstan acquisition multiples have fallen significantly between 2007 and 2009, from its highest level of over ca. $5 per boe of 2P reserves between 2005 and 2007. This reflected not only the lack of acquisition finance since 2007, but also the changes in the risk envelope of the country. Whilst the bulk of renegotiations of the largest contracts such as the case with Karachaganak, may well be isolated and not spread to other large projects, a level of uncertainty remains, in particular, with respect to the export-tax regime and the local factors’ ambitions to increase its levels of ownership in the largest of the projects.
However, the risks associated with renegotiations of contracts have affected primarily the Majors involved in the largest projects, and small and medium size producers remain largely unaffected.

DL: So, are we to expect more activity in 2011?

DN: Following the decline in acquisition multiples, a number of sizable assets bearing low technical risk remain available at reasonable multiples. Some of these assets have effectively been on the market since 2009, and Kazakhstan is emerging from the credit crunch as an attractive place for small and medium size E&P acquirers seeking both value and growth. In fact, in the 1Q 2011, the total value of mainly producing assets on the market in Kazakhstan, formally mandated by sell-side advisors for, on average, over a year now, amount to in access of $1 billion. Now, the supply / demand curve is reaching that point where we see renewed interest by investors to result in a couple of reasonably sized transaction expected to close in February / March, as the “air pocket” between the seller’s expectations (pre credit crunch) and the acquirers’ ability to spend (post credit crunch) has diminished. A couple of these larger deals have been drawn out and reflect the sellers’ dissatisfaction in case of protracted processes involving Chinese potential acquirers. On a separate note, we also see a number of small cap explorers obtaining funding for higher-risk pure exploration drilling strategies.

DL: What seem to be the most opportunistic acquisition targets?

DN: It is indeed a bold proposition, but Cogito Ergo Sum: there is a case for a “roll-up” of a number of, especially, undervalued onshore properties in Western Kazakhstan, a proven hydrocarbon basin with existing infrastructure. This is a particularly fitting proposition for smaller and medium size acquirers because of the under-developed nature of the country’s smaller onshore resources of well known geologies, relative to the big bets (the likes of Kashagan) that Majors have focused on. Western Kazakhstan was well explored during the Soviet era, the data has been stored and has been successfully used by foreign companies operating there to focus and reduce costs of their 3D campaigns.

DL: Which on-shore prospects offer the highest upside?

DN: A number of onshore assets with substantial resources offer significant financial upside that will come from the conversion of resources into reserves in the next couple of years. These are assets at a stage where a small investment in development and external valuations of discoveries to confirm reserves is required in order to satisfy creditors and raise future development capital. Whilst, such situations would usually be positioned in the upper right hand corner of the risk / reward matrix, the known character of the local geology and low technical risks, have already allowed for such strategies to obtain financing over the past two years.

We are looking at a number of portfolios where 3D seismic has been applied to the proven hydrocarbon basin, actively de-risking portfolios of low-risk, low-upfront-expenditure prospects with substantial production upside. Rolling up a number of smaller assets of this description would allow a larger acquirer to participate in several licences and diversify exploration risks for investors, in order to obtain a premium over the typical one-asset risk situations of smaller exploration plays, which is the case with most Caspian plays that are publicly traded.

DL: What about producing assets?

DN: The universe of acquisition targets for larger acquirers is case-book, as well. All Kazakhstan-based E&P players fall, quite neatly, into 3 categories: exploration plays, growing early producers and mature producers. When it comes to production,companies operating in Kazakhstan sell approximately 20% of oil in the local market at ca.50% of Brent, and export about 80% of produced oil. Barrel sold in Kazakhstan is less profitable than exported barrel but still much more profitable than, for example, Russian barrel. This is also why oil prospects in Kazakhstan are safer bets relative to gas prospects; whilst gas producers face uncertainty related gas pricing, as well as gas transportation and processing, oil producers, on the other hand, enjoy clear and stable export price that equals Brent minus a predictable discount that depends on transportation cost from the point of sale to Europe and quality of crude. Also, most producing assets and companies in Kazakhstan have substantial resources that have not migrated to reserves yet offer substantial exploration and development upside. In conclusion, we do see value for investors in a few carefully selected oil assets higher up the development curve here, as well.

Dana is Managing Director at LB Capital Limited. Prior to LBC, she was Corporate Director M&A Energy at ABN Amro and Associate Director M&A Energy at UBS Investment Bank in London. She joined UBS Investment Bank in 2004 after working at Lehman Brothers M&A Energy and McKinsey & Company’s Petroleum Practice in London and New York. Dana holds an MBA with concentrations in Finance and Accounting from the William E. Simon Business School, University of Rochester, Rochester, New York.