Encore Oil Presentation: Update and Analysis

Introduction

Encore Oil (LON:EO.) is a UK North Sea focussed E&P company. After a successful discovery and disposal of the Breagh field, it is cash rich and now seeks to appraise and monetise its remaining assets before returning value to its investors.

Encore recently held a meeting for private investors. I applaud the company for arranging this and thank Alan Booth, Encore’s CEO, and Yvonne Fraser for their time and effort. The presentation given to PIs has been published on Encore’s website and I refer to slides from the presentation in my commentary below.

 

Executive Summary

The detailed discussion & analysis which follows will show that Encore at its current share price below 17p represents an attractive risk/reward for the investor. The “Analysis” section below shows that a “worst case” scenario leads to a return of at least 15p of value to the investor (i.e. downside of 2p on a two-year view), with possible additional upside of 30p+.

Some investors may have formed a negative impression from the presentation given by Encore, simply because there IS considerable uncertainty about the direction the company will take, which depends on near-term drilling results. Alan Booth was also at pains to stress the difficult environment that North Sea operators face at present. However, these negative factors do not negate the excellent risk/reward that I believe Encore offers and that risk/reward fully accounts for them.

In the sections that follow I explain:

• My understanding of the purpose of the meeting
• The dilemma Encore faces in putting its case across to investors
• My understanding of Encore’s strategy
• The impact of current North Sea market conditions on Encore’s strategy
• Details of how I believe Encore will proceed
• Implementation of Encore’s share buyback programme
• Encore’s track record and that of its management
• An analysis & valuation of the company

Purpose of the Meeting

Encore has had to adapt its strategy to meet changing market circumstances, as I shall explain below. This has caused some confusion amongst investors. The purpose of the meeting was to highlight for investors how the market environment was impacting Encore’s decision making and likely outcomes.

Encore’s Dilemma

It is difficult for Encore to explain its situation to investors without disclosing market sensitive information or generating expectations that may not be met. I felt that Alan Booth was scrupulous in not doing so and also in not speculating in unknowables, e.g. the outcome of a well. It is up to investors to digest the information that is in the public domain, listen to AB’s statements about what Encore will and won’t do and draw their own conclusions. Judging by some posts I have seen on bulletin boards by other attendees, some may have interpreted this rather negatively. I do not think that this is the correct interpretation, as I will try to explain below.

 The following commentary is based on the presentation, Q&A session and speaking to AB afterwards.

Strategy

As in all previous Encore presentations that I have attended, the company’s core strategy (slide 3) remains unchanged: “Create value through Exploration and Appraisal activity” and then monetise assets when adequately appraised. How will value ultimately be returned to shareholders? This is an area that I felt there was considerable confusion about. One option that is open is that Encore could be acquired. The other option that the company has mentioned is “capital reconstruction”. Alan went to great pains to emphasise that a simple dividend payout would be highly tax-inefficient for some investors (a higher rate taxpayer could end up paying 40% tax on any dividend returned) and hence would not be done. Clearly, however, the subsequent change in government and taxation may cause tax planning issues to be revisited in due course

I have been in this situation, as an investor, a number of times before, notably with Galahad Gold and with Fayrewood. Both of these companies converted their assets into cash and then sought to return the cash to investors. Having taken extensive tax advice they adopted various tactics to do so. One tactic was to make a tender offer for shares at a price close to the underlying asset value. Another one was to create multiple classes of shares and giving shareholders the option of choosing which class they wanted. One class would result in the investor receiving a simple cash dividend, which might be appropriate for investors with little income tax liability; another class would result in a capital gain, for those investors who’s tax treatment is more favourable under the capital gains tax regime. This is what is meant by a “capital reconstruction”. I would also observe that in the cases of Galahad & Fayrewood the shares traded at a discount to asset value until the market had understood the details of the capital reconstruction, which yielded a nice opportunity for profit!

Consequences of Current Market Conditions

To a large extent, Encore’s strategy is dictated by the market conditions in the North Sea as described in slide 20. Another factor affecting major players’ attitude to NS developments is abandonment liabilities. At present no-one believes that they will actually get tax relief on those liabilities. This may have come across as particularly negative to attendees but is a realistic appraisal of how market conditions have evolved since before Encore’s inception, and helps explain the company’s strategy going forward. Summing it up, it means that it is not particularly attractive to embark on new North Sea exploration programmes, unless they offer an exceptional risk/reward ratio. Alan also stated the company’s expertise was chiefly in that region and offshore Northern Europe, so did not intend to seek to grow geographically.

As a consequence, Alan confirmed that Encore will NOT expend significant cash on high risk exploration. He also stressed firmly that, whilst several companies have expressed an interest, Encore is only interested in partnering with other well-funded businesses, not those that have weak balance sheets and need “rescuing”. That does not rule out spending cash to properly appraise discoveries. Note the comments on slide 23:

We will actively seek opportunities to grow and add value in the current capital constrained market: but not at any price or in any extended timeframe

If no suitable opportunities to grow or add value present themselves, return cash/assets to shareholders – efficiently.

We can see from the foregoing discussion that the recent change of government and consequent policy decisions may have a significant impact on the value of Encore’s assets –especially decisions regarding taxation. Only once policy decisions affecting the North Sea oil industry have been published can we know what this impact is.

Way Forward

 There are a number of strands to Encore’s progress from here: 

• Catcher & Cladhan
• Gas Storage
• Other prospects

These are discussed in more depth in the following.

Catcher & Cladhan

Within the next few months the Catcher & Cladhan prospects are being drilled (Catcher has, in fact, spudded a few days ago ). They each have the potential to add significantly to the value of Encore’s assets. In the case of Catcher, Encore is free carried. Cladhan’s cost to Encore is estimated at £1.9m if unsuccessful. Costs will be higher if testing is required and if it is decided to sidetrack the well – but clearly shareholders will not be objecting if the well confirms (as expected) that Cladhan is a commercial asset. What happens next will depend very much on the results of that drilling. If successful it can be expected that further appraisal drilling may be required to achieve best value from monetising the assets. See also the “Analysis” section below for further details of these prospects.

Gas Storage

Whilst marketing is underway, Slide 11 indicates that no result can be expected before mid year at the earliest. Discussions during and after the meeting indicated that it may be difficult to attract interest whilst UK gas prices remain depressed, which makes the economics of a large gas storage project much less attractive. The most important criterion for a gas storage project is “deliverability” – i.e. the rate at which a storage facility can be discharged and recharged, rather than absolute size.  A commonly held view at present is that there is and will continue to be a “gas glut”. See, for example http://online.wsj.com/article/SB10001424052748704830404575200550342671176.html?mod=WSJ_Markets_section_Commodities

Improved technology has led to a glut of gas supply from onshore shale-rock formations, and many shale-gas leases require producers to drill within a certain time frame to keep the acreage.

However, there are authoritative commentators who disagree: http://www.theglobeandmail.com/globe-investor/a-contrarian-makes-another-call-this-time-natural-gas/article1538686/ 

“Everyone thinks [shale gas] is going to solve all of our problems. There are very optimistic estimates about the economically recoverable volumes of gas from this new resource,” he said in an interview last week…

“That's dominating everyone's views about the gas supply picture – that we're going to be flooded with gas.”

The reality, he argues, is that shale gas deposits are a tiny part of the North American production pool – and they are already depleting fast.

Mr. Groppe says that while the average depletion rate in conventional gas wells is about 25 per cent (in other words, if you didn't drill at all for new wells, production would decline by a quarter each year), shale gas shows even more rapid depletion – output tumbles, on average, 45 per cent in the first year for shale wells.

Drilling of shale plays has recovered rapidly from the slowdown during the recession – indeed, the count of active horizontal drill rigs in the United States has ramped up to record levels – which, because of the high initial production volumes that are characteristic of shale wells, has flooded the market with supplies and fuelled expectations of continued rapid growth. But given Mr. Groppe's depletion numbers, the high drilling pace may also be serving to drain the resource in the major shale pools even faster than they would otherwise.

As for the shorter-term supply picture, Mr. Groppe notes that for all that horizontal drilling frenzy, shale gas accounts for just 6 per cent of U.S. natural gas production.

In the other 94 per cent – conventional gas – the rig count is 70 per cent below the pre-financial-crisis levels of September, 2008, as low prices and high inventory levels have convinced producers to keep drills idled…

OK, this is US gas but it was only because the US didn’t require the previously anticipated amount of LNG that it was possible for UK prices to be held low and cope (albeit with restrictions on industrial users) during the gas supply crisis of last winter, with plentiful LNG cargoes being available. If gas prices rebound over the next year or two, there might be considerably more interest in gas storage for the UK. To summarise: we are not likely to see a sudden massive interest in Encore’s Esmond reservoir, however the resource may have value in the fullness of time.

Other Prospects

Alan discussed Encore’s other prospects - Slide 13 shows the “Cobra” and “Python” prospects in the geographical context f the Babbage field, being brought on stream within the next few months, and Dana Petroleum Plc (LON:DNX) ‘s recent Platypus discovery. Subject to geology, a joint field development could make these assets more economically attractive. The problem with Cobra, as slide 12 shows, is that significant further CAPEX would be required to determine whether the discovery can be made to flow at commercial rates. Hence, as can be seen from slide 17, it appears at present that the best way to safely add value for Encore shareholders would be to sell or trade the asset, as and when possible. Given the fit with Platypus and Babbage, Dana is the obvious potential buyer.

For the first time, to my memory, Alan discussed the Tudor Rose and Buffalo prospects at some length, see slides 14 and 15. Previous drilling and seismic have established substantial oil in place at Tudor Rose, but it is heavy oil. The next step in commercialisation would be to establish how heavy and how viscous the oil is. Current data is not clear on these points. Drilling the field to establish this data is likely to cost £10-12m. It is notable that Nautical Petroleum (LON:NPE) , the heavy oil “specialist”, are currently 20% partners on this. Per slide 17, Encore is seeking to farm-down its interest further, so as to reduce capital commitment to a moderately high-risk venture. A decision needs to be made by April 2011 which, if either, of these prospects to drill.

Buyback

In a conversation after the meeting, Alan clearly stated that buybacks would not be made at a share price above Encore’s per share cash value, irrespective of the per share value of Encore’s holding in Egdon Resources (LON:EDR) (see “Analysis” below for more on that). The purpose of the buyback was to provide any holders that wished to do so with an opportunity to exit at the current time at a price equivalent to cash realisations the company has made so far. In practice, few have taken advantage of this opportunity (aside from some Directors!). Encore is unwilling to leave “arms length” buyback instructions with brokers and wishes to approve all buybacks individually so will not be able to buyback during closed periods.

Track Record

As can be seen from the analysis below, Encore appears to me to offer excellent value – however, one’s view on this value will depend on one’s opinion of the track record of Encore’s management. The Board’s background & previous successes can be seen here. In relation to Encore itself, the company placed 112m shares @ 15.625p on AIM Admission in March 2006 . A further 29.17m shares were placed @ 24p in December 2006; 37m shares were issued in January 2007 to acquire 4 other oil & gas companies; and 34.72m shares were placed @ 36p/share in December 2007 – leading to a total of 305.97m shares in issue and £40.46m cash raised.  Since then, the company has monetised some assets (notably Breagh ) and used some of the proceeds to buyback shares. This has led to a present position of a cash balance of ~£43m; shares in Egdon currently worth ~£5m; various other assets as described above, and 290.24m shares in issue. 

Investors in the two post-IPO placings may be somewhat disappointed with Encore’s results so far. However, considering the rollercoaster ride in the North Sea business environment in the years since Encore’s formation, it could also be argued that Encore’s management has performed admirably, husbanding resources carefully and STILL being in a position to potentially generate substantial further returns for investors. It is only with the benefit of hindsight, when currently owned assets are realised, that we will know how well the business and its management has really performed.

Analysis & valuation

To place a value on Encore, we need to do a “sum of the parts” (SOTP) assessment of Encore’s components. These are: 

• Cash: £43m
• Egdon shares: £5m (at recent market values)
• LESS CAPEX & operating costs for 2010: £4m. This is a pessimistic figure in my view - actual expenditure should be less than this, unless Encore is successful with its drilling and further appraisal work is required, which would clearly add greater value than its cost.
• Catcher
• Cladhan
• Gas storage
• Misc assets

For simplicity, I will simply neglect the miscellanous assets, including Tudor Rose & Buffalo, as it is currently unclear whether it will be possible to monetise them. Similarly I will also neglect the gas storage asset, as it appears unlikely to me that it will be possible to monetise it in the near term – though it could have significant value on a longer term view. That leaves Catcher and Cladhan as the key assets that may add significantly to Encore’s valuation in the near term.

Catcher

A previous analyst valuation of the Catcher prospect has used a DCF value of $10.75/boe in late 2008. Given that this is an oil rather than a gas target US$10/bbl still seems like a reasonable working assumption (but will depend heavily on the CAPEX required to develop it). Encore have 15% and the size estimate for the prospect ranges from 11-30mmboe [ref] Premier Oil IMS, May 2010 http://fool.uk-wire.com/cgi-bin/articles/201005130700188261L.html [/ref] . So, if successful, valuations for Encore's share would range from $16.5m - $45m, equivalent to 3.8pps to 10.4pps (290.2m shares in issue [ref] Per note 11 of Encore’s Interim Results http://fool.uk-wire.com/cgi-bin/articles/201002041300016956G.html [/ref] ).

Cladhan

Alan has always been very cautious about putting figures on the potential scale of the Cladhan discovery. All he is prepared to say is that it could vary from “non-commercial” to “very large”. Just as with Soco directors’ reticence to put numbers on the TGD discovery, the truth is that until you’ve drilled & appraised the discovery any figures are just (educated) guesswork. 

However, there are some clues in this presentation from Sterling Resources (TSX:SLG, http://www.sterling-resources.com , Cladhan’s operator). Slide 18 quotes oil in place estimates ranging from 12mmbbls of P90 contingent resources to a P10 estimate of 76mmbbls contingent resources + 159mmls prospective resources. Just for fun, if we use a figure of 50% recoverable of P50 contingent + prospective OIP figures that gives gross recoverables of 45mmbls, giving Encore’s 16.6% share a scale of 7.5mmbbls oil. Using a valuation of US$15/bbl yields a per share value of 27p. Investors familiar with SOCO International (LON:SIA) 's TGD discovery may be interested to note that Cladhan is also believed to be a fan channel stratigraphic trap. It is also noteworthy that Cladhan is a relatively short distance from Dana’s Hudson development, opening up future joint development possibilities.

Summary

Adding up the SOTP, we get a total current value per share for Encore’s cash & Egdon shares of 16.5p. In a “worst case scenario”* this reduces to 15.2p after £4m of current year expenditure. There is exposure to potentially more than 37p of upside from Cladhan & Catcher alone, in an “optimistic” scenario. Being able to buy the shares in the market currently at below 17p, this appears to represent an excellent risk/reward with 2p of possible long-term downside vs 30p+ of possible upside. 

*The “worst case scenario” assumes that neither Catcher nor Cladhan is successful, that little is achieved from Encore’s other assets and that Encore DOES return the then remaining cash and Egdon shares to shareholders efficiently (which may still take some time). Obviously it does rely on the investor trusting Encore’s management to do this, as they have stated.