Max Petroleum (MXP) - could the Kazakhstan drilling prove transformational?

Max Petroleum is a stock that's been through some tough times. Back in 2007, it sacked the CEO, chief operating officer, and a number of other staff after a big scandal about staff share options [ref] The Times, 18 October 2007: http://business.timesonline.co.uk/tol/business/industry_sectors/natural_resources/article2681642.ece [/ref] .

And this year, its results showed the most horrible loss - some USD 113.9m - after it had to renegotiate its mezzanine finance from Macquarie Bank.

But look forward, and 2010 could be an exciting year for Max Petroleum. The company seems to have spent some of 2009 in newsflow hibernation, just data crunching away on its 3D seismic data, which is the oil company's equivalent of locking yourself in a darkened bedroom to play computer games. Except that at the end, you may get a pointer to a massive oil discovery, rather than a 'high score' screen.

Now all this data crunching and interpretation of 3D seismic data doesn't make great headlines but as Oilbarrel points out, it's crucial to the massive potential of the company. It should not only give MXP guidance on where to drill, but it will also deliver real leverage when MXP is negotiating with potential farm-in partners. With one well a month planned for 2010, the dearth of newsflow we've had over the past year is likely to change [ref] Oilbarrel, 15 December 2009: http://www.oilbarrel.com/nc/news/display_news/article/no-shortage-of-newsflow-expected-as-max-petroleum-readies-for-its-one-a-month-exploration-campaign-i/771.html [/ref] .

The interesting thing is that Max Petroleum's prospects in the Pre-Caspian basin have been surveyed before and are, indeed, highly productive; the massive Tengiz field is 40 km south of MXP's prospects. But this particular area has never before been surveyed using 3D seismic [ref] Investor presentation, December 2009: http://www.maxpetroleum.com/uploads/091214mxpdecember2009final.pdf [/ref] . So MXP is bringing a new technology to a proven productive basin - which can be a promising way to find oil.

The company has two main prospective areas, pre-salt and post-salt onshore Kazakhstan, in Blocks A and E, and also holds the licence for the producing Astrakhanskiy field.  It has been interpreting 5,240 square kilometres of 3D seismic (its licence area is 13,500 sq km) for this area, and has now identified a number of prospects and defined its near term drilling programme. Which given a success rate so far of 20 out of 27 wells [ref] Investor presentation [/ref] gives it a good chance of significantly increasing its resources base.

The whole pre-Caspian area has a huge salt layer dividing older and newer rocks. MXP's management believes all the oil comes from layers below the salt, but has migrated above the salt levels. It has examined the seismic data to identify migration pathways through which the oil could have travelled, and has focused its exploration on potential traps close to these pathways.

The geology is particularly convincing. The whole area is located on a huge underlying arch below the Devonian level; MXP's licence areas are located right at the top of the arch, a prospective position given that hydrocarbons tend to migrate upwards. There are at least five prospects of 100 mmbbl up to 500 mmbl each, with three different play types. There are 11 drillable prospects and 5 leads already.

The post-salt layer, closer to the surface, offers the nearer term prospect, since it is shallow, low cost and low risk. 12 shallow post-salt prospects will be drilled across blocks A and E - wells here should cost between USD 1.2 m and USD 1.7m, and the rig is already hired and in place. So with relatively low costs, the company plans to develop this prospect while retaining a 100% interest, and shareholders can look forward to some short term news flow.

Management believes there is a 90 percent chance of successful discoveries being made [ref] Interview with Michael Young, CEO: http://www.maxpetroleum.com/InterviewwithMichaelYoungVideo.aspx [/ref] , though it has been trying to manage analyst expectations by suggesting only 3 or 4 out of its 12 planned exploration wells will be commercial discoveries [ref] Oilbarrel [/ref] . These prospects range from 10-40 mmbbl each with a total 100 mmbbl proved and probable resource being targeted.

So assuming 4 discoveries are made - and that seems conservative - you're looking at 40 mmbbl minimum, and as much as 160 mmbbl maximum oil in the ground. At three bucks a barrel that would give you a USD 120m to USD 480m valuation unrisked - against the company's current £80m market cap (though you do of course have to allow for the increased level of debt). Given the company's success so far and the relatively low risk nature of these prospects, my back of the envelope assumption was about 50% probability giving a risked valuation of USD 60-240m. Yes, very, very back of envelope, I know! (For comparison, Fox Davies used a USD 1.5 / barrel price to value the whole company - but that includes the pre-salt which will be more expensive to develop, and therefore is less valuable 'in the ground'. It's not out of kilter with the mean valuation of players in the region.)

The pre-salt layers represent a completely different funding proposition and exploration risk. They're much more difficult and costly to drill - a well reaching the pre-salt level will cost USD 25m instead of USD 1.7m! - but any discovery in these layers could be extremely large.  This is where the real potential lies.

Because of the high cost of exploration, MXP will farm out its interest in the pre-salt, probably to 50%.  The company's aim is to get the exploration programme completely financed, so it expends no cash flow on the programme but retains a stake in the field. The company is already talking to a number of players and we may get a first announcement on farm-outs in the first quarter of this year.

As well as exploration assets, the company also has a producing field, Zhana Makat. Although revenues fell in 2009 owing to the lower oil price, it still produced USD 20.6m of revenue by the interim stage and is generating about USD 3.5m a month at the moment. That more than covers direct costs, though the company made a USD 2m loss after administrative expenses (but before the exceptional financing charges) in the first half.  

However the company does have about USD 50m cash burn on an annual basis (USD 25m capitalised exploration cost at the interims [ref] interim report p 15: http://www.maxpetroleum.com/uploads/091210-2009interimreport.pdf [/ref] ).
For a company that recently had to refinance at vast cost, Max Petroleum's funding position doesn't look too bad. It has managed to increase its borrowing limits from USD 50m to USD 80m, and postpone the payment of any principal till January 2011. So assuming it gets some cash payment for farm-ins this year, it shouldn't be in any trouble. Management also states that the cash flow from its producing field at Zhana Makat, together with further borrowings within its existing limit, will enable it to fully fund the 2010 pre-salt exploration programme.

The story sounds good. What about the valuation? Fox Davies have tackled this recently [ref] Fox-Davies Capital research note, November 2009: http://www.fox-davies.com/media/95340/mxpinitiatingcoveragenov2009.pdf [/ref] . For the post-salt prospects, which they give a 38% probability of success (which seems a bit on the mean side), the valuation comes out at 28.7p a share; for the more risky pre-salt prospects, which have only a 20% probability of success, a valuation of 28.7p a share based on five prospects at 350 mmbbl each.

Astrakhanskiy is only worth about USD 3m, but the company wants to sell this field anyway; and there is some risk to the title, apparently. The value of Astrakhanskiy pretty much offsets the value of the corporate debt. Knock off corporate costs and Fox-Davies reckons the company is worth 54p a share - against a current share price of 20p. The stock has recently bounced from a distressed looking 11p a share level (it has been lower, though).

To my mind, there remains one problem with this stock, of course, which is political risk. The key question is whether the apparent discount to its likely value in Max Petroleum's share price is already sufficiently reflecting any political uncertainty. Kazakhstan does seem to have been plotting a fairly sensible political course; for instance, when oil prices fell to a level at which its export tax made oil exports uneconomic, it repealed the tax but  not as quickly as the oil companies would have liked. And the other issue is that it's AIM listed, so it's not ISA-able.