Sterling Energy - No longer a busted flush?

By the end of last year Sterling was looking like a busted flush. The share price had fallen to a tenth of what it used to be, as the Chinguetti field - expected to be a shot in the arm - proved flawed, and the company's cash cow natural gas operations in the Gulf of Mexico were hit by falling gas prices.

Worse, Sterling had borrowed heavily to fund its exploration programmes. Because of the fall in gas prices, it was in breach of its agreements with the banks, and was living from one emergency refinancing to the next. Without funds, it couldn't progress its exploration projects, and was getting painted into a corner - having to farm out from a position of weakness. Since it was pretty obvious that the company was in a mess, no one was going to offer a decent price for a farm-in, either - which would mean shareholders got a stingy share of the real value of the prospects.

Sterling has both production and exploration interests, but the two portfolios are quite separate. It's increasing likely, though, that it will end up as a pure explorer, since Chinguetti could be winding down, and management has now put the US gas interests - which account for 77% of production revenue - up for sale. (Production fell 13% at the interim stage.)

Chinguetti, in Mauritania, was expected to be a major producer for Sterling, and a 2008 drilling programme was originally intended to double production. However, the field has seem a steep decline in production, with increasing water production in most wells;  production rates have fallen from 16,500 bo/d to 9,500. Chinguetti was meant to move on to Phase 3 next year, which should have increased production again, but with lower oil prices Phase 3 may not be economically viable - in which case the field could be abandoned as early as 2011. [ref] Interim results - http://www.sterlingenergyuk.com/uploads/sterlingenergyinterimresultsfinal23sept09_2_.pdf [/ref] Assuming the US interests have been sold by then, that would leave Sterling with no production at all - so it desperately needs to get its exploration programmes working, and that means financing some drilling. Which gets us back to that little problem of where the money is coming from.

Fortunately, if the company hasn't actually got a 'get out of jail free' card, at least the slightly easier credit conditions this year have enabled it to refinance properly. A £62.5m placing enabled it to secure a bank waiver till February 2011 [ref] placing and EGM http://www.sterlingenergyuk.com/uploads/circularaug09-placingandegm.pdf [/ref] , taking the pressure off considerably. A further £20.6m open offer is expected in a month or so. Meanwhile the placing brought in a new strategic investor - Michael Kroupeev, former director of Dana Petroleum and Sibir Energy, has taken 29.99%  of the enlarged share capital through his vehicle Waterford.

Management has also got an injection of fresh blood with new chairman Alastair Beardsall. His past experience includes stints at First Calgary and Emerald Energy, both of which were sold to bidders, ensuring good returns for shareholders. He turned round Emerald, smartened it up and sold it off - no doubt investors are hoping he can do the same for Sterling Energy. (Incidentally, he worked for Waterford as a consultant some years ago.)

(If you doubt that the company was in a real fix, it's worth looking at the rather scary section on page 16 of the placing document; it states, with a few caveats, that if the company doesn't get the finance, it could end up insolvent [ref] Placing prospectus, p 16 [/ref] . That's not quite a going concern qualification, but I find it rather frightening none the less, giving shareholders a very stark choice.)

The exploration upside centres in Africa and the Middle East. Let's take a look at Africa first, where there are prospects  in Madagascar, Cameroon and Gabon, and there's a light oil target in the cross-border AGC development (shared between Senegal and Guinea-Bissau) [ref] 20082008 oil barrel presentation http://www.sterlingenergyuk.com/uploads/SterlingEnergypresentationOilbarrel3rdapril.pdf [/ref] .

Sterling has interests in two blocks offshore Madagascar, Ampasindava (Exxon operated) and Ambilobe (Sterling operated) - one of the last undrilled exploration areas in Africa. These are large licences, with multiple play types and very large structures already identified; there are multiple target reservoirs, and Ampasindava is now ready to drill. The Sifaka prospect looks highly interesting. However, the well cost will actually exceed the value of Sterling's remaining carry, so the company is looking to farm down its interest.

Large leads have also been identified in the Ambilobe block, in Cretaceous and Tertiary plays. But Sterling doesn't have the resources to carry out further exploration, so it's looking for partners to farm into the prospect. Political issues in Madagascar have also put work on the back burner so far this year.

There's also a Cameroon deep water interest. The Ntem block is highly prospective, and Noble Energy has made Tertiary  discoveries  to the north of the block. Again, Sterling is looking for farm-in partners - and again, political issues (in this case a border dispute between Cameroon and Equatorial Guinea rather than a coup) have sidelined development so far this year.

The prospect that has caught investors' attention though is the Middle Eastern one - Kurdistan. The Kurdistan Regional Government (KRG) has been quick off the mark in awarding licences to foreign oil firms for this relatively underexplored area, which appears likely to be a big producer - there are industry estimates of up to 45bn barrels of oil reserves and 100 tcf gas. 25 international oil companies are now active in the area.

Sterling's interest is in the Sangaw North Block, partnered with Addax and the KRG, 140km south-east of Erbil. (Its diluted interest, assuming the KRG exercises its options, is 40%.) This block is surrounded by discoveries; a confirmed oil column at Taq Taq to the north, and the Kor Mor gas condensate discovery to the west, so this is a proven rich hydrocarbon area; the Kirkuk oil field is just 50 km north-west. Surface oil seeps have been discovered on Sterling's patch, another good sign. [ref] 2008 oil barrel presentation http://www.sterlingenergyuk.com/uploads/SterlingEnergypresentationOilbarrel3rdapril.pdf [/ref]

The KRG typifies this as a low exploration risk area, and RISC, in its CPR, characterised the plays as 'low risk', pointing out that Taq Taq (in which Addax also has an interest) is analogous to Sangaw [ref] Placing prospectus p 24 [/ref] . However, despite these apparently favourable indications, actual data is rather poor; the immediate surrounding area has only been sparsely drilled. There's little seismic in the public domain, either, so apart from Sterling's own 2D seismic, there's not a lot to go on, and despite reprocessing, much is of rather poor quality.

Sakson Egypt has been awarded the rig contract, and drilling will commence in Decembe 2009 [ref] Sterling Energy press release, 23 September 2009: http://www.sterlingenergyuk.com/230909%20kurdistanrigcontract.aspx [/ref] . RISC gives an unrisked best estimate of 804 mmbbl, with a 27% chance of success, and an equal chance of finding oil or gas condensate. (The historical success rate of wells in Kurdistan, though, is 45% [ref] Placing prospectus, p 11 [/ref] , and there have been recent drilling successes by other companies in the area.) Sterling's share of the costs will be paid by its partner up to the point of testing, so there's no impact on the balance sheet - a definite advantage over the African prospects! If the well is successful, the route to exploitation is relatively short and simple, since both Tawke and Taq Taw are now producing, and exporting via a pipeline to Turkey.

Now, Kurdistan looks good. Not a shoo-in, but good. But remember, Sterling is at the moment a one-trick pony; it would need £60m to develop the African prospects, and it doesn't have the money.  So it's Kurdistan or bust.

On the basis of the 27% success rate used by RISC,  the risked prospect is worth just over 2p a share. If you believe it's more appropriate to ignore the competent persons, and use the historical success rate in Kurdistan of 45%, instead, then that's just under 5p a share - and the shares are currently sitting at 4.79p. On this basis, the market is already discounting success at Sangaw-1. (And Evolution reckons without Sangaw, the shares are  only worth half a penny. In fact, I suspect without Sangaw, shareholders will be wiped out as the banks pull their cash out of the company.)

And there's a real downside. If you're a bit of a bear, temperamentally, you'll probably notice the bit in the RISC report that notes there is no recent information on A&T Petroleum's Bina Bawi prospect, or Petoil's Pulkhana prospect. RISC suggests that probably means the appraisal results were disappointing [ref] Placing prospectus, p 33 [/ref] .

There's also a political downside - or actually, quite a number of political downsides. KRG's contracts may not actually be recognised by the Iraqi government, for a start. And KRG also seems to have a very short fuse, having recently stripped Norwegian company DNO of its licence. (That cuts two ways. It's a potential risk - but also, if the licences come up for grabs, a potential opportunity. However, better funded firms are in a much better position than Sterling to pick up any 'spare' licences.)

I'd love to buy the Kurdistan story. I really would. It's not that easy to find new oil fields, after all. But the numbers just don't stack up... and investing, when you come down to it, is not about stories. It's about numbers.