Stock Brief - Serica Energy (LON:SQZ)

Serica Energy shares are currently trading at all-time highs, with the share price set alight by soaring natural gas prices over the past year. The company is currently responsible for over 5% of the UK’s natural gas supply, and continues to expand its productive capacity, recently reaching nearly 30,000 barrels of oil equivalent per day (boe/d) in December 2021.

Serica’s success story has been reflected in both the share price and the company’s financial performance. Its most recent corporate update highlighted a cash build to over £218 million as at 31st December 2021. This figure is only set to grow as the company now retains 100% of the net cash flows from its Bruce, Keith and Rhum (BKR) fields in the North Sea, though 50% of Rhum is still owned by the Iranian Oil Company (IOC).

The unfortunate recent developments in Ukraine, and the looming threat of another world war, continue to push gas prices higher as energy supplies become increasingly uncertain. Despite prices falling back since the pre-Christmas 2021 peak of 450p per therm, they remain 6 times higher than this time last year.

With the fundamental backdrop for energy prices being so favourable, is there still value left to extract in Serica’s shares?

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Profile

What are the company's principal business activities, how does it generate its revenues?

Serica is a UK based upstream oil and gas producer, with a range of production and exploration assets located in the North Sea. Over 85% of the company’s current production now comes from natural gas, which accounts for over 5% of the UK’s entire natural gas supply.

Serica’s production assets include the Bruce, Keith and Rhum fields in the UK Northern North Sea. The company also operates the Columbus field and maintains an interest in the Erskine field, in the central North Sea. Combined, these fields currently produce nearly 30,000 boe/d net to Serica, guidance for this year is in the range of 27,100 and 33,600 boe/d. Proven and probable oil reserves (2P) from these fields stand in excess of 61 mmboe (million barrels of oil equivalent) as of the 1st Jan 2021.

The company’s management team have notable experience in the North Sea and are experts in optimising the use of new technologies to maximise production and extend field life.

Size, Sector & Exchange

Given the 269 million shares in issue, at the current all time-high share price of 292p, the market capitalisation is in excess of £785 million.

Serica operates in the Energy sector, under the Oil & Gas industry and its shares are listed on the LSE AIM Market.

Business strategy

As previously mentioned, Serica's unique advantage lies in its technical skill set and management expertise in extracting the maximum value from its asset base in the North Sea. Its future strategy will continue to revolve around this theme, with management actively targeting opportunities where it can add value.

The company has a proven track record of improving the performance of wells through workovers and extending their field life. For example, the R3 well reintervention on its Rhum subsea gas field in 2020/21, boosted production from 12,900 boe/d net to Serica to 19,000 boe/d net.

Equally, Serica’s net 2P reserves at acquisition for its Erskine interest in 2014 was 3.6mmboe. Since this time, net production from Jan 2014 to Jan 2022 has reached 4.97mmboe (138% of original) and net reserves now still total 2.46mmboe (68% of original).

The company has already confirmed that planning is underway for a Bruce/Keith Light Well intervention campaign in 2022, which could add further production. There will be greater anticipation for the North Eigg exploration well though, which is scheduled to spud in Q3 2022. The well is part of the greater North and South Eigg structure, potentially targeting prospective resources in excess of 100mmboe. North and South Eigg are directly adjacent to the company’s existing Rhum block.

Serica’s strengthening balance sheet not only provides it with the capex it requires for its current field developments and exploration projects, but also with the capacity to take on lucrative opportunities as and when they arise.

History & Growth

Serica's historical strategy has focused on identifying assets in the UK North Sea where the management team can apply its expertise to unlock value. Formed in 2004, the company only acquired a working interest in a producing field in 2014, when it acquired an 18% interest in Erskine.

The acquisition of the Bruce, Keith and Rhum (BKR) fields from BP in November 2018, was a transformational moment in the company’s history. Serica became an operator for the first time, and was able to effectively apply its expertise to simplify workflow processes, increase production uptime, reduce operational costs and extend field life.

Today, Serica is a company with over 150 employees, 5 producing fields, and 2 exciting exploration assets in the North Sea.

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Recent News

Rhum Production Update - A fault was discovered in the Rhum Subsea Control Module, which resulted in the temporary shutdown of Rhum production. No safety or environmental issues so far, however, production will likely not resume for at least two weeks.

Production at Bruce and other fields have not been affected. A further update will be provided when Rhum production is restarted.

Mitch Flegg, Chief Executive of Serica Energy, commented:

"This is a frustrating event, but I am confident our skilled teams onshore and offshore will safely and efficiently implement the required repairs using equipment and plans already in place to deal with such a situation. Production from Bruce, Erskine and Columbus has consistently averaged over 10,000boe/d net to Serica so far this year. We expect these rates to continue during the Rhum shut down and we will look for ways to optimise the Bruce production rates during this period." 

Corporate Update - A strong update pointing out the contribution of R3 well and Columbus field, with Serica’s production reaching 85% gas. Key operational and financial highlights included :

• Rhum R3 well put into production in late August 2021. Rhum production significantly boosted, adding up to 6,000 boe/d net to Serica.
• First production from the Columbus field achieved in late November 2021. Early production initially constrained due to temporary unavailability of full capacity in the export system. Average rates of 3,270 boe/d net to Serica now achieved in the period up to year-end.
• BKR net cash flow sharing arrangements ended on 31st December 2021. As of 1st January 2022, the company retains 100% of the net cash flow from BKR.
• Average realised gas prices of over 113p/therm and oil over $70/bbl.
• Cash pile grew to £218.4 million at 31st December 2021, consisting of £103 million held in cash and deposits and £115.4 million as temporary security with gas price hedge counterparties.
• 20% of 2022 gas production hedged, leaving considerable upside exposure.

Mitch Flegg, Chief Executive of Serica Energy, commented:

"2021 was a very busy year for Serica, which reinforced the value of our through-cycle investment strategy as our expenditure during the low gas price environment of 2020 on the R3 and Columbus projects bore fruit this year. The importance of our contribution to the provision of vital lower carbon gas to the UK's energy market was also demonstrated. We will continue to pursue our investment-led strategy this year with a planned well intervention programme on Bruce and Keith in addition to our exploration well at North Eigg. As always, we continue to look for acquisition opportunities that fit our criteria and will add value for our stakeholders."

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Catalysts

Trends & Events

UK natural gas prices hit all time highs as recently as December 2021 and are still significantly above their historical averages. The demand dynamics remain strong as natural gas adoption continues to increase. This is primarily driven by the fact that natural gas emits a lot less carbon dioxide than other fuels and is therefore necessary for our global transition towards carbon neutrality.

The supply side looks a lot more concerning, though potentially rewarding for Serica. Russia may decide to turn off its gas supplies to Europe, and other nations that continue to support Ukraine. In this case, prices may once again soar to new record heights. However, should the opposite occur and a peaceful resolution is found, a lot of the uncertainty will be removed and gas prices may fall quite abruptly. The current trends are favourable for Serica, but geopolitics must be taken into account here.

Serica will report its full year results in April. Further catalysts might include an acquisition, plans shareholder returns, or the drilling of the North Eigg well in Q3 2022.

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Risks

What risks does the business face?

Operational - Offshore wells are much more costly and complex to operate than their onshore counterparts. As shown by the fault discovered in the Rhum Subsea Control Module on 28th February 2022, issues can flare up in spite of the most rigorous operational preparedness. In this case, there have been no safety or environmental issues, but production will be hit for at least 2 weeks. This will have a notable impact on company revenues as it accounts for approximately 60% of group production.

Exploration - Serica plans to spud its North Eigg exploration well in Q3 2022 at an estimated cost of approximately £45 million. Should the well disappoint, this will also throw the prospectivity of South Eigg into doubt.

Growth - The company’s large cash pile continues to grow daily and could reach in excess of £300 mil by the end of Q1 on current forecasts. With no debts, pressure from shareholders may start to mount if shareholder distributions or acquisitions are not made. This may lead to management acquiring assets in an unfavourable pricing environment in the pursuit of growth.

Geopolitical - The events over the past week have demonstrated just how volatile the world stage is today. It is impossible to predict what might happen over the coming weeks, but investors would do well to closely monitor developments and assess their risk exposure accordingly. Serica is currently a beneficiary of the natural gas pricing environment, but that could change in an instant.

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Summary

Bull points

Serica’s net cash flows are set to grow rapidly as the company’s share of BKR rises, cash on balance sheet already over £218 million, attractive valuation with 12m forecast P/E of 2.9, extremely favourable natural gas price environment, field workovers at Bruce/Keith could provide additional production growth, North Eigg exploration well may add significant resources if successful

Bear points

Difficulties in operating offshore wells as highlighted by the recent issues with the Rhum Subsea Control Module, gas prices highly dependent on geopolitical factors at this time, company looking for acquisitions but may be forced to pay over the odds for M&A in this environment, lack of growth prospects if North Eigg well disappoints, small dividend yield

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Brokers are having to revisit their price targets for Serica higher on the back of its 100% ownership of BKR, increased production rates and elevated natural gas prices. Jeffries recently raised its price target from 290p to 360p, and rated it a ‘buy’.

Serica represents a unique opportunity as a leading mid-sized North Sea focused natural gas play. The company is in a relatively secure position, due to its importance to the UK’s natural gas supply and rapidly growing cash reserve.

However, the market has taken notice of this and the shares are now starting to command a premium as a result. If natural gas prices start to retreat, the share price may fall just as quickly. Although, ceteris paribus, a sustained period of natural gas prices beyond the current 250p per therm could turn the company into one of the greatest cash cows on the London market. Definitely one to keep an eye on!