Tullow Oil - discovery after discovery!

Tullow Oil is a FTSE 100 stock, with a market cap of £9bn. Not, then, a junior oil exploration company, or a fly-by-night with a couple of prospects. But what's interesting is that it offers a very different style of oil exposure from FTSE companions Bp and Royal Dutch Shell B - where the majors are actually beginning to exhaust their resources, Tullow is still increasing its resources with new discoveries.

Tullow's core area of operations is West Africa, where it is already producing in Gabon, Cote d'Ivoire, Mauretania, Congo and Equatorial Guinea, and has development programmes in Ghana and Uganda. Its success rate in the area has been almost 100 percent. It also has interests in the North Sea, South America, India, Bangladesh and Pakistan.

And unlike most of the juniors, it's profitable. Its profitability did fall at the latest interim results, as the result of lower production as well as a lower oil price. Turnover fell 23% - with 16% lower volume - and profits were down 81% [ref] H1 2009 presentation: http://www.investis.com/tlw/docs/Tullow2009Halfyear.pdf [/ref] . But production should increase again in 2010, once the Jubilee field begins to produce, so this is a short term issue. (Jubilee is expected to start production in the second half of 2010, at a rate of 58,000 boepd – almost doubling the 59,265 boepd production of H1 2009 [ref] Tullow Oil fact book: http://www.tullowoil.com/tlw/ir/reportspres/finreportspres/2009/reports/facaug2009/facaug2009_n.pdf [/ref] .

However, it's not really current production you're buying Tullow for. Tullow could be transformed by the success of its exploration programme. New fields are important not so much for increasing production, as for the room they give the company for significant upgrades in resources, and consequent increase in the company's net present value.

In Ghana for instance the exploration programme in the Tano licence (of which Tullow, the operator, holds 49,.95%) and West Cape block continues to test plays close to the existing Jubilee field. (Jubilee itself might be more important than current figures show - further appraisal wells are being drilled in 2010, and the field could move on to a second production phase dependent on well results. But Mahogany-4 and Mahogany Deep-2 have to be drilled first, and rig availability is something of an issue, so further development is unlikely before 2011.) Teak-1, for instance, is testing plays up-dip from Jubilee; if hydrocarbons are found here too, that would increase the resources considerably. In March this year Tullow announced a significant discovery at

Tweneboa-1 – a highly pressured light hydrocarbon accumulation which is now being appraised. Tweneboa and Teak are both substantial prospects, with upside potential of over half a billion barrels each. The geology looks good – Teak-1 is testing plays up-dip from Jubilee, and there are large Turonian leads east of the Jubilee field.

In Sierra Leone, where Tullow is partnered with Anadarko, the company has recently announced a major discovery at the Venus exploration well. Tullow owns 10% of this prospect. Venus, the first deepwater test well to be completed in the Sierra Leone / Liberian basin, encountered more than 45 net feet of hydrocarbons. Anadarko will be drilling a further 2-5 wells in the trend over the next year.

This discovery is much more important than it looks, because it's likely that the Jubilee field at one end and Venus at the other are 'bookends' to a major hydrocarbon bearing geological system lying between the two of them, offshore Liberia and Cote d'Ivoire. The West African Transform Margin is a single geological structure, covering this whole area, which makes major hydrocarbon discoveries more likely and derisks much of the exploration portfolio. Tullow's interests in Liberia and Cote d'Ivoire (the South Grand Lahou prospect) will take another couple of years to explore; satisfactory results would further increase the company's resources.

However, investors should remember that while such overall geology stories look tempting, they can be disappointing in practice. The Chinguetti field, offshore Mauritania, was one such - Dana Petroleum failed to prove any significant reserves from its exploration programme there. While there is certainly good potential for Tullow from its African offshore permits, it can't be guaranteed.

 Tullow's other major area of exploratiion is in Uganda, where it operates Block 2 with 100% ownership, and has 50% in Blocks 1 and 3a. In 2008 Tullow announced that it had discovered five metres of net oil pay and nine metres of net gas pay at its Ngege-1 well in the Lake Albert Rift basin. This confirmed a well developed reservoir, and was the 11th well in the basin to encounter hydrocarbons. In May this year, the Nsoga-1 exploration well found further hydrocarbons. Tullow now estimates 100-400mb of oil under the Ugandan side of Lake Albert – and though there's no firm data on the Congolese side of the lake, has already secured an agreement to explore there. (The agreement still has to be ratified by the President, though, and might end up getting more expensive as Ugandan oil proves up.)

Total resources in Uganda already exceeded 700 million barrels of oil, before adding another discovery at Ngassa (block 2), which was announced in September 2009. Morgan Stanley estimated the Ngassa-2 discovery as worth 160p a share on its own [ref] Morgan Stanley note, http://ftalphaville.ft.com/lib/data/filecache/attachment/m/s/ms-oil-E-P.pdf [/ref] . This has de-risked the follow-up potential for the Ngassa oil field, which has the potential to be the largest oil field in the region. It's worth noting though that the Ugandan resource is waxy crude, which has higher cost of production and processing than most oils.

Tullow is now moving into South America. That sounds at first like a diversion from its West African core. However, there's a good reason for management's interest in the area; the geology is believed to be analogous to the Ghana field. Jubilee-type leads have been discovered on the Guyane Maritime licence, in French Guiana. This raises the tantalising possibility of discoveries of equal importance to those made offshore Ghana and Sierra Leone.

In order to ensure sufficient finance to complete its exploration programme and bring the Jubilee field into production, the company has secured a new $2bn debt facility, with net debt of £430m at the end of H1 2009 [ref] Tullow Oil - Half year results presentation [/ref] . In fact, cash flow from operations was positive in the first half of the year to the tune of £105m [ref] Half year presentation [/ref] – the company needs finance only for its new developments and is not burning cash.

Capital expenditure this year will be £750m, with a 65/35 split between production/development and exploration/appraisal. The focus is strongly on developments in Ghana and Uganda, which will take £500m of this total [ref] H1 2009 presentation [/ref] .

The shares' performance over the past five years has been exceptional, increasing from 72p to over £12. However, this may not all be down to the company's exploration success; the Investors Chronicle points out that Tullow is one of the shares most strongly correlated to the oil price [ref] Investors Chronicle, 16 June 2009: http://www.investorschronicle.co.uk/Tips/FairlyPriced/TipsOfTheWeek/article/20090616/fc4927c6-5a6e-11de-b342-0015171400aa/Tullow-back-on-form-in-Uganda.jsp [/ref] .

While West Africa is clearly a major area for the group, its involvement in the area is split between several nations, mitigating the political risk of its operations. According to the company, its value is fairly evenly split between Ghana (23%), Uganda (33%) and other Africa (36%). Tullow has clearly built up some very specific expertise in the region and in particular types of geology, which gives it a competitive edge – it claims a 90% global exploration success rate [ref] First half presentation [/ref] .

Tullow continues to enjoy a remarkable record of success with its exploration programme, announcing new discoveries on a regular basis. This month alone has seen finds in both Sierra Leone and Uganda. The shares saw a flurry of activity earlier this month as ENI considered a bid. However, the share price fell after ENI pulled out after completing its due diligence [ref] Guardian, 16 September 2009: http://www.guardian.co.uk/business/marketforceslive/2009/sep/16/tullowoil-enrc [/ref] . Nonetheless, they remain close to a one year high at 1124p.

But is the share price up with events? Citigroup thinks so [ref] Investors Chronicle, 26 June 2009: http://www.investorschronicle.co.uk/Tips/default/TipsOfTheWeek/article/20090626/517ed3a0-60b7-11de-8d5d-0015171400aa/Five-rules-for-the-new-oil-age.jsp [/ref] , stating that at above £9, the share price discounts further discoveries. There has been some further success since then, though, de-risking the portfolio and adding to the value of the resources.

On the other hand Panmure Gordon believes that with an 850p existing asset backing, the shares could achieve a 1500p value within the next twelve months. Panmure justifies this by assessing the wells proposed over the next year as a 2000p potential, and risking them at a 30% success rate. That's very conservative compared to Tullow's 90% success rate so far, of course.

I think on balance I'd be tempted to go with the Panmure view. The geology looks good, as far as I can judge, and the company's track record suggests it's spending its exploration money wisely. Moreover, unlike many other oil companies, it doesn't have any problem funding its exploration programme, so it won't get pushed into a corner and have to sell off or farm out its fields at low prices – shareholders should get the full benefit of any discoveries. And of course it's a nice big liquid stock – again unlike most oil stocks with this kind of exploration potential.