MARI elixir report

We re-initiate coverage on Mari with our DCF based Dec-17 PT of PKR2,009/sh, offering an upside of 27% from last closing. Our liking for the stock emanates from i) a robust 3 years earnings CAGR of 58%, ii) recent 62% upgrade of Mari's reserves, iii) ~4x higher prices on new finds & iv) aggressive exploration targets where the company is looking to drill 9wells/annum over next 3 years, looking to add reserves of ~679bcf (~87% RRR).  The stock is trading at a PEG of 0.29x relative to ~1.0x in the broader Elixir universe & an EV/Reserves of 2.6x (USD/mmboe) relative to 5.5x on average for its peers.  Upside to our estimates include; i) higher than estimated flows from Mari, ii) higher than estimated oil prices & iii) further exploratory success. Strong Earnings Growth: Earnings for MARI are estimated at grow at a 3 year CAGR of 58% over FY16-19, on the back of i) unwinding of pricing discount on its core asset (i.e. Mari field), ii) improved flows from Mari field (HRL) that would fetch 4x higher prices relative to base price (USD4.2/mmbtu vs. USD1/mmbtu) and iii) tie-in of flows from recent discoveries coming online which are entitled 3x higher prices relative to current weighted average well head prices (USD4.2/mmbtu vs. USD1.46/mmbtu). Best in Class Exploration Play: A combination of i) low base pricing of current assets, ii) low lifting cost, iii) high exploration capex relative to market cap compared to peers iv) high success ratio (1:2 relative to ~1:3 for peers) and v) higher cash availability for exploratory endeavors on account of ceiling on payouts makes Mari an ideal oil exploration bet in a country with a low drilling density of 2.77 wells/1000sq.km. The company has opted for 2012 policy for its exploration blocks resulting in new finds fetching 3x of current weighted average realized prices. The implication of which would be that a fraction of replenishment of current production is required to replace current production in value terms. Aggressive Exploration Plan Chalked Out: The Company plans to drill 9 wells per annum over the next 3 years relative to 6 wells drilled in FY16 with a target ~679bcf of reserve additions translating into RRR (Reserve Replacement Ratio) of ~87% relative to ~20% over 2011-15 i.e. depletion of ~170bcf/annum prior to the new GPA (Gas Purchase Agreement). The company would expand its exploration portfolio through i) fresh bidding for exploratory licenses and ii) farm-in opportunities to deploy robust cash reserves stemming from payout ceiling where we estimate deployable cash generation of >USD120mn for exploratory activities on average over the next 3 years relative to market cap of USD1.6bn. The company has significantly scaled up its exploration capex (+2x in FY16 relative to last 4 year average prior to dismantling of the old GPA). Moreover, the company’s prospecting efforts post dismantling of its previous restrictive GPA have also expanded (3D seismic activity ↑~5x). Key Risks: i) lower than estimated volumes, ii) lower oil prices & iii) higher than estimated dry well costs. Value Proposition Comments 1) Strong Profitability Growth  Strong Earnings Growth a. Unwinding pricing discount on Mari Field, b. Incremental production fetching 4x higher prices relative to current pricing of Mari, c. Tie-in of flows from recent discoveries that are entitled to 3x higher prices relative to current weighted average well head prices. 2) Best in Class Exploration Play  High exploration capex relative to market cap compared to peers  High success ratio (1:2 relative to ~1:3 for peers)  High deployable cash for exploration on account of improved profitability & ceiling on payouts.  New discoveries to fetch higher well head prices, the implication of which would be that a fraction of replenishment is required to replace current production in value terms. 3) Aggressive Exploration Plan  In consideration of improved profitability, the company would have fiscal space to spend over USD120mn/annum annually on exploratory efforts.  The company plans to drill 9 wells per annum over the next 3 year relative to 6 in FY16.  The company is aiming to add 679bcf over the next 3 years targeting a RRR ratio of ~87%. 4) Mari to Capitalize on Improved Pricing Incentives  The current GPA effective from 2015 offers market based pricing albeit slab wise & absolute discounts on well head prices. Old GPA had offered a fixed return of 30% on equity scalable to 45% based on increased production.  Incremental flows from Mari entitled to ~4x higher 2012 policy pricing, effective from February 2015. Risks to Our Thesis Comments 1) Lower Offtake  Delays in installation of compressor by TPS Guddu, which is expected to take up additional gas. Unscheduled outages at plants of major consumers (Ferts & Power) could restrict additional volumes of HRL reserve that fetch higher prices. 2) Lower than Estimated Oil Prices  Lower than estimated oil prices where we have assumed FY17/18 oil price of USD50/60/bbl with a LT price of USD60/bbl pose downside risks to our estimates. 3) Dry & Abandoned Wells  Higher than estimated quantum of dry wells Mari Petroleum has exploration, development and production interests across 19 licenses distributed across four provinces spanning ~30,000 sq.km with varying degrees of stake ranging from 20%-100%. 12 of the licenses are operated by MPCL while remaining 7 are operated by its partners. Cumulative remaining gas reserves of the company are ~5.3tcf (Dec-16), with gas sales accounting for 90% of the revenue of the company. Mari’s 2P gas reserves are equivalent to 25% of Pakistan’s overall gas reserves as reported by Pakistan Petroleum Information Service (PPIS). The remaining oil reserves of the company are equivalent to 1.6mmboe (Dec-16) out of 348mnbbl of the total reserves of the country. Mari’s oil reserves from Ghauri Block are currently under evaluation. Mari field alone accounts for ~95% of the gas volumes however on account of relatively lower gas pricing, its contribution in gas revenues is ~80% of gas revenues. The company also has in-house drilling (Mari Drilling Unit) and prospecting facilities (Mari Seismic Unit). Following dismantling of the previous restrictive GPA that had imposed a ceiling on exploration cost (i.e. USD40mn), the company can now expand its exploratory efforts (>USD100mn in FY16) and is considering various farm-in opportunities like the recent acquisition of a 32% stake in Shah Bandar exploratory block from PPL & increase in stake in Bannu West Block. Based on our estimates, the company would have fiscal space to spend >USD120mn annually on average for exploratory activities over the next 3 years given there is a restriction on payouts. The fiscal space could allow the company to meet its target of drilling 9 wells per annum over this period. Moreover, the company has above average success rate of 1:2 relative to 1:3 for Pakistan. Year Event 1954 Mari Gas Field Initially owned by Stanvac Petroleum project; a joint venture between GoP & Esso Eastern Incorporated. 1957 First Discovery made in Lower Kirthar formation. 1967 Production from Mari Commences. 1984 Mari Gas Company was incorporated with Fauji Foundation, GoP & OGDCL holding 40%, 40% & 20% shares respectively. 1985 Company commenced operations under the now defunct Mari Gas well head price Agreement. Salient Features i. Cost plus return basis: 22.5% of guaranteed return net of all taxes on on equity; allowing for all costs. ii. Exploratory Efforts were not allowed that resulted in depletion & limited additions in Mari’s portfolio. 2001 Mari Entered Oil & Gas Exploration Business with revised returns albeit under similar arrangements (i.e. cost plus). Salient Features i. Exploration expense allowed for fields other than Mari equivalent to lower of USD20mn or 30% of gross sales, ii. Guaranteed return revised up to 30%, iii. 1% escalation in guaranteed returns allowed for every 20mmcfd additional gas production over 425mmcfd upto a ceiling of 45%, iv. Operating costs allowed as approved by BoD in the annual plan, v. Debt servicing for development project financing allowed, vi. Fiscal constraints put in place that included ceiling on payout, 2012 Limit for Exploration capex raised to USD40mn/Annum Salient Features i. ECC of the cabinet revised up limit for exploration capex from USD20mn to USD40mn in a phase wise manner with an USD5mn annual increase in the next 4 subsequent years to USD40mn. Prior to the dismantling of the previous GPA, the allowed exploratory expense was USD37.5mn 2014 Five year Extension in MARI lease till 2019 along with restrictive Mari GPA dismantled in favor of a market based formula. 2015 (February) Salient Features i. Crude prices linked to oil prices with a 50% discount (Similar to pricing offered to Sui & Kandhkot earlier) albeit in a phase wise manner (unravelling entitlement factor) over five years till 2019, ii. Dividends capped in accordance to the older PPA till 2024, which would have resulted in dividends to remain at ~PKR5- 6/sh. iii. Risk & reward transferred to the company for exploration and development activity. iv. Undistributed reserves equivalent to PKR9.67bn to be distributed in the form of preference dividend which would be redeemed in 10 years offering Kibor+3% returns, minority shareholders. v. PKR0.92bn worth of preference shares in respect of reserves for Mari Seismic Unit issued to the GoP. 2015 (October) Company opted for conversion of Mari D&P Lease to 2012 policy for production enhancement. 2016 (February) Pakistan’s First E&P company to avail 2012 policy on incremental production incentive of 10% in Mari. Strong Profitability Growth Earnings for MARI are estimated to grow at a 3 year CAGR of 58% over FY16-19, on the back of: i. Unwinding of pricing discount of its core asset (i.e. Mari field) where the entitlement factor of pricing currently stands at 73% which would completely unwind by 2HFY19. The well head gas prices are expected to increase from USD1/mmbtu to USD1.6/mmbtu by FY19 (based on our oil price assumption of USD60/bbl for FY19.) ii. Improved flows from Mari field as the company optimizes production from its core asset. The incremental flows i.e. over 525mmcfd from Mari (HRL reserves) would fetch 4x higher prices relative to base price for Mari field. The management expects additional 50mmcfd (8% of current flows) to come online by 3QFY17, however we have incorporated the same from FY18. iii. Tie-in of flows from recent discoveries coming online which are entitled 3x higher prices relative to current weighted average well head prices. These include ~26mmcfd additional gas discoveries in Mari, Karak & Hala. ) Best in Class Exploration Play Mari offers an ideal proxy to the exploration upside in the country with one of the lowest drilling density of 2.77wells/1000sq.km on account of: i. High exploration capex relative to market cap compared to peers which is likely to expand further with curtailment of dividends and improving earnings profile. We estimate that the companies available reserves for deployment for exploration actively to exceed USD200mn by FY19. ii. Low base pricing of current assets where we estimate current realized well head gas price of USD1.4/mmbtu, allows new finds to have a proportionately higher impact on the bottom line. Where we estimate that every USD5/bbl increase in oil price would have an earnings impact of ~PKR11/sh on our FY18 earnings. iii. High success ratio of 1:2 relative to 1:3 on average in the country. iv. The company has opted for 2012 policy for its exploration blocks resulting in new finds fetching 3x of current weighted average realized prices. This implies that a fraction of replenishment of current production is required to replace current production in value terms. Mari plans to drill 9 wells/annum over the next 3 years i. The Company plans to drill 9 wells/annum over the next 3 years relative to 6 exploratory wells drilled in FY16, with a target to add 679bcf of reserves translating into RRR (Reserve Replacement Ratio) of ~90% relative to net depletion of ~164bcf/annum prior to the new GPA (Gas Purchase Agreement) against last 6 year average production of ~213bcf. ii. The company would expand its exploration portfolio through i) fresh bidding for licenses & ii) farm-in opportunities to deploy robust cash reserves stemming from payout ceiling where we estimate deployable cash generation of ~USD196mn for exploration activities on average over the next 3 years relative to market cap of USD1.5bn iii. The company has significantly scaled up its exploration capex (+2x in FY16 relative to last 4 year average prior to dismantling of GPA) its prospecting efforts post dismantling of its previous restrictive GPA have also expanded (3D Seismic up ~5x). 4) New GPA Opens Up Exploration Potential What the Old GPA Entailed? The previous GPA was essentially a fixed return based structure (30% return on equity scalable up to 45% upon increase in production) after allowance of budgeted expenses and capex; a structure similar to power & gas utilities. Moreover, as allowance for exploration was inadequate, it was raised to USD40mn/annum in 2012 from USD20mn/annum to be increased linearly over the subsequent 4 years. The implication of this restrictive GPA was that i) company’s reserves depleted at a rate of 166bcf/annum (net of additions) & ii) production growth remained limited with gas volumes of the company growing at an average of ~3% over 2002-12 relative to 4.8% of the country in the same period. What the New GPA offers? The new GPA offers commercial terms with Risk & Rewards for exploratory efforts being transferred to the company. The new GPA links the pricing of MARI to crude oil prices albeit with i) absolute and slab wise discount & ii) further time bound discounts (entitlement factor) that completely unwind by FY19. While Low Base for Pricing & Exploration Activities makes it a Best in Class Exploration Play: A combination of i) low base pricing of current assets, ii) high exploration capex relative to market cap compared to peers (and likely to expand further going forward), iii) high success ratio (1:2 relative to ~1:3 for peers) & iv) higher cash availability for exploration endeavors on account of ceiling on payouts; makes Mari an ideal oil exploration bet in a country. The company has opted for 2012 policy for its exploratory blocks that would fetch 3x of current weighted average realized prices. The implication of which would be that a fraction (i.e. 1/3rd) of replenishment is required to replace current production in value terms. The company is targeting to add 679bcf (i.e. 87% replenishment rate) over the next 3 years to arrest depletion. The company has significantly scaled up its exploration capex (+2x in FY16 relative to 4 year average prior to dismantling of GPA). Mari’s prospecting efforts post dismantling of its previous restrictive GPA have expanded as well with 3D Seismic activity up ~5x