|Shares Out. (in M):||33||P/E||N/A||10x|
|Market Cap (in $M):||170||P/FCF||N/A||N/A|
|Net Debt (in $M):||0||EBIT||0||0|
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We believe Harvest Natural Resource's stock is conservatively worth more than $15 per share (3x its current price), albeit with a large dispersion of potential outcomes. While there are only a few (unlikely) scenarios in which the Company’s stock may be worth less than its current price, there are some scenarios in which it could even be worth more than $45 per share within three years. Importantly, there are numerous catalysts over the next year that are likely to clear Mr. Market’s fog regarding the fair value of these shares. Thus, we believe the balance of risk and reward is now vastly skewed to the latter at current stock prices relative to the Company’s huge 3P present value (at $71 WTI) of $45 per share ($1.65 billion/37 million shares fully diluted). In fact, Harvest’s stock is currently trading below the value of cash, after-tax proven reserves (1P) at $40 WTI oil prices, and other tangible assets. We would encourage you to read the four previous VIC write-ups and Q&A for more detail on the Harvest’s efforts over the past two decades. You can also find a company overview presentation here.
No, We are Not Taking Crazy Pills - Harvest is a small U.S.-based oil and natural gas E&P company with sizable, low-cost producing oil fields in Venezuela (since 1992) as well as current exploration properties in the U.S., Indonesia, China, Oman, and Gabon. The Company formerly owned parts of two joint ventures in the USSR/Russia which it sold earlier this decade for nearly $300 million (when oil prices were below $15) to pay off its large debt. The Company currently has no debt, around $35 million in cash at year-end (our estimate), book value of $260+ million, and a market cap of $170 million.
Assuming the price of oil remains around $70 per barrel over the long-term, Harvest’s 32% net ownership in its joint venture (i.e. PetroDelta) with state-owned PDVSA is likely to be worth more than $450 million (current PV10 of proven reserves) even after giving it a 50% haircut for its obvious and perceived Scarlet Letter V(enezuela) due to huge recovery upside to the Ryder Scott estimates. Thus, our $15 conservative fair value estimate assumes Harvest’s economic interest in PetroDelta is diluted substantially over time by increasing taxation, fees, and/or “re-nationalization”, offset by recovering more than double the current proven reserves. Our estimate also assumes that Harvest achieves modest success at only one of the Company’s six major exploration projects outside Venezuela over the next three years.
Importantly, Harvest recently announced its first U.S. oil production (albeit tentative and small) in a Utah joint venture with Newfield Exploration Company to go along with at least two other shots on goal over the next twelve months in getting proven, producing reserves outside of Venezuela. The Company has also indicated there is some external interest in its Gabon and Oman exploration projects (see 3Q09 earnings call transcripts). Lastly, PetroDelta’s production is likely to more than double over the next few years from last quarter’s still depressed 21,000 barrels of oil per day (about 4,500 BOPD net to Harvest after a 33% in-kind royalty to Hugo). Recent indications suggest that PetroDelta’s production has already jumped 20%+ to more than 25,000 BOPD as a result of new drilling. Harvest’s presentations clearly delineate spikes in daily production (slide 8) over the past few years whenever more than one rig has been drilling PetroDelta’s fields - as should be the case in 2010. With an after-tax $30 cash margin per barrel at $70 WTI oil prices (slide 10), a doubling in production would mean Harvest could be collecting annual dividends nearing $100 million from PetroDelta in 2012 and beyond.
Why Harvest is So Absurdly Cheap (if it weren’t obvious already) - One need not be an oil and gas expert by any means to sense that there’s potentially a tremendous mispricing of Harvest’s stock by the market: you get a greater than $15 per share of net asset value by adding the Company’s PV10 of proven reserves to other tangible assets. Despite this, the Company’s stock has wallowed over the past few years due to several factors:
1) Harvest is covered by only one sell-side analyst (that we know of). In addition, the Company’s market cap is too small for most funds to be interested in doing the necessary due diligence after seeing the Scarlet Letter V. COUNTERPOINT: After doing our due diligence, we believe the risk that Harvest’s stock is worth less than $5 is extremely low.
2) The Company’s GAAP financials show no revenue (due to its PetroDelta joint venture structure in Venezuela) and some losses over the past few years (due to sizable exploration expenses as well as PetroDelta production declines). COUNTERPOINT: Adjusting GAAP to reflect economic reality is not one of Mr. Market’s strengths; it is one of the VIC community’s. In Harvest’s case, we can incorporate the JV revenue and costs into an income statement reflecting economic reality (also separating out discretionary exploration costs), as well as calculate a true book value with proven, probable, and/or possible reserves.
3) Harvest’s only material producing oil fields are in Venezuela, a country run by a socialist dictator who just devalued its currency and whose bonds have one of the highest chances of sovereign default in the world. COUNTERPOINT: Ironically, the devaluation actually benefits Harvest (as it improves PDVSA's cash flow) and the well-known risks in Venezuela put Harvest’s stock on the “do-not-buy” list for most investors (a good thing for us!).
4) Many investors fear additional action after Hugo had Venezuela’s oil industry (among other industries) nationalized for the “benefit” of its populus - a process which prevented drilling and caused production declines for PetroDelta between 2004 and 2007. COUNTERPOINT: We wonder why there is such fear when the nationalization was largely a wash for Harvest (more oil at a higher margin for a longer period). To reiterate: Harvest has already been through ONE nationalization, for which they were adequately compensated. Thus, we think the risk of outright expropriation is extremely low.
5) Since PetroDelta is likely to reinvest cash flow to increase production over the next several years, Harvest may not receive material dividends for the next two years. Thus, Harvest’s cash on hand is likely to run out in 2010 without additional fundraising. The Company recently filed a shelf offering of $300 million to allow “the flexibility from time to time to offer and sell up to $300 million of equity, debt or other types of securities”. COUNTERPOINT: We believe management has a good track record of avoiding equity dilution by using other sources of liquidity. Even massive dilution alone would not make Harvest worth less than $5 per share given the value of its proven reserves and huge potential exploration upside. Furthermore, aggressive reinvestment in PetroDelta is actually a good thing as production (and dividends) should explode over the next several years. Lastly, in 2008 management made open market purchases and the Company bought back $60 million in stock above $10 per share.
6) PetroDelta’s production is running at a fraction of its potential due to almost seven years of drilling issues: the two month 2002/03 oil strike that lead to a 24% GDP decline, the 2004-2007 nationalization process, OPEC quotas that led PDVSA to originally plan a PetroDelta cap at 16,000 BOPD in 2008, and PDVSA cash flow issues as oil prices declined leading to contractor payment problems in 2009. COUNTERPOINT: although PetroDelta production has been a serial disappointment this decade, the contractor payments are being made, the Bolivar devaluation dramatically improves PDVSA’s cash flow (at least in the short-term), oil prices are unlikely to approach $45 again (where PetroDelta still makes $18 after-tax per barrel), and Venezuela production declines versus its stated long-term targets make it unlikely PetroDelta will be hindered by OPEC quotas in the next several years.
7) Harvest’s recently updated PV10 for proven reserves is only $449 million at $71 WTI, which doesn’t make the stock appear massively undervalued when incorporating Hugo risk. COUNTERPOINT: it is essential to understand that the Ryder Scott reserve report is extremely conservative using a recovery rate of 1/3 of Harvest’s historical results in Venezuela (see 2Q09 earnings call transcript). In addition, several of the PetroDelta fields are just beginning development - this is why probable and possible reserves jumped by 48% and 108%, respectively, in the last eight months after two appraisal wells were drilled in the El Salto field (which has nearly one thousand potential drilling locations). We think it is a slam dunk that Harvest’s proven reserves will increase massively over the next several years.
8) It has been many years (2003) since Harvest had material production outside of Venezuela, thus Mr. Market views the Company’s current exploration opportunities as worthless until proven valid. COUNTERPOINT: Similar to what Mark Sellers frequently pointed out in his presentations on Contango Oil & Gas, it is a good thing for those purchasing the stock that Mr. Market is not paying for optionality on Harvest’s six different exploration opportunities outside Venezuela. Management has stated that they believe most of Harvest’s exploration targets (most of which have been accumulated since 2007) are of similar or larger size than its interest in PetroDelta. In addition, these projects are all in areas of known active hydrocarbon formations. One out of six assets maturing into material production does not seem to be an optimistic assumption to us. As the 10-Q states: “Either one of the two exploratory wells to be drilled in 2009 on the Antelope project and the Budong PSC can have a significant impact on our ability to obtain financing, increase reserves and generate cash flow in the future.”
9) Harvest’s largest shareholder, Mohnish Pabrai, has been slowly selling a small portion of his shares over the past several months. COUNTERPOINT: it is unknown if Harvest fails his checklist now or if he is simply trimming due to his smaller position weightings.
Traded It Straight Up - The nationalization process from 2004-07 proved that Harvest’s economic interest in PetroDelta is beneficial for Venezuela. The simplest way to understand why Hugo needs Harvest is to decide which is worth more (to Venezuela): a) 100% of a quarter or b) 85% of a dollar. Since even the ego of a dictator shouldn’t lead to the wrong answer, we strongly believe the risk of uncompensated expropriation of PetroDelta is vastly overestimated by Mr. Market. The facts are clear:
1) The oil fields currently owned by PetroDelta had experienced a recovery rate of 9% of original oil in place before Harvest took them over in 1992. Subsequently, Harvest was able to achieve a 30% rate of recovery (slide 7) - a 300%+ increase. The recently updated PetroDelta reserve assessment by Ryder Scott Company with a 3P of $1.65 billion net to Harvest assumes recovery rates of only 10% in many of the largely undeveloped fields (see 2Q09 earnings call transcripts). Thus, we tend to believe that Harvest’s interest in PetroDelta is somewhat likely to even exceed the current 3P estimate over the next decade.
2) Hugo already captures much more of the economics than PDVSA’s 60% ownership of PetroDelta would suggest: When you tally the 33% in-kind royalty and the various taxes, it is clear that Hugo is receiving close to 85% of the economics of PetroDelta’s oil fields. With half of government receipts and 90% of exports comprised of oil, we doubt Hugo would risk switching to another unproven entity, potentially trading that dollar for a quarter and thus risk jeopardizing his power with production declines that could send GDP into a debilitating downturn like in 2002-03. We also remind you that our $15 per share fair value estimate assumes long-term downward pressure for Harvest’s 15% effective economic interest in PetroDelta, offset by vastly higher recovery rates than those embedded in the current Ryder Scott reserve report.
3) Although the Company received a net 32% explicit (approximately 12% net effective) economic interest in its previously wholly operated fields due to nationalization, the net effect (slide 20) on total future cash flows is likely to prove a wash: three additional oil-rich fields were added, PetroDelta now receives a 50% higher margin per barrel than Harvest did under its former OSA, and Harvest’s economic interest extends fourteen years longer than before (to 2026). This was hardly a bad deal for Harvest. Although the JV structure prohibits the Company from reporting GAAP revenue and gives the (mis)perception that cash is stuck in Venezuela, the Company will get paid a dividend whenever PDVSA gets paid one. For example, Harvest received over $70 million in dividends from PetroDelta in 2008.
Thus, Harvest’s moat against unilateral seizure by Venezuela arises from the Company’s proven ability to increase total recovery of oil in place by more than 300% above those achieved by Venezuela. Specifically, in order to maintain power Hugo needs to maximize Venezuela's oil revenue without severely interrupting supply. The lowest risk method of accomplishing this goal is to continue PDVSA’s current joint venture with Harvest. This suggests to us that Harvest is likely to maintain its sizable economic interest in PetroDelta. In our opinion, a worst-case scenario would likely see Harvest compensated close to book value (over $100 million) for its PetroDelta ownership.
The History of Harvest (Formerly Benton Oil) - Please see the previous VIC write-ups for a detailed chronology of events.
PetroDelta’s Low-Cost Oil Reserves are a Buffer from Declining Oil Prices - If you are concerned that oil prices are likely to decline due to a stagnant economy, you can easily hedge the oil price risk. However, PetroDelta continues to generate good cash margins ($18 per barrel) at oil prices as low as $45 per barrel. In fact, at current oil prices (which produce a $30+ per barrel cash margins) most of PetroDelta’s costs are taxes, whose variability helps cushion against a severe decline in oil prices. Furthermore, PetroDelta’s cash costs of less than $10 per barrel (net of 33% in-kind royalty) should decline as production ramps significantly and the Bolivar devalues.
Disclosures: We and funds we manage own shares of Harvest Natural Resources. We disclaim any responsibility to update our ownership status. Please do your own due diligence as we have lost money before and HNR’s shares may lose value.
So, You’re Saying There’s a Chance? Catalysts Abound
-As major oil companies start bidding on new Venezuelan oil fields, it may become obvious that Harvest is worth substantially more in a partial or complete sale. Perpetual fear over the Venezuela risk is likely to dissipate over time as Harvest receives dividends and there is renewed interest from major oil companies. This is similar to the tightening of sovereign debt yields in the years following a default.
-PetroDelta's production and proven reserves are likely to expand quickly in the future, a precursor to major dividend payments to Harvest. PetroDelta production has been a big disappointment over the past few years (see previous VIC writeup expectations and management guidance of up to 75,000 BOPD) due to the nationalization process. Just when drilling could start in earnest after the conversion process was finalized, falling oil prices lead to OPEC quotas (initially capping PetroDelta at 16,000 BOPD) which then lead to contractor payment issues for PDVSA (which have been recently resolved). We believe the Bolivar devaluation and higher oil prices will finally give PetroDelta a long enough runway to get production off the ground with multiple rigs.
-Harvest recently announced that the first well of eight in the (Green River) Utah JV with Newfield had initial production of 350 BOPD and the third well appeared to have a much thicker pay. All eight wells will have definitive results by the fourth quarter earnings call in March, potentially leading to guidance about annual cash flows or bankable proven reserves.
-Two wells are to be spud soon in Indonesia as well as one that is already being tested in (Mesavarde) Utah, leading to potential material results (and bankable assets) in the next several months.
-Harvest may monetize some of its ownership in the projects in the Gulf Coast, Oman, or Gabon given management’s recent indications of external interest (see 3q09 earnings call transcript).
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