By Michael Feller, Equities Analyst, Lincoln Whether it's the safe haven of gold, the industrial metals of copper and aluminium, or the 'agflation' story of wheat, commodities have been in a boom market over the last year. Unfortunately for investors in the most-traded of commodities, however, this hasn't been exactly the case with oil, notwithstanding a weak US dollar which should, in theory, be leading to much higher prices. This relatively poor performance has, in turn, dampened enthusiasm for Australian-listed oil companies as their peers in minerals and agriculture zoom ahead. But rather than seeing this as a problem we see it as an opportunity, especially for little-known oil producer Nido Petroleum Limited (NDO).
NDO crossed our radar when it became a Lincoln Stock Doctor Star Stock on 14 September. After reporting its interim results to June clocking a 250% rise in earnings per share (excluding forex and derivative movements) NDO's shares have since moved from 15.5 cents on its Star Stock debut to 17 cents at the close of 29 September. Nonetheless, this stock has a lot further to go in our opinion. Notwithstanding a 30% rise over the last year, the Lincoln Valuation on NDO is currently 22 cents per share based on a basic discount cash flow (DCF) valuation. (Important note: since the time of writing we have updated our valuation on NDO. Please see the end of this article for details.)
NDO is also cheap on other fundamental measures. Based on a relative price to cash flow per share (P/CFPS) approach, NDO is worth 59 cents per share, and based on simple P/CFPS, it is worth a whopping 85 cents per share. For the time being at least, we believe that's a target too far, but nonetheless it does illustrate that NDO has more in its story than many of its peers.
Cash flow is a key theme in NDO, which has otherwise been treated as a speculative exploration stock by the market. The company's operating cash flow to tangible assets ratio is double the industry average and its ratio of profits to total liabilities is a very strong 0.82, whereas the industry average is negative: -0.07.
While an outstanding $US17.3 million Merrill Lynch convertible note puts pressure on the balance sheet, with $A38 million in revenues for the first half of the 2010 financial year (which in NDO's case ends in December), Lincoln have currently rated the company's overall Financial Health as 'Strong'. But why hasn't the share price reacted? There are several reasons:
First, we believe the stock is being lumped with other speculative explorers in an environment where a relatively stagnant oil price isn't attracting much excitement. Yet with a 27 cent broker price target, the market's apathy is the astute investor's opportunity, especially if the oil price changes, which hasn't been factored into our DCF valuation.
Second, we believe some recent operational difficulties, which have only just been surmounted, have limited investor interest.
The more exciting angle, however, is the big picture story for oil in general and NDO's geological assets in particular. While we'd love to see the petroleum-driven economy banished to the history books, the fact remains that we're inevitably facing a peak in conventional and easily extractable oil. We're also facing an increasingly belligerent OPEC bloc, many of whose Arab members have their currencies pegged to the US dollar and are thus eager to bring back the easy money. Libya, for instance, is pressing for oil at $US100 per barrel, arguing that commodity inflation elsewhere, especially wheat, is hurting its economy.
We've also a situation where demand from China and India is showing little signs of slowing and there's a compelling argument that even if China's alleged over-capacity in fixed assets (i.e. empty freeways and skyscrapers) caused an overall slowdown, Chinese commuters will still buy cars in increasing numbers thanks to a high level of personal savings and a permanently-changed culture of car ownership. Thus, even if we have a situation in China that leads to lower bulk commodity prices, such as iron ore, demand-side drivers could nevertheless remain strong for oil and other 'consumption commodities' well into the future.
NDO is well positioned for this phenomenon with the majority of its assets offshore, The Philippines. While not an OPEC member, or a place that tends to be associated with oil extraction, The Philippines operates Asia's most generous royalty tax regime, allowing contractors double the share of more prominent oil-producing nations such as Malaysia, Brunei and Indonesia. The Philippines also has a new pro-investment government, under the leadership of Benigno 'Noynoy' Aquino, the son of former president and human rights activist Corazon Aquino.
NDO's assets lie in the North West Palawan Basin, east of Palawan Island and across the highly prospective fault line between the Sabah and Palawan geological provinces. This part of the South China Sea is better known for the hotly-contested Spratly Islands, which are due west of NDO's acreage. While a lack of exploratory drilling means there are no proven reserves on the Spratly Islands, a 1993/1994 US Geological Survey estimate put the reserves at a potential 28 billion barrels. That's multiples higher than Australia's 1.5 billion barrels of proven reserves.
Within the North West Palawan Basin NDO is focused on five targets across 30,000 square kilometres of acreage. It holds a minority working interest in the Galoc, Nido, Matinloc and West Linapacan fields, which provide cash flows, and development interests in the Tindalo field, which commenced extended well testing in May. NDO also has significant interest in several exploration assets, namely Service Contracts (SC) 54, 58 and 63, all to the west of Palawan Island.
Of these various assets Tindalo is key, with estimates of 5.1 million barrels of recoverable oil. And while the company's recent interim test on Tindalo well 1ST1 seems to have disappointed the market with lower than expected flow rates, this situation could improve with further acid soaks.
It is NDO's management of Tindalo thus far that has been perhaps the greatest dampener on the share price. Tindalo's potential is very strong, but amidst the company's impressive balance sheet turnaround, the project has suffered a number of delays and wells have, until recently, been spewing more water than oil.
Nevertheless, what the latest 1ST1 flow result shows is that the well's water cut is now below 1% and indeed it is quite promising that 5,000 barrels of oil was chocked after only two of four planned acid soaks. Regular flow from 1ST1 could not only provide regular cash for other exploration activities, but could send the company's share price beyond the 20c resistance level it bounced against in June and attract the type of institutional interest that any $184 million market cap stock finds difficult to gain. It is also promising that NDO recently made its first 194,336 barrel shipment of Tindalo crude to South Korea, which will provide $US14 million in gross revenue to the joint venture.
Risks remain in NDO's convertible note overhang and Tindalo's potential is still yet to be confirmed, but therein lies the opportunity. Furthermore, NDO has reported new oil indications adjacent to Shell's Malampaya gas field. This find, known as the West Calamian block, within Service Contract 58, is exactly the kind of target NDO would be positioned to throw money at once Tindalo is producing. This is another reason to like the stock. At current levels NDO's potential is relatively low risk, but certainly not low reward.
(NOTE: Update as at 5 October 2010 - following a third acid test of Tindalo well 1ST1 we have lowered our valuation for NDO slightly to 19 cents from 22 cents per share. This is based on a reduced estimate for Tindalo's production resulting from a surprisingly higher watercut than previous tests indicated. Our valuation may change again on the results of further tests.)
NDO Price at posting:
15.5¢ Sentiment: LT Buy Disclosure: Held
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