The major problem in evaluating the proposed merger with ELK is...

The major problem in evaluating the proposed merger with ELK is the total lack of information available to MEL shareholders about the likely longer term returns and the total absence of any information on ELK's short term cash requirements.  For example beyond the commitment of the initial AU$2.5 million by MEL there is absolutey no estimate of the required ongoing expenditure and it seems this could be significant over a long period.

On 12 February 2013 ELK did provide an economic analysis of the Grieve development at http://www.asx.com.au/asxpdf/20130212/pdf/42cz5mq81syjg3.pdf

A summary of that report is given below. The base case prepared by Ryder Scott assumed oil production nett to Elk of 5.46 million barrels out of a total 18.6 million barrels for the project. At a discount rate of 10%, the Report showed a net present value to Elk of US$95 million.



However this analysis is worse than useless in the current circumstances: -

• The Ryder Scott economics were unrisked and did not include income tax or financing.
• Moreover it assumed a constant crude price of USD86.40 while the current price is likely to be close to half that.
• No new technical work was undertaken, I nstead the analysis used production simulations that were prepared prior to the commencement of field repressurisation. ELK have continued to promise an updated simulation based on work by Denbury but so far no new information has been provided.

• We also now know that Denbury apparently believe that total recovery will only be 12 million barrels rather than the 18.6 million barrels used in the simulation.
• The estimated capital cost has also blown out from the estimate at the start of 2013.
• While Ryder Scott did look at the sensitivity to a six month schedule blow out for first production, it now looks like the blow out will be closer to three years. So totally useless.

Short term cash requirements

Details on ELK's short term funding is even more lacking. Although detail is completely lacking, it appears that the structure of the Grieve EOR field development was along the lines: -

Much of the project infrastructure is directly funded by Denbury and will be leased back to the Joint Venture: -

• The CO2 supply line and metering system - originally estimated at USD1.2 million. This facility has been completed but an updated actual cost has been provided.
• CO2 recovery and recompression facilities - originally estimated at USD50 million. This facility is yet to be constructed and no updated cost has been provided.
• Additionally in the September 2014 quarter ELK advised "The operator (Denbury) incurred additional expenditures beyond these joint venture costs for the 230-kV power line and electrical substation." There was no indication of the cost of this facility or how the cost was tothistle covered from the JV.

The originally estimated capital cost for field development in 2011 appears to have been USD62.8 million which seems to have been the basis of the funding arrangements.

• ELK's share of this at 35% interest was USD22 million and ELK's funding for this USD22 million was made up of: -
• USD 10 million free carry by Denbury plus the next USD12 million was provided as a loan from Denbury which is to be repaid from ELK’s share of initial oil production. Based on details in the annual report this loan was at a variable interest of 11%.

Beyond the original USD62.8 million, the project was to be funded by each of the JV partners in proportion to their interests.

Given that the expenditure for the field development now stands at USD70 million, it means all of ELK's existing funding has already been fully drawn down. It is likely that the AUD2.5 million initially provided by MEL is to fund ELK's immediate share of the overrun from USD62.8 to USD70 million. ELK has not provided any estimate of forward expenditure required, in fact it looks as if ELK has not received any estimate from Denbury. But additional expenditure is almost certainly required. Even if there is no requirement for additional capital expenditure, there will be operational expenditure associated with the continued repressuring of the field. Given that Denbury has fully funded the electricity supply, apparently outside of the original JV agreement, it is likely that at least the JV will be charged an ongoing lease payment. There has also been discussion about replacing the ESP in the water well with one of a higher capacity required to meet the current 2017 date for first oil.

Based on the September 2014 Quarterly, ELK's ongoing expenditure is of the order of AUD700,000 per quarter. While the Quarterly showed that ELK had a cash balance of AUD1,602,00 at the end of the quarter it is likely that the majority of this has already been committed.

ELK also has an unsecured short term loan of AUD1.25 million at 12.5% interest maturing on 8 January 2015 and while ELK has committed to make reasonable endeavours to secure an extension of this facility, given the obvious difficulties in securing the loan initially, it can be expected that renewal on acceptable conditions is not guaranteed.

It therefore seems probable that MEL may be forced to commit a further AUD1.25 million to ELK early in the New Year to ensure that ELK can continue to trade. Since first oil is not now expected till 2017 it is likely that the project will demand additional funding for at least two more years. Given that ELK has mentioned trying to refinance this loan from Denbury so that it has access to some early cash flow, it is likely that the full nett proceeds from the initial oil production is due to Denbury until the loan is fully repaid. Even more problematic, since the power supply appears to have been funded by Denbury outside of the original JV Agreement, ELK may have to pay lease costs for this facility plus potentially a transport tariff for the crude oil export pipeline. This would mean that ELK could remain in a negative cash flow position for some time after first oil. It is therefore likely the ELK may not have any free cash flow for a year or more after first oil production (i.e. 2018) or later.

The only asset held by ELK that could be sold to raise additional funding is the Grieve crude oil export pipeline. ELK has tried to sell this pipeline several times, always unsuccessfully. ELK has again just announced a Letter of Intent for the sale of the pipeline but it will take time to determine if the sale can be successfully completed this time around.

Grieve oil pipeline

The oil pipeline runs from the Grieve field to a storage and distribution hub at the Platte Station near Casper, Wyoming and includes 32.4 miles of 8" pipeline and associated branch lines from other fields together with additional storage tanks and other facilities. The pipeline was purchased from Unocal Pipeline Company in April 2011. The pipeline is approximately 50 to 60 years old and was taken out of service in 2002.

ELK has not provided any indication of the cost of purchasing this asset; however payments for purchases of "other fixed assets" for the three quarters ending 30 June 2012 show a total spend of AU$1,486,000. This was during a period of little other expenditure on corporate activities

In addition Annual Reports for years 2013 and 2014 show Elk spent a total of US$417,480 on refurbishment. This included replacing approximately 350 feet of pipe which resulted in restoring the maximum operating pressure (MAOP) of the pipeline to 700 psig. Elk has stated that further work is planned to re-establish the pipeline to its former maximum design pressure rating of 1,460 psig. In my experience on similar old crude oil pipelines, significant expenditure is required to restore the pipeline to the original design operating condition. Elk have indicated that this additional work is not required to allow crude to be transported from the Grieve field, but it may be more difficult to dispose of the pipeline in a down rated condition. I expected that any sale agreement may included a condition that ELK complete the refurishbment of the pipeline to achieve the original MAOP of 1,460 psig and that Elk carry any financial risk associated with the upgrade, which may be significant.

Given that first oil from Grieve, and so first revenue from the Grieve pipeline, is not now expected until 2017, it is understandable that Elk has struggled to sell this asset. In addition a further complication is that ELK may need to negotiate a tariff free period for a year or more until the Denbury loan is repaid, making the asset even less attractive to any potential purchaser.

Summary

So in summary we have a very poor understanding of the overall economics of the project and almost certainly an extended period, maybe 3 years or more, where the project continues to demand cash injections. Not a very encouraging position.

It is quite unacceptable that MEL can attempt to railroad this significant change in direction through without any requirement for a vote by shareholders. We can only hope that ASX does look at it seriously and use its discretion to insist on a shareholder vote or to force MEL to provide additional detailed cash flow information.