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Tullow’s shrugs off disappointing drilling results

Balancing act for the London-listed player, as it shrugs off disappointing drilling results, saying it remains committed to exploration-led growth

Tullow Oil may have been forced into writing off about $670 million last year, mostly due to dry wells, but it has no intention of changing its exploration-led strategy, chief executive Aidan Heavey says. On 13 February, the London-listed independent reported a 4% rise in pretax profit to $1.116 billion largely on the back of a farm down of two-thirds of its interests in Uganda to China National Offshore Oil Corporation and Total for about $2.9bn.

Heavey said: “2012 was a year of major progress. We enhanced the business with a basin-opening oil discovery in Kenya by adding prospective new licences in Africa and the Atlantic Margins, refinancing debt, and partially monetising our Ugandan assets.”

Such farm-outs have been a key plank of Tullow’s success. “Tullow’s key strategy has been to focus on exploration rather than development and has partially divested from its Ugandan licences, preferring to focus on discoveries in frontier areas but leaving the development with firms with more cash,” IHS Global Insight said in a note.

This focus on exploration has rewarded investors since Heavey, who founded the company in 1985 as a gas exploration business, listed it in 1987. If you’d bought a Tullow share 10 years ago at around 85 pence ($1.32), you could cash it in today at around 1,260p. Tullow’s market value tripled between 2008 and 2011, driven by oil finds in Ghana and Uganda. Since then there has been a feeling Tullow has stalled. In the 12 months to mid-February, shares fell 23%, making it the worst performer in the FTSE 350 Oil & Gas Index. Much of the concern centred on Tullow’s biggest producing field, Jubilee, offshore Ghana. In an operational update released on 11 February, Tullow said Jubilee oil output averaged 79,200 barrels of oil equivalent per day (boe/d) in 2012, lower than the 80,000-84,000 boe/d forecast. That helped drive shares down over 5% on the day of the announcement.

This has led some investors to worry Tullow is in danger of becoming more like a production-focused oil and gas firm – a slave to output targets and on what Heavey calls the “treadmill of development and production”.

Brian Gallagher, analyst at Investec, said Tullow’s production figures underlined its view the company might not reach output of 100,000 boe/d until 2018. “This will put pressure on the exploration portfolio to deliver exceptional results,” he said.

Tullow Energy report card

That’s true. But while admitting that 2012 was a mixed year for one of the industry’s best performing drillers – Tullow’s 76% success rate in 2012 with exploration and appraisal wells is more than double the industry average – many analysts believe 2013 could and should be better.

The company has committed to capital expenditure of $2bn this year, $900m of which will go on drilling 49 exploration and appraisal wells as Tullow aims to grow its 1.2bn boe of group reserves. Last year’s write-downs are the inevitable risk of this ambitious strategy. The company says it expects to drill high-impact wells in Kenya, Ethiopia, Mauritania, Mozambique, Norway, French Guiana and Côte d’Ivoire.

Kenya was the source of what Tullow calls its “2012 highlight”, with the discovery of a new oil basin – the fourth major basin-opening find by Tullow in the past six years. The company holds rights to 10 basins across Kenya and Ethiopia, each a similar size to the Lake Albert rift basin in Uganda, where Tullow discovered almost 1bn barrels of oil. In March 2012, Tullow hit a 100-metre oil column with Ngamia-1. In late November, it found 30 metres of oil at Twiga South. In September, Tullow made Kenya’s first gas find, hitting 53 metres of natural gas in the Mbawa-1 well, offshore Malindi.

Tullow says the Ngamia and Twiga South discoveries “demonstrate that substantial oil generation has occurred in the South Lokichar basin”. Recent tests in Twiga South produced at 2,351 b/d, the company said, and “provide the first potentially commercial flow rates achieved in Kenya and offer encouragement for the Ngamia tests”.

Nevertheless, 2012 saw a few disappointments, including Zaedyus-2, offshore French Guiana, which failed to hit commercial hydrocarbons. A discovery in 2011 by Tullow offshore French Guiana increased investor interest in the potential of Equatorial Margin countries, but later wells have been less encouraging.

Though it sees itself as primarily an explorer, Tullow needs production and farm downs to fund growth. As such, analysts say the main issue for the company remains one of getting the balance right. Investors will want to see better output figures, with the company forecasting working-interest production between 86,000- 92,000 boe/d this year, compared with the disappointing average 79,200 boe/d in 2012.

Much will depend on the Jubilee field, which Heavey says will provide the base for the company’s production profile and cash flow. Downhole problems have dogged the project, delaying production ramp-up. By the end of 2012, output was running 110,000 b/d gross; this is expected to rise to 120,000 b/d by the end of 2013.

Yet Investec analyst Gallagher said project delays are likely to put upward pressure on the company’s net debt – around $1bn at the end of 2012 – which indicates a major asset disposal may be one way to raise funds. “We estimate a current capital spending bill, dependent on disposals, in excess of $18bn out to 2020,” he said. “Progress on disposals is required to help meet commitments, which cannot be solely funded by internal cashflow.”

That makes Tullow a sell for Gallagher, who downgraded the stock on 8 January. He’s not alone: as of January, 16 analysts were listed as having hold/underperform/sell ratings on the stock, compared with 15 analysts with buy/strong buy ratings.

Mark Wilson of Macquarie Securities is another who downgraded the stock to underperform, seeing a stock trading at 99% premium to its core net asset value (compared with a sector average of just 9%) but with an exploration premium that he sees as too reliant on P10 expectations (reserves which are claimed to have at least a 10% certainty of being produced). Tullow, Wilson says, is a “good company, expensive stock”.

“Our rating is based on our view of the exploration premium in Tullow’s current share price, not the quality and ability of Tullow’s management team,” he says.

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