Introduction
Sometimes the best investment opportunities present themselves when the situation looks bleak and emotions start to take over. The turmoil in Egypt has resulted in one of these opportunities. The share price of oil exploration and production company Transglobe Energy (TGA) has declined significantly in recent months due to the deteriorating economic and political climate in Egypt, where the majority of its operations take place. To further complicate the situation, the military has ousted President Morsi, and it remains to be seen whether the country will be able to find its economic footing, or whether a lack of focus and discipline will continue to highlight economic policy. For investors with a longer investment horizon, this article will show that the decline has been more than factored in to the current share price, which is supported by a combination of a strong balance sheet, positive cash flow, proven reserves, and untapped growth opportunities.
Imbalances in Egypt's economy are coming to a head, as the nation long known for being an oil exporter has had to deal with rising internal demand and its transformation into an energy importer, a reality that is at odds with the government's reluctance to end costly energy subsidies for its citizens. This has resulted in unsustainable budget deficits, which has led the country to fall behind on its obligations to various energy companies. However, these same energy companies that have supported Egypt's economy in the past also represent the way forward to future prosperity. From multinational energy firms such as BP (BP) to smaller firms with operations solely in Egypt, there is no question that lucrative drilling opportunities continue to exist in the country. However, each firm must evaluate its liquidity and cash flows to determine whether it possesses the financial wherewithal to weather the potentially prolonged political storm. It does not appear to be in the interest of Egypt, its allies, or its creditors to see energy companies leave the region. Thus, it is necessary to focus on survival in the short term, with an eye on recovery and growth in the medium-to-long term. Transglobe presents a unique opportunity, as its declining share price belies a strong balance sheet and the ability to generate ample cash, not to mention future growth opportunities that dovetail well with existing operations.
Background
Properties
Transglobe's business activities consist of the exploration for and production of crude oil in Egypt and, to a much lesser extent, Yemen. The companies drilling interests in Egypt are represented by five production sharing contracts (PSCs) in West Gharib, West Bakr, East Ghazalat, South Alamein, and South Mariut. The company is also in the process of obtaining PSCs for the areas of North West Gharib, South East Gharib, South West Gharib, and South Ghazalat. These were won in the 2012 Egyptian Bid Round (2012 AIF page 10). The following graphic gives an indication of the geography (Company Presentation). Notice that three of the four pending PSCs are for areas surrounding West Gharib. As will be shown, West Gharib represents a large chunk of the company's oil production, and exploration of the surrounding areas should present an exciting growth opportunity. The company also has interests in four production sharing agreements (PSAs) in Yemen, which are referred to as Block 32, Block 72, Block 75, and Block S-1.
Under the terms of the PSCs, the Government is entitled to an oil royalty on the gross production. Once this amount has been taken out, the remaining production is designated as either cost sharing oil or production oil. Cost sharing oil is used to recover operating and capital expenses. The ceiling for this amount is a certain percentage of production. What is left over is production sharing oil, and this is split between the Government and the company as defined in the PSC (2012 Annual Report page 8). The purpose of this explanation is to show that the government has an interest in both the gross production of oil for royalty purposes and in making sure this production occurs in an efficient manner. The reason for this is that the Government shares in the difference if the cost sharing production comes in under budget. Thus, there is ample incentive for the Government to work with the company to make sure production flows smoothly.
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Production by Site and Overall Metrics
The table below shows the production and reserves summary for production areas in Egypt. 1P, 2P, and 3P represent proven, probable, and possible reserves, respectively. Reserve data is provided to the company by DeGolyer and MacNaughton Canada Limited, an independent petroleum engineering consulting firm. In addition, South Mariut is estimated to possess an average of 20.2 MMbbl of oil, and the company is waiting on approval to start an eight well drilling program in South Alamein. As can be seen, West Gharib and West Bakr represent most of the current production (Production in barrels of oil per day (bopd) as of end 2012 to match reserve data). For the areas shown below, reserves have increased nicely, especially the proven reserves for the West Gharib block, which saw an increase of over 25%.
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This is encouraging, since the new blocks won in the bid round should integrate very well with existing production, as shown in the graphic below. The company has indicated that it may be able to achieve operational synergies between West Bakr and West Gharib, and one could surmise that similar synergies could exist once the new areas are drilled (Company Presentation, slide 16). Clearly, the seventy nine appraisal locations will provide ample room for growth.
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Overall production and reserves have increased at a nice clip, as shown in the following graphic from the company's presentation slides (Company Presentation). Reserves have largely kept up with production, an encouraging sign. Also, note that basically all of the growth has come from Egyptian operations, which have accelerated greatly over the last year. Notice the large projected increase in production for 2013. As will be discussed, this very optimistic view has subsequently been revised downward, accounting for some of the recent decline in share price. So far, this report has not focused on the operations in Yemen. As shown in the graph, these represent a relatively small component of total production. Also, the company has stated that it is looking into selling this part of the business in the near future.
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Egypt Can't Pay Up
The largest problem facing investors of Transglobe is that Egypt will be unable to fulfill its obligations to the company, and Morsi's exit could lead to even more uncertainty. Oil produced by the company is delivered to the state-owned Egypt General Petroleum Corporation (EGPC), which then owes payment to the company in the form of accounts receivable. Unfortunately, the EGPC is behind on its payments. Companies are supposed to be repaid within two months, yet at the end of last year, EGPC was past due on roughly 75% of its payments to Transglobe, with about 50% over 90 days past due (2012 Annual Report page 39). This problem is not unique to the company, however, as the government was $7-8 Billion behind on payments to oil and natural gas companies in total as of the middle of last year, a number which has ballooned to closer to $9 Billion today (Reuters, "Egypt to Import Libya Oil, Pay Down Energy Debt"). Major foreign operators in Egypt include Dana Petroleum, BP, Eni, and Repsol. According to a manager at Dana, "It's a burden largely shared across all the oil companies." (NYTimes).
A large part of the problem facing Egypt is that its citizens have become accustomed to having the cheapest fuel in the region. For example, natural gas costs as little as $.16 per liter (NYTimes). In past decades, this was not such a big problem, since Egypt was historically a net exporter of fuel. It did not really matter if they gave it away to their own citizens as long as it was theirs to give. In recent years, however, local consumption has increased, and Egypt has found itself in the precarious position of having to pay market rates for its subsidized fuel. This is clearly shown in the following graphic provided by the EIA. If these practices are not curtailed, the country may never get its head above water. The country's financial supporters, such as the IMF and economically connected countries such as Libya and Qatar, are calling for cuts in the subsidies. However, the post-revolutionary government led by Mohammed Morsi was extremely unpopular with the country's populace. The idea of curtailing subsidies in the short term would almost certainly have added fuel to the fire (no pun intended). With Morsi out, even more uncertainty has been added. Hopefully the new leadership will recognize that the path to stability starts with the economy.
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As dire as this sounds, foreign operators have publicly expressed confidence that investment in the area will rise, even with the debt troubles (Reuters, "Egypt debts to oil firms highlight subsidies struggle"). Talk is cheap, but it appears many of these companies are backing up the talk with new investment projects. BP intends to drill 18 wells as part of its $13 Billion West Nile Delta Project. BG Group and Petronas will invest $1.5 Billion in natural gas investments, which due to the more generous subsidies, are even more vulnerable to government lapses in payment than petroleum. Overall, energy investment in Egypt is expected to increase in 2013 (Reuters, "Egypt debts to oil firms highlight subsidies struggle"). Granted, this was all said before Morsi's ouster, but it seems unlikely that these decisions were made without strong consideration of this possibility and its implications. Clearly, then, the challenge is for firms to manage their liquidity positions in the short to medium term, as energy companies have indicated that there are opportunities for growth in the long term.
Transglobe Can Ride Out the Storm
Two aspects of Transglobe's business will allow it to ride out the potential liquidity crunch. First, operating cash flow remains positive, despite increases in working capital due to accumulation of receivables. Secondly, the company's existing debt repayment schedule is manageable and it has recently reaffirmed its line of credit. It has a strong cash position and significant PP&E that one would think could be used as collateral in case the situation becomes especially bleak. The following table shows selected cash flow data for the past five years, along with historical working capital levels. It can be seen that operating cash flow has grown meaningfully over the past couple of years, despite the large increase in non-cash working capital, which is largely attributable to the increase in accounts receivable. In 2012, operating cash flow provided the company with funds to cover capital expenses, as well as providing cash for future development, even in a challenging environment in which it had a tough time collecting receivables. One would imagine that if the company is able to capitalize on the recently awarded PSCs and can get accounts receivable under control, the results will be truly impressive.
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The following table shows Transglobe's repayment schedule as of year end 2012 (2012 Annual Report page 40). The largest payment, the convertible debenture, is not due for another 4-5 years. Also, the conversion price on the debenture is around $15/share, so investors will not have to worry about this feature unless the stock price greatly appreciates. Cash and cash equivalents was just under $83 Million at year end, and has since increased to $112 Million at the end of Q1. In addition, the company has drawn down approximately $17 Million on a $100 Million line of credit that was recently reaffirmed. Thus, with about $200 Million between cash and the undrawn portion of its line of credit, the company appears to be in good shape from a liquidity standpoint.
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Recent Events and Simple Valuation
The recent decline in stock price has been largely caused by the Q2 mid-quarter update, which clearly shows a step back in progress, as well as some worrying trends. 2013 production levels have been revised downward from 21-24 thousand Bopd down to 19-20 thousand Bopd. This was largely due to a prolonged shut in at the Block S-1 location in Yemen, delayed approval for surface access at the South Alamein site, and delayed stimulation program at the West Gharib site. Well stimulation is a way to flush out blockages, similar to using Drano on a home bathtub. The delay was caused by extended contract negotiations which appear to have been settled. The shut in at the Block S-1 site, while disturbing, should not be cause for long-term concern, as the company has indicated that it would like to dispose of its Yemeni operations in the future. The effect of the decrease in production was a reduced funds flow estimate of $145 Million. To compound the problem, it was revealed that so far this year, $102 Million has been collected from the EGPC. Unfortunately, at the end of Q1 2013, $75 Million had been collected, so this implies that only $27 Million has been collected since. This has prompted the company to reduce its projected exploration and development budget for the year from $125 Million down to $80 Million (June mid-quarter report). Clearly, the company is preparing for tough times ahead as it appears that receivables collection will remain uncertain.
A full discounted cash flow model is probably inappropriate for a growth company with uncertain future cash flows, like Transglobe. However, a simple model that makes some very conservative assumptions should help provide a floor on the stock price. Let us first look at possible scenarios that assume the company does not go into bankruptcy in the near term. Once these are established, a default assumption will be added. The following table shows a very simplified cash flow model that uses the methodology of the Gordon growth model. The cash flow estimate is simplified to equal funds flow minus changes in working capital and capital expenditures. The growth rate was chosen as the long-term average US growth rate of 3% to reflect a very conservative situation in which the company achieves little to no future growth above that of the overall economy. This assumption is clearly unrealistic, as production CAGR was shown to have been 25% over the past four years, but is used to help represent the case where growth prospects are severely hampered by the current political/economic climate. Two cases are presented, one where working capital increases are expected to continue indefinitely (unrealistic, but informative), and a second in which they are expected to even out completely over the long term. Due to the conservative low growth assumption, Capex was maintained near current levels.
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This value does not include interest cost or cash balances. The value of long-term debt is close to that of cash on hand, so these largely cancel each other out. Even under these conservative assumptions, the upside to the current share price of around $6.30 is substantial if the company is able to recover its debts from the EGPC. Consider that these calculations assume that the new PSCs hardly contribute any value to the firm. If these do in fact prove to be successful, the values shown above would increase dramatically.
As a second step in the simplified valuation, let us assume that Egypt defaulting on its debt would lead to an instant bankruptcy for the company and a loss of 100% for equity holders (simplified, but conservatively so). Moody's currently rates Egypt Caa1 and the five-year probability of default on government debt is about 40% (source). Taking the average of the equity values shown in the graphic above and applying a survival probability of 60% (assumes that the situation will or will not be resolved in five years, which is admittedly a guess) still yields a value of about $6.40. Remember, this is largely discounting ANY future growth. In reality, this value could be a great deal higher. Granted, relying on rating agency data can be unreliable (as we saw in 2008), and the outlook on Egypt is negative, but this back of the envelope calculation hopefully conveys that at worst, the current stock price is largely discounting most if not all future growth.
Conclusion
The stock price of TGA has been beaten down over fears that the political and economic deterioration in Egypt will permanently hamper its operations and negate future growth. Egypt is certainly in a state of flux, with the ouster of President Morsi. This has resulted in uncertainty for the country's energy markets, and investors hate uncertainty. They hate it so much that they will depress prices beyond levels that are appropriate. The current stock price assumes that failure is imminent, even though energy companies from all over the world continue to invest in Egypt. It largely assumes that a significant portion of accounts receivable will never be recovered. If and when the situation improves, the share price of Transglobe could easily double or triple due to growth initiatives. While clearly a high risk, high reward situation, overreaction appears to have created a viable investment opportunity.
Disclosure: I am long TGA. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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