Description

Cairn Energy PLC (LSE: CNE LN): 174.6p, £920m market cap

EXECUTIVE SUMMARY

Cairn Energy, a $1.2 billion market cap Scottish Exploration & Production company, is an eighth inning special situation with the game almost over as India and Cairn look to settle their long-standing dispute.  Due to the perceptions of “limited upside”, Cairn on the cusp of settling its dispute with India is ironically, at a share price well below where it has trading for most of the almost decade long dispute.  This, despite Cairn looking to accept India’s offer of a 7900 crore ($1.06 billion) settlement to its $1.75 billion (including costs and interest) arbitration award by the Permanent Court of Arbitration in the Netherlands last December.

At 174p, Cairn is trading at a discount to proforma year end 2021 cash of 180p and giving no value for its new Shell Egypt acquisition, any success from its $86 million in exploration expenditures, and contingent interests in previously sold assets.  Often the complaint with cash rich companies is that you’ll never get your hands on the cash, however, just this month Cairn management committed to a $700m capital return program made up of a $500 million (~70p) special dividend (which we believe would be a qualified dividend to US taxpayers) to be paid before year end (likely in mid to late November) and a $200 million share repurchase program.  The remainder of the $1.06 billion settlement ($360m) will be slated towards M&A to enhance Cairn’s low-cost production base.

INDIA SETTLEMENT

India and Cairn are on the cusp of settling a long running dispute over India’s seizure of Cairn’s shares in Cairn India almost ten years ago over a retrospective tax India passed.  While Cairn recently won a $1.75 billion arbitration award, we believe Cairn will settle with India under the law recently passed which would grant Cairn 7900 Crore or about $1.06 billion.  Cairn has indicated they will settle and return $700 million of the settlement to shareholders.  We expect payment in a matter of weeks as the law and paperwork get finalized, with a special dividend likely in November, but definitely before year end.

Should something go wrong, we believe Cairn could resume its enforcement actions to freeze and seize India assets around the world.  They were successful earlier this summer freezing $20m of real estate in France and are currently suing Air India in New York, an action stayed pending a settlement according to the new law.  Should the near-term settlement fall apart for any reason, the full $1.75 billion + future interest would be back on the table.  Previous, to the news of the settlement we expected India’s futile appeal process and various enforcement actions to take about 18 months to bear significant fruit.

EGYPT WESTERN DESERT ASSETS

On March 8, 2021, Cairn, together with an Egyptian partner, Cheiron Energy, entered into a sales and purchase agreement to acquire a portfolio of upstream oil and gas exploration, development, and production interests from Shell in the Western Desert, onshore The Arab Republic of Egypt for a purchase price of approximately US$646m effective January 1, 2020 (compared to equity of $786.3m at Dec 31, 2019, 82% of book).  Cairn is acquiring 50% of assets being sold by Shell, and its share of the consideration is $323m.  Additional contingent consideration of up to US$280m ($140m net to Cairn) is payable depending on the price of oil (if Brent > $55/bbl, capped at $100m) and the consortium’s exploration success ($40m).  The total consideration also rises or falls based on the path of equity and working capital from the effective date.  As of 6/30/2021, the projected consideration had fallen to $302 million due to cash pulled out of the business by shell.

The interests being sold by Shell are comprised of 14 concessions (including 3 exploration concessions), with 21 development leases. The producing fields and exploration areas are split over four and three distinct areas, respectively.

Cairn describes its partner Cheiron as a company that “focuses on onshore and shallow water opportunities and specializes in revitalizing and optimizing production from mature fields with upside potential. Cheiron also has an in-depth knowledge of the Egyptian hydrocarbon basins and infrastructure. Its operations range from near field exploration and appraisal activity to new field developments. Cheiron has an established track record of using its technical and operational expertise, coupled with prudent cost management practices, to add value to its asset base.”

Bapetco, a joint venture company currently owned 50:50 by Shell and the Egyptian General Petroleum Corporation ("EGPC"), is the operator of all of the producing concessions within the portfolio.  Following the transaction, Cairn will own 25% of Bapetco.

Importantly the assets’ production (measured in mmboe) is about 2/3^rd gas (63% at year-end 2020) for which the consortium is paid a fixed price and 1/3^rd oil for which the Consortium receives a slight discount to Brent.  Given the fixed price for the gas production and the oil price linked contingent liability to Shell (described above) that hedges both crude upside and downside, this acquisition will not live or die on the commodity.  Rather, success hinges on the Consortium’s execution of their operational and exploration business plans.

The interests being sold by Shell are comprised of 14 concessions (including 3 exploration concessions), with 21 development leases. The producing fields and exploration areas are split over four and three distinct areas, respectively.

Cairn describes its partner Cheiron as a company that “focuses on onshore and shallow water opportunities and specializes in revitalizing and optimizing production from mature fields with upside potential. Cheiron also has an in-depth knowledge of the Egyptian hydrocarbon basins and infrastructure. Its operations range from near field exploration and appraisal activity to new field developments. Cheiron has an established track record of using its technical and operational expertise, coupled with prudent cost management practices, to add value to its asset base.”

Bapetco, a joint venture company currently owned 50:50 by Shell and the Egyptian General Petroleum Corporation ("EGPC"), is the operator of all of the producing concessions within the portfolio.  Following the transaction, Cairn will own 25% of Bapetco.

Importantly the assets’ production (measured in mmboe) is about 2/3^rd gas (63% at year-end 2020) for which the consortium is paid a fixed price and 1/3^rd oil for which the Consortium receives a slight discount to Brent.  Given the fixed price for the gas production and the oil price linked contingent liability to Shell (described above) that hedges both crude upside and downside, this acquisition will not live or die on the commodity.  Rather, success hinges on the Consortium’s execution of their operational and exploration business plans.

Cairn and Cheiron believe that Shell has recently (2020 and 2021) significantly underinvested in the asset due to the pandemic and its disposal plan, and in general has operated the asset “like an oil major” as opposed to a savvy local operator.  As such, Cairn anticipates that when they get their hands on the Western Desert Assets the Working Interest (WI) production (net to Cairn) will be at a depressed 33k-38k boepd in 2021, significantly below the potential inherent in the fields.

Cairn/Cheiron’s strategy, once they get control of the Western Desert Assets is to invest heavily to a) lower costs and b) expand production.  This strategy is designed to increase revenue and operating profits which would be valuable in itself, but has the added function of enabling the claw back of significant historical costs which are recoverable but subject to limits as a percent of revenue.  Historic Recoverable Costs at year end 2020 were approximately a massive $948.5m for the group ($445.7m net to Cairn).

Cairn/Cheiron’s business plan contemplates capital expenditures jumping to $167m ($83.5m net to Cairn) in 2021 from $60m in 2020 with follow on spending of $276m, $221m, and $175m in 2022, 2023, and 2024. Based on this commitment, Cairn’s third-party expert, Gafney Cline, projected a PV10 (at December 31, 2019) of $331.8m net to Cairn for the Proven Reserves, $572.2m for the Proved + Probable (2P) Reserves, and $746.4m for the Proved + Probable + Possible Reserves.   However, these values were a) as of December 31, 2019, b) assumed an oil liquids price that is aggressive for 2020 ($63.38 vs actuals of $40), and c) assumed liquid pricing that is likely conservative for 2021 ($64.50 in 2021 vs actual 1H2021 prices averaging $65.50 and Q2 prices averaging $74 so far in July 2021).

Our own model assumes Cairn pays $302m for 41.8m in net working capital at the end of 2021 for all the cash flows in 2022 and beyond.  We estimate the Net Present Value of the fields to be $432.6m using GafneyCline/Company projections by field for production, capex, the economics of the fields, and the current Brent Oil Curve which we risk weight by 90% for a net value of $390m.  Cairn cites significant 2C reserves of 49 mmboe as a notable opportunity.  We estimate, again using company production projections, 2C cash flows could be worth $75m which we risk 20% for a base case value of $15m.

Operated Exploration

Egypt’s Western Desert also offers a significant exploration opportunity for Cairn.   Gross unrisked resources are estimated at 800 mmboe over three exploration concessions which Cairn will operate covering 9,000 square kilometers.

The prospects, South Abu Sennan (SAS, 100 mmboe), West El Fayum (WEF, 400 mmboe), and South East Horus (SHE, 300 mmboe). Are close to existing infrastructure and significantly more oily (~70-80%) than the existing production assets.

Two 3D seismic surveys and 9 exploration wells are planned over the next three years per a $19.5m budget.  Shell is owed $0.4 per barrel of independently audited 2P reserves capped at $40m, i.e. capping at 100m barrels.  Assuming 200m barrels is the upper range of 2P reserves, an upside case might be worth $1.1b ($65/bbl-$6 opex = $59/bbl*100mmbboe = $5.9b in revenue * 18.5% profit share * 50% working Interest).  We apply a 10% risk factor in our base case to the value and 100% to the exploration costs.  We assume the capex to develop the wells is recovered through the cost oil parameters of the contract.  In terms of scope, 200 mmboe may prove conservative relative to a called out 800 mmboe opportunity with 50% productivity record.  We don’t ascribe much precision to this exercise, but simply highlight that Cairn and their partner believe that significant upside may be captured from exploration here.

CONTINGENT CONSIDERATION ASSETS

U.K./North Sea Asset Sales (Catcher & Kraken)

Cairn is selling their 20% interest in Catcher and 29.5% interest in Kraken to Waldorf Production for firm consideration of $460m as at an effective date January 1, 2020.  Working capital adjustments, as of December 31, 2020, would result in adjusted consideration to Cairn of $316m.   Consideration includes a four-year $35m sellers’ note.  The transaction was approved by shareholders July 19^th and is expected to close 3Q21.  Cairn is retaining the majority of its significant U.K. tax loss assets ($486.3m UK ring fence losses and $409.8m supplementary charge losses) which we are valuing at zero given Cairn’s U.K. activities are now limited.

Additionally, Waldorf owes Cairn consideration based on Brent prices in excess of US$52/bbl in the years 2021 to 2025 assuming certain volume thresholds are met.  These contingent payments are weighted toward near dated volumes and are uncapped.  Management has guided that these series of call options (paid quarterly) are worth ~$80m at $60 Brent and ~$125m at $65 Brent.  Based on actuals so far in 2021 and the Brent Forward Curve, our unrisked and risked PV10 for these 20 call options is $136.6m and $108.2m (79.2% average risk weighting) with half of the value coming in 2021.

Senegal Contingent Consideration

Cairn announced the disposal of the Group’s interests in its Sangomar field, Senegal, in July 2020 and completed the sale to Woodside in December 2020 for $525m.  Further consideration may be payable to Cairn If first oil, as defined in the Senegal SPA, occurs on or before December 31, 2023 Woodside will pay $100m cash to Cairn if the Average Brent Price during the 180 days after First Oil is above US$60 per barrel; or US$50 million if the Average Brent Price during the 180 days after First Oil is above US$55 per barrel but less than or equal to US$60 per barrel; or in the first half of 2024 Woodside will pay in cash to Cairn US$50 million if the Average Brent Price during the 180 days after First Oil is above $60 per barrel; or US$25 million if the Average Brent Price during the 180 days after First Oil is above US$55 per barrel but less than or equal to US$60 per barrel.  With regard to timing, Woodside is on schedule for first oil in 2023, as announced with its Q2 2021 results:

“Work on our Sangomar Field Development Phase 1 offshore Senegal continued on schedule during the quarter and the project is now nearly one-third complete. In July, the first of two drilling vessels arrived in Senegal and the drilling campaign commenced for the project’s 23 wells.”

At 31 December 2020, the company valued this Senegal deferred compensation at $27.2m when Brent was ~$50/bbl; ($5 below the minimum threshold price).  With Brent now at $68/bbl, $13/bbl higher than the $55 threshold for a $50m payment and $8/bbl more than the threshold for a $100m payment (and the Brent futures curve predicting 2023 prices in excess of $61) we risk weight the first $50m payment tranche at 75% and the second $50m at 50% for a blended risk factor of 62.5%.

EXPLORATION ASSETS

UK North Sea Exploration Assets

In the North Sea Cairn is partnered with Shell (50/50) in two prospects (P2379 and P2380) and is going alone in a third prospect (P2381).  These prospects are attractive because they are close to infrastructure and would be inexpensive to develop through tiebacks to Shell’s Nelson Platform (pictured above), implying a quick payback. 

P2379 and P2380 (Cairn 50%, Shell 50%)

·       Shell operated “Jaws-1” well to spud Q2 2021.  The well is targeting the Jurassic Fulmar level and is estimated to have 32 mmboe of gross recoverable resources.

·       Cairn operated Diadem-1 well to spud Q2 2022

·       Multiple follow-on prospects if success is achieved with these first two wells.

P2381 (Cairn 100% WI)

·       Targeting Jurassic and deeper levels

·       Jaws results will inform value

P2468 (Cairn 50%, operated) in the East Orkney Basin

·       Reprocessing of legacy 2D seismic is completed and shallow boreholes and geophysical data will be acquired in 2021 to inform a decision on acquisition of 3D seismic over this acreage.

$20.6m was charged to the income statement for unsuccessful North Sea exploration activities in 2020, including $19.4m on the Agar-Plantain license which was relinquished early in 2021 after concluding the discovery was not commercially viable in a lower oil price environment.  Cairn has budgeted $10m for exploration in the North Sea in 2021.

Mexico Sureste Basin

($55.7m carrying value)

Cairn has interests in four blocks in the Gulf of Mexico, two as Operator (Blocks 9 and 15) and two as non-Operator (Blocks 7 and 10*).

Block 10 (ENI Operator & 65%, Cairn 15%, Lukoil 20%)

ENI made a discovery, Saasken, in February 2020. 

·       Initial analysis indicates an in-place resource of 200-300 MMbbls. 

·       The consortium plans an appraisal well and are initiating studies for commercial development

ENI planning to spud another well, Sayulita-1, H1 2021

·       ENI estimates 160 mmbls of oil in place

Block 9 (Cairn 50% WI)

Cairn completed its second operated well in Mexico in Q1 2020.  The exploration objectives were dry and the

well was permanently plugged and abandoned. Cairn continues to update its assessment of the perspectivity of Block 9.

Block 7 (30% WI)

ENI completed Operations on the Ehecatl-1 well in Q2 2020 and the well was permanently plugged and abandoned. The Operator ENI and Cairn are working to identify prospects for drilling a second exploration well, currently planned for 2022.

Across all three Blocks, $47.3m in unsuccessful drilling costs were expensed in 2020 as well as $8.7m in other exploration related expenses.

Suriname Guyana Basin

($13.5 carrying value)

Cairn is the sole operator on Block 61, the largest offshore Production Sharing Contract (PSC) in Suriname at 13,080 km².  The block is located in the world class Guyana-Suriname basin.  Cairn is hunting for a major exploration discovery here.

Significant discoveries such as Stabroek, Sapakara, Sloanea, and others have been made by Exxon and others moving eastward from Guyana into Suriname recently.  Multiple targets have been identified across the area at 100-800m of water depth.  To the East in Guyana, Exxon has discovered an estimated recoverable resource of nearly 9 billion oil-equivalent barrels on the Stabroek block.  Oil was recently discovered (Dec 2020) offshore Suriname by Petronas and Exxon in Block 52, adjacent to Cairn’s Block 61; however the size of the discovery has been yet to be made public.

The risk for Block 61 is that it may be too much at the edge of the sedimentary basin.  Cairn is considering acquisition of 3D seismic to develop potential drilling opportunities in both shallow and deep-water areas.  Cairn may bring in partners to help fund the next phases of exploration.

Cairn spent $4.2m here in 2020 and the license has been extended for an additional 12 months until June 2022. Assuming all goes according to plan, Cairn is 2-years from drilling. 

Israel

($1.7m carrying value)

Cairn has a 33.34% WI as Operator in eight licenses offshore Israel. During 2020, as part of the minimum work commitment, Cairn awarded a contract for seismic processing, which is ongoing. The project aims to improve the imaging of existing seismic in order to mature prospectivity.

Mauritania

($21.0m carrying value)

Potentially large.  Relatively early stage.  Cairn spent $11.3m on licenses to Block 7 in early 2020, however the license was relinquished after Cairn’s operating partner, Tullow, withdrew.  Cairn expects to complete the signing of a new license across the acreage in 2021.

Cote d’Ivoire

($12.2m carrying value)

Cairn has assumed Operatorship (90% WI) in blocks CI-301 and CI-302 from Tullow which has exited both licenses. Cairn remains in the Tullow-operated CI-520 (30% WI). The JV has exited blocks CI-518, CI-519, CI-521 and CI-522 effective end Q4 2020 resulting in $11.6m in write-offs. 

In total Cairn invested $8.6m across its seven licenses in 2020.  The proposed 2021 work program for blocks CI-301 and CI-302 is focused on completing the planned 2D seismic acquisition subject to COVID restrictions.

Catalyst

Finalization of settlement with India (next several weeks)

Receipt of the $1.06 from India (next several weeks)

Payment of $500m Special Dividend (by year end 2021)

Closing Egypt Aquisition and updating operating plan (Q3 2021, and Q1 2022)

Approval and launch of $200m share repurchase

Announcement of M&A (1H2022)

Receipt of 2021 UK Sale contingent consideration (Q1 2022)

Exploration outcomes