The Gulf Keystone Petroleum Limited CPR: Buy in or sell out?

I’m not sure what Todd Kozel, the CEO of Gulf Keystone Petroleum Limited (LON:GKP) was expecting, but the firm’s first ever Competent Persons Report (CPR), which valued the firm’s proven  and probable reserves at just $1bn, received a brutal reception from the markets yesterday. As I write, the firm’s shares are down by 28% on Monday’s opening price.

The question is why. Have Kozel & co been guilty of overhyping the 14bn barrel oil-in-place figure, or have markets overreacted to what appears to be a very conservative CPR, with far more upside than downside?

What happened?

The firm issued an update yesterday confirming that the firm’s plans for 2014 are still on track:

• Move from AIM to main market will be complete by the end of March 2014
• Production still around 10,000 bopd, targeting between 20,000 and 40,000 bopd in 2014
• Working on debt funding to pay for next stage of development, targeting 100,000 bopd
• First ever CPR published

The first three points are as expected — the next ‘interesting’ geological piece of news should be the results from the Shaikan 7 well, which are due in the next few months.

It was the CPR that seemed to shake investors out of their positions, regardless of cost, and here’s why — the report said that the firm’s current proven and probable (2P) reserves will generate a profit of just $1bn. The resulting fall in the share price has cut Gulf Keystone’s valuation to just $1bn, suggesting that investors have been scared by the CPR and/or they have little confidence in Gulf Keystone’s ability to move beyond the first stage of development.

Short-sighted?

By valuing Gulf Keystone at no more than the discounted earnings expected from its current reserves, Mr Market is probably being short sighted. To help clarify the situation, I’ve put together some of the key figures below.

• Shaikan 2P reserves: 299 mmboe (163 mmboe net, diluted to GKP)
• Total 2P reserves and 2C resources: 1,323 mmboe (739 mmboe net, diluted to GKP)
• NPV10 of Shaikan Phase 1: $1bn

(2C contingent resources are considered to be recoverable but have not yet been shown to be commercially viable)

It’s reasonable to expect that a substantial portion of the 2C figures will be come 2P reserves in due course. It’s also possible that the recovery factor — the proportion of the oil in place that can be successfully extracted — will be higher than the fairly conservative assumption made in the CPR.

In either case, the figures suggest to me that Gulf Keystone should have little trouble growing its 2P reserves from the CPR’s cautious 299 mmboe baseline.

Finally, the big difference between the diluted and undiluted figures requires an explanation of its own, in my view, as it could have a material affect on the company’s future valuation.

Diluted or not?

Gulf Keystone currently has a 75% working interest (WI) in Shaikan, while its associated company, Texas Keystone International, has a 5% interest. However, Gulf Keystone’s original licence included an option for the Kurdistan Regional Government (KRG) to take up an interest of up to 20%, and for a third part nominated by the KRG to take a further 15%.

So far, so predictable. In an uncharacterically coy move, however, Gulf Keystone asked ERC Equipoise Limited (ERCE), the company which produced the CPR, to assume that all options were fully taken up — even though the fiscal terms for these options have expired.

My reading of this is (and it’s only my opinion) is that Gulf Keystone is covering its back ahead of its main market listing, and also that it won’t risk derailing its strong relationship with the KRG for the sake of a contractual technicality. By assuming that GKP’s interest in Shaikan will be diluted as originally planned, there’s no downside — if it doesn’t happen, the the firm will simply make more money from the same capex.

How much upside?

GKP’s first CPR has brutally and effectively established a baseline for the valuation of the company. It’s conservative, relatively undemanding, and almost certain to be exceeded — but by how much?

Would-be buyers eyeing the company now must surely see a bargain. Not only has ERCE been conservative in its valuation, but it has also assumed lower recovery rates than those achieved by other established operators in the region.

A failure to deliver future 2P and 2C upgrades from this point would be very surprising indeed. The Shaikan 7 well, currently drilling, is targeting the lower Triassic and Permian intervals and could indicate significant new resources across all blocks.

Given the firm’s drilling success rate on Shaikan so far, it’s reasonable to expect that many of the planned development wells will deliver as expected, too.

Finally, in addition to Shaikan, GKP also operates the Sheikh Adi field (80% WI), which already has 2C resrouces of 155 mmboe, while the firm also has non-operated interests in the Ber Bahr and Akri-Bijeel fields.

As with all frontier operations, risks remain with Gulf Keystone, but I’ve no plans to sell my shares and am debating whether to average down by buying a few more at the current price.

UPDATE: In the interests of disclosure, subsequent to publishing this article I decided to average down and increase my holding in GKP.

Disclaimer: This article is provided for information only and is not intended as investment advice. The author may own shares in the companies mentioned in the article. Do your own research or seek qualified professional advice before making any purchase decisions.