Dragon Oil. Upside potential is overlooked

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1 Oil and gas Dragon Oil December 2011 December 9, Miramgul Maralova +7(727) Buy 12M target price GBp 761 Current price GBp 485 Upside potential 57% Market cap (bn) $ 3,9 Free float 49% Number of shares outstanding, mn week range GBp Ticker Dragon Oil stock vs. Brent performance since January 2011 GBp/share DGO Brent Jan-11 Mar-11 May-11 Jul-11 Sep-11 Nov-11 Source: Bloomberg DGO LN $/bbl Dragon Oil Upside potential is overlooked We initiate coverage of Dragon Oil, a London-listed large-cap oil and gas company operating in Turkmenistan, with a 12-month target price of GBp 761 and a Buy recommendation. Dragon Oil s oil and gas reserves amount to 906mmboe (as of December 31, 2010). The company is operating under a Production Sharing Agreement with the government of Turkmenistan and is currently entitled to 40% of the profit oil. All of the entitled oil is shipped to the European market via a Baku-Tbilisi-Ceyhan pipeline. Dragon Oil is on track to increase its production rate from the current 67,000bopd in 2011 to 100,000bopd by 2015, we believe. Dragon Oil is currently negotiating with the Turkmens the terms of gas sales and is yet to agree on the price and export routes. Meanwhile, the company plans to build a small gas treatment plant to strip gas condensate from its gas. The condensate will be added to produced crude to improve its quality and sold under the same terms as current oil sales. Before Dragon Oil agrees with the Turkmen government on its gas resource potential, we do not anticipate the market to assign a full fair value to the company s gas potential. Dragon Oil has a strong balance sheet with a zero debt and $1.4bn cash. This puts the company in a good position for acquiring smaller development and exploration stage companies. Dragon Oil may spend $200-$500mn on acquisitions and focus primarily on assets in Central Asia, the Middle East, Africa and South East Asia. Diversification of geographic and single-asset risks will add value to the company s shareholders, in our view. Our sum-of-the-parts valuation of Dragon Oil stock shows that the bulk of the company s value currently stems from its oil assets, while the company s dry gas and gas condensate sales add roughly GBp 40 to the stock value. The future growth potential of the firm lies in further development of the PSA-area oil fields, its large untapped natural gas reserves and future acquisitions. Year Revenue Revenue EBITDA EBITDA Net Net Debt ROE After tax EPS growth margin Income ROIC ($ mn) (% yoy) ($ mn) (%) ($ mn) ($ mn) (%) (%) ($/share) 2010A % % 386 (1 337) 18% 48% 74,7 2011F % % 475 (1 822) 19% 67% 92,0 2012F 892-2% % 462 (2 131) 16% 57% 89,3 2013F 879-2% % 446 (2 437) 14% 50% 86,3 2014F % % 510 (2 854) 14% 56% 98,7 Source: HF estimates Halyk Finance 1

2 Table of contents Company overview... 3 Oil... 4 Natural gas... 6 Acquisitions strategy... 7 Valuation... 8 Halyk Finance 2

3 Company overview Dragon Oil is a mature oil and gas company operating in Cheleken contract area in the Turkmen part of the Caspian Sea under a Production Sharing Agreement (PSA) with the government of Turkmenistan. (See Figure 1.) The company was registered in Ireland in 1971 when it also listed on the Irish Stock Exchange. Its shares are traded on London Stock Exchange (premium listing) under DGO ticker. Signed in November 1999 (the PSA became effective in May 2000), Dragon Oil s PSA has an initial period of 25 years and may be extended by a minimum of 10 years. To boost production at its oilfields, the company invested more than $2bn in additional development wells, construction of new platforms and development of other infrastructure at the fields. By late 2011, Dragon Oil increased oil output at Cheleken tenfold, which at the time of signing PSA was yielding less than 7,000bopd from Soviet-era wells. In addition to significant oil reserves of 639mmboe (as of December 31, 2010), Dragon Oil s Cheleken area is believed to contain 267mn boe of gas in 2P reserves, which are yet to be commercialized. Currently, Dragon Oil is negotiating the terms of gas sales with the government of Turkmenistan. The terms are not expected to be reached in the short-term. Meanwhile, the company plans to build a gas treatment plant to recover and sell gas condensate. Dragon Oil has no debt and $1.4bn in cash on the balance sheet, which puts it in a good position for future acquisitions. To diversify its single-asset and geographical risks, the company links its growth strategy to future acquisitions in the Central Asia, the Middle East, Africa and South East Asia. Figure 1. Location of the Cheleken contract area Caspian Sea In 2010, Turkmenistan s GDP grew by 9.1% and totaled $17.7bn. The hydrocarbons industry is the leading sector of the economy. On the global scale, Turkmenistan was ranked 21 st by gas production and 4 th by the amount of proved gas reserves. (Based on 2010 data.) Source: Company data, HF Halyk Finance 3

4 Ownership structure Headquarters of Ireland-incorporated Dragon Oil are located in Dubai, United Arab Emirates. The company s majority shareholder (51%) is Emirates National Oil Company (ENOC), owned by the government of Dubai. The rest of the shares are in the free float. (See Figure 2.) Two directors of the six-member board are nominated by the main shareholder. In November 2009, ENOC attempted a $1.8bn takeover bid of Dragon Oil at a price of GBp 455 per share, or at a 34% premium to the price at that time. The offer was rejected by minority shareholders. This year, mass media reported about a possible second attempt by ENOC to take over Dragon Oil, which we believe is quite likely in the next few years. Figure 2. Ownership structure ENOC 51% Source: Company data Free float 49% Reserves and resources According to an independent resource estimate, as of December 31, 2010, Dragon Oil had 639mn barrels of oil and gas condensate and 1.6 trillion cubic feet (tcf) of natural gas in 2P reserves. The company also has 1.4 tcf of gas resources. (See Figure 3.) Previously, Dragon Oil reported gas resources of 3.1tcf. More than half of this amount was converted to 2P reserves in 2010 thanks to completion of the infrastructure necessary to bring gas onshore, expansion of the gas processing capacity and the planned capacity of the gas treatment plant (GTP). Figure 3. 2P reserves and resources Oil and condensate, mn bbls Gas, TCF Oil and condensate, mn bbls Gas, TCF 2P reserves 639 1, Resources - 1,4-3,1 Source: Company data Oil Assets overview Cheleken territory covers an area of 950 km 2 that includes two offshore oil and gas fields: Dzheitune (Lam) and Dzhygalybeg (Zhdanov). Dzheitune and Dzhygalybeg were discovered back in 1972 and 1967, respectively. In 2000, only 20 of the Soviet-era wells were in service and produced less than 7,000bopd. By December 2011, Dragon Oil will have added 64 new wells which should increase its production tenfold to 70,000bopd. Drilling program In the first eleven months of 2011, Dragon Oil completed eleven new development wells. The initial test rates at these wells are in the range of 783-3,463 bopd. In the next three years, Dragon Oil plans to complete 50 more wells, including two appraisal ones, and to achieve a 10%-15% production growth rate per year. The company invested more than $2bn in the infrastructure and field development since 2000, when Dragon Oil signed a PSA with the government of Turkmenistan to develop Cheleken contract area. (See Figure 4.) Halyk Finance 4

5 A mature oil producer, Dragon Oil focuses its drilling program on production growth. By 2015, the company plans to reach a production rate of 100,000 bopd. To achieve this target, the company will invest a total of $1bn in field infrastructure development. We assume Dragon Oil s annual production growth rate of 13% and see the company as being on track to reach 100,000 bopd in The capacity of Dragon Oil s existing infrastructure allows the company to handle the 2015 target production. However, a further increase in output will require new capex in infrastructure development. Figure 4. Production vs. capex Production, kbopd A 2008A 2009A 2010A 2011F 2012F 2013F 2014F 2015F Source: Company data, HF Production, kbopd Capex, $ mn Capex, mn $ Infrastructure Dragon Oil currently operates three Soviet-era platforms at Dzhygalybeg and nine producing platforms at Dzheitune field, two of which were constructed since (See Figure 5 for a map of Dzheitune and Dzhygalybeg facilities.) In 2010, the company awarded construction contracts on the two new wellhead and production platforms to support jack-up rigs at Dzheitune and Dzhygalybeg. At Dzheitune, Dragon Oil expects to complete a third new wellhead platform (Dzheitune C) by the end of this year. The company also installed offshore Block 1 riser platform, which will act as a gathering station and help increase the throughput capacity of Dzheitune West area. Next year, Dragon Oil plans to award new contracts for construction of two more platforms at Dzheitune (Platforms D and E). To build these two platforms and to execute other key infrastructure projects, the company already contracted a jack-up rig, expected for delivery in Turkmenistan in 1H2012, and is currently in the process of tendering two more rigs planned for delivery in 2012 and Platform A, the first one to be built at Dzhygalybeg since signing of the PSA, is expected to be completed in 1Q2012. Dragon expects delivery of another platform at Dzhygalybeg (Platform B) in Each of these wellhead and production platforms is designed to support either a land or a jack-up rig and will include an accommodation facility and up to 16 slots. In 2011, the company also started construction of Block 4 riser platform and pipelines at Dzhygalybeg. Upon its completion in 2H2012, Dragon Oil will use this platform as a gathering station for oil produced from the new platforms at Dzhygalybeg. In March 2007, the company commissioned a Central Processing Facility (CPF) with a capacity of 50,000 bopd, which allows the company flexibility in storage and export of the entitlement barrels. Last year, the company doubled the capacity of CPF to 100,000 bopd and 220mn cubic feet of gas per day. Dragon also commissioned a 30- inch 40 km trunkline, which runs from Block II to the CPF. Halyk Finance 5

6 Figure 5. Infrastructure in the Cheleken area Source: Company data Oil export route In July 2010, Dragon Oil signed an 18-month contract to sell its crude via BP-operated Baku-Tbilisi-Ceyhan (BTC) pipeline, and in October 2011 extended it until the end of next year. Under the terms of the extension the crude oil is sold at a 10%-13% discount to Brent. The number of alternative oil export routes from the landlocked Caspian Sea region is limited, and we expect the company to sell its crude at an average discount of 12% regardless of the export route employed. Other oil export options available to Dragon Oil include transportation by rail from Baku, Azerbaijan, to Batumi, Georgia, on the Black Sea, which Dragon Oil used in the past, via Neka in Iran and via Makhachkala in Russia. Until July 2010, the company sold 80%-90% of its crude under a swap agreement with Iran. The oil swap allowed Dragon Oil to realize an average netback price of Brent less 5%-6% transportation discount. After Iran requested a larger discount, Dragon Oil chose the BTC export route. Natural gas Dry gas Dragon Oil has substantial natural gas reserves and resources. Currently, Dragon produces 140mn standard cubic feet of gas per day (mmscfd) and brings it onshore via the newly-built 30-inch trunkline. The company currently supplies a portion of Dragon Oil s unprocessed gas through the compressor station and into the Turkmenistan system and flares the rest of its gas. Dragon Oil delivers a portion of produced gas to a coastal town of Hazar free of charge. Seeking to capitalize on its large gas reserves and resources, Dragon Oil has been negotiating with the government of Turkmenistan on the terms of the future gas sales from its fields. We suggest the main topics of discussion are the future export route and the price of gas. Dragon believes the negotiations will take another year or two. Halyk Finance 6

7 The company explains that the speed of the negotiations process is negatively affected by limited existing infrastructure that could deliver its gas to the export markets. Until the agreement with Turkmens is reached, the commercial potential of its gas will remain largely untapped. We see China as the most likely export market for Dragon Oil s gas. That would require a gas pipeline that would connect the field to the Central Asia-China gas pipeline. Other, albeit less likely, options include gas sales to Russia (via the territory of Kazakhstan) and/or to Iran. With Turkmenistan currently selling its gas at about $200-$220 per mcm, we expect Dragon Oil to receive at least $150 per mcm for its gas production. Gas condensate Meanwhile, the company plans to build a gas treatment plant (GTP) that will strip the condensate from gas and blend it with crude oil to improve quality of the crude. Upon revision of the front-end engineering design (FEED) study last year, the company is considering a smaller and a less expensive than previously planned gas condensate recovery plant with an expected capacity of 1,000-1,500boepd. This plant will cost the company approximately $75mn, we assume. The company believes that the condensate will be sold on the same terms as its oil. Acquisitions strategy With $1.4bn in cash on its balance sheet and no debt, in 2011 Dragon Oil announced that it will focus on acquisitions as a way to achieve further growth. The company said it may invest up to $200-$500mn in assets in Central Asia, the Middle East, Africa and South East Asia. Future acquisitions may help Dragon Oil reduce its exposure to a single-asset risk, we believe. In October 2011, Dragon Oil signed a farm-in agreement with Cooper Energy. Under the terms of the agreement, Dragon Oil will acquire a 55% interest in Bargou Exploration Permit area in Tunisia by contributing 75% of $26.6mn of the well s estimated drilling cost. Should the costs exceed this amount, future expenses will be shared pro rata between Cooper Energy and Dragon Oil. Upon completion of the farmin conditions, Dragon Oil will develop the permit jointly with Cooper Energy (30%) and Jacka Resources (15%). According to Senergy estimates, Hammamet oilfield contains mmbbls of oil. In Central Asia, the most likely targets of Dragon Oil acquisitions are small-cap exploration-stage companies operating in the region, such as Jupiter Energy and Max Petroleum. Should their ongoing exploration efforts result in major discoveries, both of them will require additional capital injections to fund production development, and the cash-rich Dragon Oil would be well-positioned to buy these companies out, we believe. Halyk Finance 7

8 Valuation We valued Dragon Oil equity as a sum of the parts and by comparing the firm to its traded peers based on EV/2P and EV/EBITDA multiples. The sum-of-the-parts valuation gives us a fair price of GBp 709, while the relative valuation-based share price estimate lies in the range of GBp Averaging out results of the two methods, we calculate the current fair value of Dragon Oil stock at GBp 658, and a 12-month target at GBp 761. (See Figure 6.) Figure 6. Valuation summary M target price GBp 761 Fair value GBp 658 Current price GBp Sum of the parts (50%) EV/2P reserves (25%) EV/EBITDA (25%) 52-week range Source: HF estimates Sum of the parts method DCF valuation of oil assets We used a DCF model to value Dragon Oil s current oil production. Based on the company s guidance, we assume its production to grow at 13% a year in and then expect it to remain flat after that. We model the average Brent price at $90 per barrel in 2012 and at $80 in the long term and anticipate Dragon Oil to continue selling its oil at a 12% discount to Brent. We also assume the cost of sales and SG&A to grow at 5% a year and anticipate Dragon Oil to have the dividend payout ratio of 15%. In our model, the company s weighted average cost of capital (WACC) equals 15.6%, mainly due to a high country risk premium (6%) and the company s zero debt. According to the PSA, Dragon Oil operates under the following terms: from its annual oil output, Dragon Oil subtracts the pre-psa production volume, which declines at an annual 7.5% rate and stood at 2,000 bopd in 2010; on the remaining oil balance, the company pays a royalty of approximately 7%, which is growing as the company increases its production; Dragon Oil then recovers the cost oil (calculated based on capex and opex), which is capped at 70% of the annual oil production; on the difference between production after royalty and cost oil (i.e. profit oil ), the company puts aside 7.5% in cash in a abandonment and decommissioning account. This money is used to cover the costs of abandoning wells; Halyk Finance 8

9 the remainder is split between Turkmen government and Dragon Oil as 60/40; on its share of profits, Dragon Oil pays a corporate income tax rate of 25%. The PSA terms described above can be summarized as: Cost Oil = (Capex+Opex)/Oil price Profit oil = (Production-2,000bopd)*royalty-cost oil Dragon Oil s share=cost oil+0.4*(profit oil-7.5%*profit oil) On Dragon Oil s income statement, revenue reflects only the company s own share of oil because Turkmen government takes its portion as physical oil. Multiples-based valuation of gas reserves We value Dragon Oil share (assumed at 60%) in the Cheleken PSA s gas reserves at an EV/2P reserves multiple of 2.0x. The gas reserves add GBp 40 per share to DGO stock. We estimate the value of Bargou permit farm-in based on the assumption of 100 mn bbl in 2P reserves 1, and, at the EV/2P multiple of 2.0, calculate that Bargou adds another GBp 25 per share. Our sum of the parts valuation results in a fair value of Dragon Oil stock of GBp 709. (See Figure 7.) Figure 7. Sum of the parts valuation summary Oil Cash Gas reserves Bargou farm-in Target price Source: HF estimates Sensitivity analysis The sensitivity of the equity value estimate to oil price fluctuations and WACC is presented in Figure 8. For every $10 change in long term Brent price, the equity value changes by 9%, while for every 1% change in WACC, the value of Dragon Oil changes by 4%. 1 Due to early stage of the development, we apply a 50% discount to our crude estimate of Bargou s 2P reserves. Halyk Finance 9

10 WACC Dragon Oil December 2011 Figure 8. Sensitivity to Brent price and WACC Brent price in 2012 and beyond ,6% ,6% ,6% ,6% ,6% ,6% ,6% Source: HF estimates Relative valuation In our view, Dragon Oil s closest peers are other internationally listed mature large-cap companies with assets in Kazakhstan and Russia: Lukoil, Rosneft, Bashneft, TNK-BP Holding, KMG EP and Zhaikmunai. On the EV/2P reserves and EV/EBITDA multiples Dragon Oil is slightly underpriced compared to its peers. (See Figure 8.) On the EV/2P reserves multiple, Dragon Oil appears to be only slightly underpriced compared to its Russian peers and is fairly priced relative to KMG EP and Zhaikmunai. Dragon is trading at EV/2P reserves multiple of 2.7x, while the median of the peer group is 3.0x, and the average is 3.1x. Currently, the company is trading at a 2012 EV/EBITDA multiple of 3.1x, or at a small discount to its peers. We deem that this discount is associated with the high country risk of operating in Turkmenistan. However, with growth of Dragon Oil production and EBITDA expected to be significantly higher than those of its peers, we believe that the company s shares should be traded at least times 2012 EV/EBITDA, or at GBp per share. Figure 8. Relative valuation Name Bloomberg ticker Market cap, $bn Current EV, $bn EBITDA, 2P EV/EBITDA multiple $bn reserves, bn bbl EV/2P multiple Lukoil LKOD LI 45,2 51,3 19,0 18,8 16,7 36,55 2,7x 2,7x 3,1x 1,4x Rosneft ROSN LI 73,2 87,0 20,4 20,0 20,0 29,31 4,3x 4,3x 4,3x 3,0x Bashneft BANE RU 7,8 12,2 3,0 2,9 3,0 2,32 4,1x 4,2x 4,1x 5,3x TNK-BP Holding TNBP RU 39,4 41,3 12,2 12,1 12,5 13,07 3,4x 3,4x 3,3x 3,2x KazMunaiGas EP KMG LI 7,0 6,6 1,7 1,0 0,9 2,20 3,9x 6,6x 7,2x 3,0x Zhaikmunai ZKM LI 1,8 2,1 0,6 0,7 0,7 0,70 3,4x 2,8x 3,2x 3,0x Maximum 4,3x 6,6x 7,2x 5,3x Minimum 2,7x 2,7x 3,1x 1,4x Average 3,6x 4,0x 4,2x 3,1x Median 3,7x 3,8x 3,7x 3,0x Dragon Oil DGO LN 3,9 2,4 0,8 0,8 0,8 0,91 3,1x 3,2x 2,9x 2,7x Source: Bloomberg, HF Halyk Finance 10

11 Appendix 1. Pro-forma financial statements Dollars in millions, except per share Select parameters of the financial model 2010A 2011F 2012F 2013F 2014F 2015F Production, bopd Brent, $ per bbl Income Statement Sales Gross Profit EBITDA EBIT Pretax Income Net Income Diluted weighted average shares (in millions) Earnings Per Share Balance Sheet Cash Short-term investments PP&E Other assets Total Assets: Current Liabilities Long-term debt Total Liabilities: Capital Other capital reserves Retained earnings Total Equity: Total Liabilities and Equity: Cash Flow Statement Cash Flow from Operating Activities: Cash Flow from Investing Activities: (672) (563) (559) (646) (691) Cash Flow from Financing Activities: (71) (69) (67) (77) (82) Net cash flow 63 (4) (3) Source: HF estimates Halyk Finance 11

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Fixed Income Securities Bakytzhan Khochshanov 7 (727) BakytzhanH@halykbank.kz Erulan Mustafin, 7 (727) ErulanM@halykbank.kz Equity Research Timur Omoev 7 (727) Tomoev@halykbank.kz Mariyam Zhumadil 7 (727) MariyamZh1@halykbank.kz Miramgul Maralova 7(727) MiramgulM@halykbank.kz Bakai Madybaev 7 (727) BakaiM@halykbank.kz Address Halyk Finance 19/1, Al-Farabi Ave., Nurly-Tau Business Center, 3b Almaty, Republic of Kazakhstan, Tel. +7 (727) Fax.+7 (727) Bloomberg HLFN eng.halykfin.kz Halyk Finance 12