Oil and gas Condor Petroleum

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1 Oil and gas Condor Petroleum How to unlock value by cutting the losses Initiation of coverage Miramgul Maralova 7(727) December 29, 2012 Recommendation Buy 12M target price CAD 0.53 Last price (12/28/2012) CAD 0.35 Upside potential 51% Market cap (mn) $121 Free float 44% Number of shares outstanding, mn week range CAD Ticker Condor Petroleum s stock price performance since IPO CAD/share 1,8 1,6 1,4 1,2 1 0,8 0,6 0,4 0,2 0 Apr-11 Jul-11 Oct-11 Jan-12 Apr-12 Jul-12 Oct-12 Source: Bloomberg CPI We initiate coverage of Condor Petroleum, a small-cap oil and gas E&P play, with a 12M target price of CAD0.53 per share and a Buy recommendation. We are confident that in the long-term Condor Petroleum shares offer investors an attractive risk-return tradeoff. Condor develops two assets: Zharkamys West and Marsel, both in Kazakhstan. Exploration in Zharkamys targets three types of subsoil structures, the shallow post-salt (up to 1,500m depth), deeper sub-salt (1,500-4,500m depth) and the deeper pre-salt (4,500m-7,500m depth). The shallow drilling so far resulted in three discoveries. One of them, Shoba field, with only 18 months lead time to production, is currently producing about 400bopd. Taskuduk field, relatively small in size, with 3P reserves of 0.25mmbbl, will be put into production later. The third, Ebeity discovery, requires further evaluation. In 2013, Condor plans to drill five deeper sub-salt wells targeting 48mmbbl of unrisked mean resources. If confirmed we estimate that these resources could add some CAD0.93 per share to our target price on unrisked basis. Pre-salt drilling is still in the planning stage. Condor plans (prudently and with a strong shareholder backing) to farm in this complex, risky and expensive ($25-$30mn per well) job. If Condor finds the partner, the well could be spud as soon as in The development of Marsel requires a $400mn investment into exploration, infrastructure and gas pipeline construction, with the first gas production expected only in Condor Petroleum recognizes that it is not in a position to develop both Zharkamys West and Marsel, and chose, in our opinion, quite sensibly, to sell Marsel and to focus on Zharkamys West. We agree: Zharkamys has shorter lead time to production, lower drilling cost per post- and sub-salt well, and overall offers a better chance at unlocking the potentially large shareholder value. The sale of Condor s 66% stake in Marsel will provide the company with additional funds to develop Zharkamys West 1 asset. Condor Petroleum is unlevered and has $32mn cash as of end of 3Q2012. We estimate the company s operating cash flows will be negative in at current production rates (excluding production ramp up from five targeted sub-salt wells). However, the sale proceeds from Marsel, about $15-$20mn, we estimate, will be sufficient to cover the cost of its drilling program in Condor plans to drill five wells at a cost of $1.5- $2.5mn each. Strong backing from the majority shareholder, Eurasia Group, holding a 51% stake, is beneficial for the minority shareholders, in our view. Eurasia Group sees Condor Petroleum as a long-term strategic investment. Eurasia seeded Osisko Mining, a $5bn gold company, which is also a strategic investment with 10+ investment horizon.

2 We would like to highlight that Condor s management team has a 20+ experience in oil and gas companies, extensive knowledge of Kazakhstan and excellent technical expertise. With Condor having lost 75% of its market capitalization since going public less than two years ago, the management team is yet to convince the minority investors in its ability to deliver. The course of action that the company began to chart recently provides some grounds for cautious optimism. In particular, we appreciate the decisions to divest Marsel and to sell the exploration risks of pre-salt drilling at Zharkamys. Unlike most of its peers, the company has a funding for next year investment program and no debt. Year Revenue Revenue EBITDA EBITDA Net Income Net Debt ROE After tax EPS growth margin ROIC ($ mn) (% yoy) ($ mn) (%) ($ mn) ($ mn) (%) (%) ($CAD /share) 2011A 4,00 20% (10,79) 45% (13,46) (68,98) (7,0%) (8,0%) (38,90) 2012F 2,20-45% (10,11) 12% (9,33) (12,75) (5,6%) (6,3%) (26,96) 2013F 6,39 190% (6,38) 68% (9,05) 5,36 (5,8%) (5,6%) (26,14) 2014F 16,61 160% (0,05) 66% (11,34) 10,71 (7,8%) (6,8%) (32,79) 2015F 60,06 262% 23,63 58% 1,51 (5,05) 1,0% 1,4% 4,36 Source: Halyk Finance estimates 2

3 Table of contents Company overview... 4 Assets... 5 Zharkamys West I... 5 Marsel... 8 Valuation

4 Company overview Condor Petroleum is a small-cap exploration and production company developing two assets in Kazakhstan. The company went public in April 2011 by listing its shares on Toronto Stock Exchange (TSX: CPI). Condor Petroleum s 3P reserves at Zharkamys West I are estimated at 6.5mn bbls (as of December 31, 2011) and unrisked prospective resources at 336mmbbl in shallow post-salt and sub-salt prospects (as of April 2011). The deep pre-salt structures are believed to contain up to 582mmbbl (unrisked recoverable) based on 3D seismic analysis covering half of the contract area (as of October 2012). This amount could double after completing the analysis of the 3D seismic data on the second half of the license area. The unrisked mean resources at Marsel, the second asset, are estimated at 592bcf, of which 69bcf are classified as contingent resources. Condor is currently in the process of selling its 66% interest in Marsel. The sale proceeds will be used to fund exploration drilling program in Zharkamys West, the development of which will be the primary focus in the short to medium-term future. Figure 1. Assets in Kazakhstan Source: Company data Ownership structure Figure 2. Ownership structure Condor Petroleum s majority shareholder, Eurasia Resource Holding, owns 51% of the company. About 5% is held by the management and Board of Directors. The rest of the shares is in the free float. Free float 44% Management and BoD 5% Source: Bloomberg Eurasia Resource Holding 51% Established in 2003, Eurasia Resource Holding is a private investment company specializing in natural resource companies. In addition to Condor Petroleum, Eurasia s current investments include Osisco Mining and a 50% stake in Caspian Energy Services through Novolog Company. All the projects are financed through Eurasia s own funds. Eurasia Group has a long-term strategic view on investment in Condor Petroleum. Eurasia s strategy is to have Condor reach a stage where its production (25,000bopd rate at peak) generates stable operating cash flows and to secure a high reserves base. We believe that support of the majority shareholder is beneficial for minorities. 4

5 Assets Figure 3. Condor Petroleum's exploration program Condor Petroleum has licenses to develop two contract areas: Zharkamys West I and Marsel, both in Kazakhstan. In the short- to medium-term future the company will focus its efforts on the exploration of Zharkamys West I asset. Condor Petroleum plans to divest its 66% interest in Marsel block in Zharkamys West I Zharkamys West I block is located in the eastern part of the Pre-Caspian Basin in Kazakhstan. The exploration license expires in August 2015 if extended for two years. Phase Depth Description Cost per well Status/plans Phase ,500m Shallow post-salt prospects Phase 2 1,500-4,500m Deeper, higher impact post-salt prospects Phase 3 4,500-7,500m Deep, pre-salt structures targeting Permian and Devonian structures Source: Company data To identify the drilling targets Condor Petroleum relies on 2D and 3D seismic which almost fully covers the area of the block of 2,610 sq. km. The resources identified by 3D and 2D seismic contain largely oil. Condor Petroleum searches for oil in three types of subsoil structures (post-salt, sub-salt and pre-salt ones) and groups its exploration projects in accordance with this classification. Within the shallow structures Condor Petroleum distinguishes post-salt (650-1,500m) and slightly deeper sub-salt (1,500-4,500m), higher impact prospects. The pre-salt prospects are located much deeper, beneath the salt layer, at a depth of 4,500-7,500m. Thus, Condor s exploration program in Zharkamys West I is divided into three phases. (See Figure 3.) $0,7-0,9mn $1,5-2,5mn $15-30mn Drilled 9 wells Drilled 2 wells Prospects are prepared for drilling based on Phase 1 drilling results and 3D seismic Plan to drill first well in 2014 Phase I Since the shallow post-salt prospects are located close to the Earth surface, they are characterized with short lead time to production (18 months for Shoba field) and low upfront costs (average $1mn drilling cost per well). Since March 2011 Condor has drilled nine shallow post-salt exploration wells. These drilling efforts resulted in three commercial discoveries: Shoba, Taskuduk West and Ebeity. 5

6 Shoba Condor discovered Shoba field in March 2011 and put the field into production under the Trial Production License in September According to Kazakhstani legislation, Trial Production License (TPL) allows selling oil on the domestic market for a three-year period. Currently, the company is producing 400bopd from three wells. The company may tie into production two more wells under this TPL. The production is expected to peak at 1,500bopd in mid-2014, when the field will be put on full development, i.e. start export sales. Condor is currently selling all of the produced oil in the domestic market at a netback price of $35 per bbl. Shoba field was assigned 5.3mn barrels of Probable plus Possible reserves. No proved reserves have been assigned yet. Figure 4. Zharkamys West I drilling history When Well Depth Flow rate Status 2009 Tas W-3 n/a 280 Tested during 90-days Phase 1 (average cost per well $1mn) March 2011 Shoba April 2011 Shoba May 2011 Shoba June 2011 KN Dry well July 2011 TSE Dry well August 2011 Eibety Suspended, further evaluation and remedial work September 2011 Eibety Dry well October 2011 Tas W day production test November 2011 Ut Dry well Shoba appraisal wells April 2012 Shoba day production test expected in August 2012 May 2012 Shoba To be flow tested May 2012 Shoba To be tied in TPP August/October 2012 Shoba 7/7a 730/890 While tripping out of the hole for core barrels, a gas influx occurred and the well was shut in. Now is expected to be completed in 4Q2012. Phase 2 (average cost $1.5-$2.5mn) December 2011 ZhK Plugged and abandoned November 2012 KN-NE-1 n/a To be spud in November 2012 September 2012 Shoba No commercial oil. Plugged and abandoned. The first 'salt flank' well at Zharkamys. June 2012 Ebeity E Dry well. Lack of a suitable migration pathway Source: Company data Trial Production Period started in September 2011, expected to continue until mid Production from five wells at 400bopd. Taskuduk Two wells have been drilled in Taskuduk West. The first TasW-3 was drilled in 2009 and flowed 280bopd during testing period. The second well, TasW-4 was drilled in October 2011 flowing 350bopd in a 90-day production testing. Based on one well, the field was assigned 0.25mmbbls in Probable plus Possible reserves category. Condor s Taskuduk field, located on the border of the contract area, is a part of the larger structure, being developed by Chinese Sinopec. Given relatively low reserves, Condor plans to wait until Sinopec puts its part of the field into production. This will allow the company to save on the infrastructure facilities construction costs. 6

7 Ebeity Of the two wells drilled on Ebeity, Condor s Ebeity 1 well is currently suspended and requires further evaluation. In 2011, the well was drilled to a total depth of 1,000m with an 8m net oil pay in the Triassic section. The second Ebeity (Eb-5) well was dry. Phase 2 Figure 5. KN-E-201 well (Phase 2) In the second exploration phase Condor focuses on deeper (up to 4,500m depth) sub-salt (i.e. around the salt dome) prospects. According to the company s analysis of 3D seismic data, these prospects have top seals, a unit with low permeability, preventing the escape of hydrocarbons from the reservoir. The 3D seismic also helped to identify the clear migration pathways from the pre-salt. The last but not the least element common for these prospects are structural traps with three or four-way closures. The traps are formed as a result of changes in the structure of the surface due to tectonic, gravitational or other processes. The average drilling cost per well is estimated at $1.5-$2.5mn. To date, Condor Petroleum has drilled three wells, all dry. The company explained us that it has a clear understanding why the drilling was not successful. In June 2012, Condor Petroleum drilled Ebeity East 201 well which showed no commercial hydrocarbons. The primary reason for no oil shows at this shallow interval was explained due to lack of a suitable migration pathway. Source: Company data Figure 6. Pre-salt well Ebeity-401 Phase 2 wells are a primary focus for Next year Condor plans to drill up to five wells targeting 48mmbbl of unrisked mean resources. The next well will be spud in 1Q2013. (See Figure 5.) Phase 3 Salt Under the third phase Condor Petroleum plans to drill deep (up to 7,000m depth) wells targeting pre-salt Permian and Devonian structures. These prospects are of high risk, complex and expensive to drill, but hold the highest shareholder potential, in our view. Based on analysis of analogue fields in the Pre-Caspian basin, Condor believes that these pre-salt targets represent a significant potential resource with volumes that would justify the target depth and geologic risk. According to an independent resource review, unrisked mean resources are estimated at 582mmboe based on 3D seismic acquired in 2010, representing half of the contract area. This figure could double after processing the 2011 data on the second half of the contract territory. Source: Company data The first deep well in Ebeity prospect with estimated unrisked recoverable resources of 180mmboe will target Permian, Carboniferous and Devonian formations. (See Figure 6.) The average cost of the presalt well is estimated at $25-30mn. The company aims to find a farm-in partner for the pre-salt drilling planning to spud the Ebeity well in We welcome Condor s plans (prudently and with a strong shareholder backing) to farm in this complex, risky (geologic chance of success ~20%) and expensive ($25-$30mn per well) job. 7

8 Figure 7. Marsel drilling history Transportation Due to nearby location of oil fields in the area, the infrastructure is well developed. The Atyrau Kenkiyak pipeline, a part of Kazakhstan China, lies through the contract area. Meanwhile, to facilitate the domestic sales from Shoba and Taskuduk West fields, the company acquired a 90% interest in an existing oil storage terminal, 12km northwest of Zharkamys area. The Sagiz terminal includes 7,500bbls of oil storage capacity and is able to load four rail cars simultaneously. The terminal is also tied in to the main rail line between Aktobe and Atyrau. Oil transportation through the terminal will reduce transportation costs and allow the company to increase alternative transportation routes. Marsel Acquired in 2007, the Marsel contract area is located in the Chu-Sarysu basin of southern Kazakhstan. The exploration license is valid until July 2016 if extended for two years. Holding a 66% interest in Marsel, Condor fully funds the capital program and exploration permits. The remaining 34% stake is held by Kazakh investor. The working program commitments require Condor to invest $33.4mn in into Marsel development. When Well Depth Flow rate Status 2010 Tamgalytar-5 n/a 2mcf of gas per day November 2011 Asa ,1-11,1mcf of gas per day November 2012 Bugudzilskaya n/a Source: company data Production testing was set, awaiting additional flow testing Marsel block covers an area of 18,500sq.km, where 34 large structures are identified. Exploration drilling in Marsel dates back to the Soviet times. Thus, between mid-1960s and 1980s thirty exploration wells were drilled, but none was put into commercial production. Exploration drilling resulted in three commercial discoveries: Pridorozhnaya, West Oppak and Ortalyk fields, all three excluded from Marsel contract. Based on the interpreted 2D and 3D seismic data Condor identified a portfolio of Devonian sandstone/conglomerates and Carbonate shoal/pinnacle prospects. In 2010, Condor Petroleum drilled the Tamgalytar 5 exploration well to a total depth of 2,550m. During the testing period the well flowed up to 8

9 2mcf per day. In April 2012, Condor drilled Asa-1 well, the second in Marsel and the first well based on the new 3D data. The well flowed natural gas with no formation water between 2.1 and 11.1 Mmscf per day. Condor plans to drill the third exploration well on the Bugudzilskaya structure with multiple targets within the Lower Carboniferous and Devonian clastics. The company believes that the primary target, Upper Devonian sandstones, contains high quality reservoir. The company estimates that a $400mn investment is required to develop Marsel. This includes construction of a 180km gas pipe, a tie in to Kazakhstan-China gas pipeline, construction of a gas treatment facility and exploration capex. An average drilling cost at Marsel is $5-$6mn per well. Yet, the first gas production could start only in In November Condor Petroleum announced that it plans to sell its interest in Marsel to an international oil and gas company. Condor Petroleum recognizes that it is not in a position to develop both Zharkamys West and Marsel, and chose, in our opinion, quite sensibly, to sell Marsel and to focus on Zharkamys West. We agree: Zharkamys has shorter lead time to production, lower drilling cost per post- and sub-salt well, and overall offers a better chance at unlocking the potentially large shareholder value. The sale of Condor s 66% stake in Marsel will provide the company with additional funds to develop Zharkamys West 1 asset. 9

10 Valuation Our 12-month target price of CAD0.53 per share and a Buy recommendation are established based on the Net Asset Value (NAV) model. We verified our NAV valuation by relative valuation model, which also suggests that Condor Petroleum is underpriced, compared to its peers. The valuation summary is presented in Figure 8. We valued separately Condor Petroleum s Zharkamys West I and Marsel assets. Zharkamys West I valuation is based on NAV model and Marsel is valued using precedent transactions multiple. Figure 8. Valuations summary 0,70 0,60 0,50 0,40 0,30 12M target price CAD 0.53 Target price CAD 0.46 Current price CAD ,20 0,10 - NAV valuation Traded peers (EV/Resources) 52 week low/high Source: Halyk Finance estimates Zharkamys West I We use a Net Asset Value (NAV) model to value Zharkamys West I asset, which is a common methodology for valuing exploration companies. NAV suggests a target price of CAD0.42 per share. However, we note that should Condor s drilling efforts be successful, the stock price could jump well above our target price. We adjust for net debt and SG&A expenses. We assume a WACC of 15% and use a consensus forecast of Brent price ($111, $112, $110 in , $101 afterwards). We assume SG&A costs of $10mn per year starting from We separately valued Shoba and Taskuduk West fields, and the resources targeted by five Phase 2 wells. We do not include in our valuation Condor Petroleum s other prospective resources in sub-salt prospects as well as deep pre-salt prospects because their exploration drilling is in a relatively far distant future, we believe. We apply a geologic chance of success of 20% to unrisked mean resources. (See Figure 9.) 10

11 Figure 9. NAV summary Zharkamys West I Unrisked P50 Chance of Success Risked P50* NAV per boe Risked value NAV per share Unrisked NAV/share mmboe % mmboe $ mn CAD CAD Shoba 5,30 100% 5,30 14,76 78,22 0,22 0,22 Taskuduk West 0,25 100% 0,25 12,49 3,12 0,01 0,01 Phase 2 prospective 48,00 20% 9,60 6,78 65,05 0,19 0,93 resources targeted by five wells Other Phase 2 288,00 20% 57,60 6,78 390,33 1,12 5,60 prospective resources Deep pre-salt well 180,00 20% 36,00 1,04 37,52 0,11 0,54 Total (excl. deep pre-salt and other Phase 2) 0,42 1,17 Less: SG&A 38,96 0,11 0,11 Less: Net debt (31,73) (0,09) (0,09) Marsel Contingent gas resources 12,95 100% 12,95 0,43 5,57 0,02 0,02 Prospective gas resources 37,55 100% 37,55 0,43 16,15 0,05 0,05 Source: Halyk Finance estimates Total 0,46 1,21 Marsel Our unrisked NAV for Marsel drilling program is based on gas asset transaction multiples in Kazakhstan. We valued Condor Petroleum s 13mmboe contingent gas resources by applying an average of three recent transactions. Given relatively recent date of three transactions, we believe they are a good proxy to value Marsel. We also include the company s prospective resources that Asa well was targeting (we assume about 200bcf). Figure 10. Precedent transactions valuation summary Date Acquirer Target Stake sought, % Jan-12 Sep-09 Xinjiang Guanghui Xinjiang Guanghui Industry Price (incl. debt), $mn 2P reserves, mmboe Price/2P, $/boe Nanyimaxiefu 51% ,43 Tarbagatay Munai 49% 40,5 33 2,49 Aug-12 Zhaikmunai Rostoshinskoye 100% ,12 Darjinskoye Yujno- Gremyachenskoe May-12 Total OiltechnoGroup 50% 70 n/a n/a Source: Companies' data Mean 1,02 Median 0,43 11

12 Relative valuation In our view, Condor Petroleum s closest peers are other public mid- and small-cap oil and gas companies operating in Central Asia: Tethys Petroleum, Max Petroleum, Jupiter Energy, Roxi Petroleum and Caspian Energy. All six are exploration plays dependent on the success of their drilling. Condor Petroleum is undervalued on the EV/resource multiple compared to its peers. We note that compared to its peers, Condor Petroleum s exploration program is fully funded for At the current estimate of Condor Petroleum s resources, the company should then be traded in CAD per share range. Figure 11. Relative valuation Name Ticker Market Cap, $ mn EV, $ mn 2P reserves, mmbbl Risked resources, mmbbl EV/Reserves EV/Resources Jupiter Energy JPR AU 109,8 113,9 24,2 18 4,70 6,41 Caspian Energy CEK CN 16,0 58,8 3, ,08 0,46 Tethys Petroleum TPL CN 158,5 173,5 25, ,86 0,83 Max Petroleum MXP LN 63,9 192,7 10, ,12 1,47 Roxi Petroleum RXP LN 20,9 50,1 9,0 116,4 5,56 0,43 Average 10,47 1,92 Median 6,86 0,83 Condor Petroleum's estimated multiple Low 5,83 0,71 High 7,88 0,96 Reserves/Resources (mmbbl) 5,6 196,0 Value per share (GBp) Low 0,09 0,40 High 0,13 0,54 Source: Halyk Finance estimates * We implied a 20% dis count to TPL and RXP unris ked mean res ources **For MXP we us ed only contingent and 3P res erves in res ources 12

13 Appendix 1. Pro-forma financial statements CAD $ in thousands, except per share Actual Projected Year Ending December 31, 2011A 2012F 2013F 2014F 2015F 2016F Income Statement Sales Cost of sales (excl. depreciation) Gross Profit SG&A (excl. depcreciation) EBITDA (10 787) (10 109) (6 376) (47) Depreciation EBIT (12 236) (11 940) (11 412) (13 293) (3 826) Pretax Income (13 695) (11 662) (11 307) (14 180) (3 476) Income taxes (236) (2 332) (2 261) (2 836) 377 (695) Net Income (13 459) (9 329) (9 045) (11 344) (2 781) Diluted weighted average shares (in millions) Earnings Per Share (39) (27) (26) (33) 4 (8) Effective tax rate 20% 20% 20% 20% 20% 20% Balance Sheet Cash Accounts receivable, net Other current assets Total Current Assets: PP&E Exploration and evaluation assets Other l-t assets Total Assets: Short-term debt Accounts payable and accrued liabilities Total Current Liabilities: Provisions Other l-t liabilities Total Liabilities: Capital Deficit Total Equity: Total Liabilities and Equity: Cash Flow Statement Operating Activities Net Income (9 045) (11 344) (2 781) Depreciation Change in working capital (792) (1 955) (1 135) Change in other long-term assets and liabilities Cash Flow from Operating Activities: (4 800) (53) Investing Activities Capital expenditures (13 300) (5 300) (5 800) (800) Short-term investments (14 315) Cash Flow from Investing Activities: (5 555) (5 300) (5 800) (15 115) Financing Activities Issuance / (repayment) of short-term debt (14 754) (954) Issuance of long-term debt (Repayment) of long-term debt (Dividends) to minority interest holders (Dividends) to common equity holders (Repurchase) of equity Option proceeds Cash Flow from Financing Activities: (14 754) (954) Net cash flow (0) (1 006) Source: Halyk Finance estimates 13

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Macro Sabit Khakimzhanov, 7 (727) sabitkh@halykbank.kz Nurfatima Dzhandarova, 7 (727) nurfatimad@halykbank.kz Madina Kurmangaliyeva, 7 (727) MadinaK2@halykbank.kz Equity Research Mariyam Zhumadil, 7 (727) mariyamzh1@halykbank.kz Miramgul Maralova, 7 (727) miramgulm@halykbank.kz Bakai Madybayev, 7 (727) bakaim@halykbank.kz Fixed Income Research Yerulan Mustafin, 7 (727) erulanm@halykbank.kz Sabina Amangeldy, 7 (727) SabinaA@halykbank.kz Address Halyk Finance 19/1 Al-Farabi Ave., Nurly-Tau Business Center, Bldg 3b Almaty, Republic of Kazakhstan, Tel. +7 (727) Fax.+7 (727) Bloomberg HLFN 14