SOUND ENERGY OIL & GAS SOU.L 12.80p Market Cap: 134.8m SHARE PRICE (p) Exciting times ahead Sound Energy, together with its partner Schlumberger, has started drilling its second exploration well in its current programme on the Tendrara concession, onshore Eastern Morocco where it is operator with a 47.5% working interest. This programme is looking to evaluate multiple independent geological play types contained within the licence. The next two wells are targeting multi-tcf potential which, if successful, has the ability to provide a step change in the group s reserves and resource base. In addition to Sound s obvious exploration potential, we derive a valuation for Sound Energy s share of the TE-5 discovery of approximately US$360 million using industry standard valuation methodology equivalent to 27.1 p/share. Sound s on-going exploration has the potential to materially increase this valuation. Although not covered in the report Sound also has a second asset in country, Sidi Moktar, with significant potential. The valuation of this asset will be covered by a follow-up to this note shortly. 12m high/low Source: LSE Data KEY INFORMATION Enterprise value Index/market Next news Gearing Interest cover 133.9m LSE 56.2p/11.0p Trading update N/A N/A SOUND ENERGY IS A RESEARCH CLIENT OF PROGRESSIVE ANALYSTS Peter Hitchens +44 (0) 20 7781 5304 phitchens@progressive-research.com Tendrara campaign. Sound s first well in the current three well programme (TE-9) was drilled on the A1 prospect which had a primary target of a Triassic fault block. The reservoir quality was poor. The company spudded its next well (TE-10) on 7 December which is targeting a large stratigraphic trap and a smaller structural closure. P50 unrisked gas in place is estimated at approximately 2.8 TCF, worth potentially 110p/share. This is expected to take 30-40 days to complete. Once this is completed, management is looking at drilling a Palaeozoic target although the precise location of the prospect has not yet been finalised. This programme has been selected to explore three major geological targets and will then allow the management to ascertain the potential running room in the licence for future drilling programmes or to demonstrate sufficient understanding of the basin to be able to monetise the assets early. TE-5. As well as this exploration programme, the company is moving forward the TE-5 discovery ready for development. An independent reserve certification has identified gross contingent recoverable resources in this discovery of approximately 377 BCF of gas. The partners are progressing with the FEED (Front End Engineering & Design) with the hope of getting FID in 2019 and start up of production in the field by 2021. Valuation. Using the industry standard valuation of a discounted cash flow analysis, we derive a valuation for the Sound Energy s share of the TE-5 discovery of approximately US$360 million which adjusting for the cash equates to a value of 27.2 p/share. This uses a gas price of US$8.9/mcf in 2019 and is escalated at 2% per annum. The discount rate used is 10% (with a 2% reduction increasing the valuation by a further 17%). Using this metric as a basis for the exploration upside, one could assume that a discovery of 1 TCF net recoverable resources to Sound Energy could add a further 166 p/share to the asset value. Investors should view any valuation in the context of their own assessment of relevant risks. www.progressive-research.com This marketing communication has not been prepared in accordance with requirements designed to promote the independence of investment research. Please refer to important disclosures at the end of the document.
TABLE OF CONTENTS INVESTMENT SUMMARY... 3 SWOT ANALYSIS... 4 ASSET BASE... 5 Tendrara... 5 Exploration programme... 5 Morocco - Background... 6 Finances... 6 STRATEGY... 7 EASTERN MOROCCO VALUATION... 7 Sound Energy... 7 Sensitivity analysis... 8 Exploration upside... 8 2
Investment Summary The next six months are going to be exciting for Sound Energy as it progresses with its Moroccan operations. The main focus will be on the Tendrara concession where Sound Energy has a 47.5% working interest, alongside Schlumberger, and is the operator. Here the company is looking at moving the TE-5 discovery into production or early monetisation post de-risking the development with a GSA and FEED. On top of this, the company has started the second well in its three well exploration programme. The TE-5 discovery was originally made by ENI but had a tight reservoir. Sound Energy realised the potential and acquired the licence. Subsequent wells have achieved commercial flow rates using stimulation. The management has now appointed an Enagas led consortium to complete FEED on the infrastructure, at their own cost, with the hope to achieve FID in the middle of next year. The current reserve certification estimates that this field contains 377 BCF of gas. It is hope that this will be brought on stream in 2021. The partners have already got in place an agreement with some midstream partners, led by Enagas, who will build a pipeline up to the main Algeria/Europe gas trunk line. (For more information see page 5) On the exploration programme, the company has drilled the first well in a three well programme. This first well encountered poor quality reservoir. The rig is now moving on to drill the next two wells. This programme is designed to test the differing geological play type located in this licence. This will allow management to assess the potential running room in the licence and allow it to plan any future exploration programme as well as demonstrate additional value in the event of an early monetisation. The next well has started drilling ahead on the North East Lakbir prospect which is a significant size with potential gas in place of 2.8 TCF. For more information please see page 6) At the start of October 2018, the company had cash of approximately US$33 million. This will be sufficient to complete the drilling programme, with the wells expected to costs between US$7 9 million each. The group also has a EUR 28.8 million corporate bond. At current exchange rates this means that the company broadly has a small but positive net cash balance (Please see page 6). We have looked at the industry standard valuation of the assets through a discounted cash flow analysis. The main discovered asset is the TE-5 field. Here, using a gas price of US$8.9/mcf, we achieve a value of 27.1 p/share. Adjusting for the balance sheet this would imply a value for the share of 27.2 p/share. On a fully diluted basis this would slip to 26.6 p/share. This implies a value of US$2.4million per BCF of gross resources found. Therefore it would seem sensible to say that if Sound Energy discovered 1TCF of net gas reserves and resources in the licence that this might increase the implied asset value by approximately 166p/share. The current exploration well, TE-10, is targeting 2.8 TCF of gas in place. Assuming a 50% recovery this would entail net recoverable resources of 665 BCF of gas equivalent to 110 p/share. In its two main licences there is the potential of unrisked net prospective resources to Sound of over 8 TCF. (For further details please see page 8) Current exploration campaign Source: Company information 3
SWOT Analysis Strengths The main strength of the company is the large acreage position that has been acquired onshore Morocco. This acreage portfolio has a wide array of prospect and leads which have the potential of providing a significant increase in reserves and resources. The fiscal regime in the country will lead to any reserves having high unit value. The Company also has a well respected exploration team recently hired from BG Group and an entrepreneurial and commercial leadership. Weaknesses The biggest weakness is that the company has a relatively weak balance sheet given the potential scale of the asset. The drilling campaign will use up much of the cash sitting on the balance sheet and this could limit the potential follow up work that might be required. The progress on the development of the TE-5 discovery could give the company access to bank financing. Opportunities The big opportunity that the company has is that it has large working interests in the acreage. This gives the company the ability to monetise early or to farm down and get carried for much of the programmes and this will provide shareholders with an early monetisation event or reduce shareholder risk as well as allowing the company to further build up the business if that is the chosen route. Threats Perhaps the largest threat to the business (as with all E & P companies) comes from the operating environment especially the oil and gas prices. Weakness in commodity prices will lead to lower than expected cash flows from its discoveries. The company s operations are all located in Morocco and hence the company is reliant on stability in the country. That being said, Morocco has proved to have been stable compared to the other areas in North Africa. 4
Asset base Sound Energy has evolved to become a pure Moroccan E & P player. The company has three large onshore licences Tendrara, Anoual and Sidi Moktar and a further asset in Sidi Moktar (subject of a further update). In the Tendrara licence, the company is the operator with a 47.5% working interest with the remainder being held by Schlumberger (27.5%) and the state oil company, ONHYM, (25%), the state oil company, with a 25% working interest. This licence already boasts a gas discovery. The Anoual licence is adjacent to the Tendrara licence and the partners have similar interests. The other concession is the Sidi Moktar licence in the West of the country and close to the Meskala gas field. Here, Sound has a 75% working interest with ONHYM holding the remaining 25%. Provisionally the company has identified prospects and leads (based on the preliminary 2D seismic data) with up to 11.2 TCF net unrisked prospective resources. Sound Energy is looking at farming out this licence and with little work expected on this in the very short term we are not discussing this permit in this research note. Tendrara Sound entered the Tendrara concession in 2015. Within this licence there was an existing discovery (TE-5) made by ENI in 2008 but this proved to have a tight reservoir and flowed at a mere 1.5 mmcf/day. Sound realised the potential of this discovery and drilled two further wells into the structure in 2016/17 and, with the help of stimulation, Sound managed to achieve significantly higher flow rates. The first well (TE-6) was a vertical well and flowed at a rate of 17.9 mmcf/day. The next well (TE-7) was a horizontal well and achieved a flow rate of 27.8 mmcf/day. Sound commissioned a CPR (Competent Persons Report) on this discovery and RPS estimates that the TE-5 contained gas in place, on a mid case basis, of 651 BCF. With a recovery factor of 58% this gave the partners gross 2C recoverable resources of 377 BCF. With its 47.5% working interest, Sound Energy share of the recoverable reserves and resources is 179 BCF (30 mmboe on an oil equivalent). Sound Energy is now moving ahead with a FEED (Front End Engineering & Design) on this discovery with the expectation of achieving a FID (Final Investment Decision) in mid 2019. Sound has agreed a Heads of Terms with a consortium of midstream contractors (led by Enagas) to build a 120 km 20 inch gas pipeline up to the main trunk gas pipeline Gas Maghreb-Europe pipeline) which transports Algerian gas through to Europe. This will be done under a BOOT (Build-Own-Operate-Transfer) structure where the midstream partners will fund the gas pipeline and central processing facility and, in return, will receive a fee not to exceed US$45 million. After 15 years, the pipeline will revert to the upstream partners. This is an attractive option for Sound since the company is not burdened by the significant capital expenditure of building this pipeline and processing facility. At present, the upstream partners are negotiating the GSA (Gas Sales Agreement) to determine the volumes and prices of the gas. Once this is achieved the partners will be in a position to move ahead on the development. Exploration programme With the TE-5 discovery moving ahead, the partners are looking at the exploration upside within the licence and started a three well exploration programme. The programme was designed not so much to test the best prospects in the licence rather to test the differing geological plays in the licence so that the partners could ascertain the running room in the licence. Overall the company believes that the potential gross gas in place, on a mid-case basis, in the Triassic interval could be up to 21.2 TCF of gas in place (100% basis) with a further 12.8 TCF in the Palaeozoic. This drilling programme will allow the company to get a better understanding of the geology and de-risk many of the prospect and leads and hence plan further exploration to exploit the potential resources or indeed to secure an early monetisation with some value ascribed to exploration. 5
The first well (TE-9) was drilled on the A structure. This was Triassic fault block - similar in style to the TE-5 discovery and located 25 km to the north west. The well was unsuccessful, although gas was found the reservoir was of poor quality. This was a relatively high risk well with RPS estimating the pre-drill chance of success at 25%. The rig now started drilling the next well, TE-10, which is a Triassic stratigraphic pinchout play. This prospect, North East Lakbir, is located 25 km north east of the TE-5 discovery. This is a large play with management estimating that potential gross gas in place, on a mid case basis, could be 2.8 TCF of gas. Assuming a similar recovery factor as in the TE-5 discovery, this would equate to potential 2C recoverable reserves and resource of 1.5 TCF of gas. This well is expected to take 30-40 days to drill. The third well (TE-11) is likely to be drilled on a deeper Palaeozoic play. This is a play that Repsol/Royal Dutch Shell is looking at in the adjacent acreage to the west. The target will be selected once the interpretation of the phase 2 & 3 seismic data is completed. This seismic data was acquired in August. Morocco - Background The gas market within Morocco is attractive. The country imports approximately 90% of its gas requirements for power generation, predominantly from Algeria. With gas fired power generation expected to account for an increased percentage of the power market there is a huge future growth in demand for gas and the country is having to look at the potential of importing expensive LNG to satiate it needs. This will lead to generous price for domestic gas production. Sound believes that the gas price for power generation will be in the range of US$7 US$9 /mcf (and some of this may be linked to the oil price). It should be noted that SDX Energy has been able to achieve a higher price than this from its production in the country with its average price realised in Q3 being over US$11/mcf, although the volumes are much smaller. The other factor that makes this area exciting is the attractive fiscal regime. On a simplistic basis, the main two taxes are royalties and corporation tax. The royalty for onshore gas is a modest 5% of wellhead revenue. Corporation tax on profits is 30% but there is a ten-year tax holiday from the start of production which will account for a significant part of the fields life and reserves produced. The other method that the state participates is through the state oil company, ONHYM, taking a 25% working interest in the licence. ONHYM will be carried by the partners for its share in the exploration/appraisal phase and will now start to pay its share on development. Finances The company has a relatively strong balance sheet. At current exchange rates (GBP/USD: 1.26 & GBP/EUR: 1.11) and adjusting for VAT receivable, the company has net cash of approximately US$1.3 million. Of this, the company has cash of US$32.7 million and VAT receivable of US$1.3 million which is offset by a bond of EUR 28.8 million. This bond is due in 2021 and secured on Sound Energy Morocco South. These exploration wells are expected to cost US$7 million on a dry hole basis and up to US$9 million if testing is required. Sound s share of this cost is 63%. This means that there is more than sufficient financial resource to cover the future shortterm expenditure on exploration. The development of the TE-5 discovery is modest given the BOOT agreement in place with Enagas and partners. This would mean that Sound would not need to shoulder the burden of the building of the pipeline and central processing facilities. However, we believe that the company will be able to secure additional financing once this development moves forward. 6
Strategy In the short term, the company is focusing on the exploration programme and the moving of the TE-5 discovery to FID. Thereafter the company will face the choice of either building up the business or selling the business. The strategy of building up the business is the usual model adopted by the E & P companies. However, Sound has a relatively lean operating team and building the business will mean that the company will have to staff up significantly in order to move forward with the development. We expect the company to test the market with the Tendrara portfolio once it s exploration drilling has completed. Eastern Morocco Valuation Sound is an exploration company and this presents certain valuation challenges. With this report we have looked at the valuation of the TE-5 discovery onto which an investor could add their assessed value of the exploration portfolio. We have used the industry standard valuation of a discounted cash flow analysis. We have assumed that the field is brought on stream in 2021 with a gross plateau production of 66 mmcf/day. This plateau will be maintained for 10 years before natural decline occurs. This envisages gross recovery of over 300 BCF of sales gas. The gas price that we have used is US$8.9/mcf and this is escalated at 2% per annum. The capital expenditure is modest since we are assuming that the BOOT contract is adopted and so most of the main capex will be the drilling of the development wells. The reduction in the capex is offset by the fees that will be paid to the midstream partners. However, this will be easily met from the cash flow generated. The discount we have used is the standard 10% that the industry widely uses. We have modelled the field in US dollars and translate this at the prevailing exchange rate (GBP/USD 1.26). The value of the field is then adjusted by the balance sheet of the company. Investors should view any valuation in the context of their own assessments of the relevant risks. Sound Energy Using the process described earlier we attain a gross value for the TE-5 field at US$758 million. With its 47.5% interest, this gives Sound s interest in this field at US$360 million equivalent to 286 million. The balance sheet adjustment is modest with the company having a small level of net cash. In dealing with the number of shares, the company has 1.053 billion shares in issue. However, the company has a significant level of options, warrant and restricted stock that leaves to the fully diluted shares rising to 1.154 billion. For the sake of completeness we have given two scenarios. The first is on the current shares in issue and then on a fully diluted basis. On this latter case we have adjusted the balance sheet to reflect the proceeds from the issue of warrants. The following table detail these two scenarios. Sound Energy Eastern Morocco only valuation (pence per share) Source: Progressive Research 7
Sensitivity analysis We are aware that many investors will have differing views on the potential gas price that will be achievable. As such the following chart shows the potential impact off differing gas prices in 2019. We have maintained the escalator on this, as with our base scenario, of inflating at 2% per annum. This is all carried out on a fully diluted basis. As can be seen the field is relatively resilient to the gas price. Chart of valuation relative to gas prices Asset value (p/share) 40 35 30 25 20 15 10 5 0 6.00 7.00 8.00 9.00 10.00 11.00 2019 gas price (US$/mcf) Source: Progressive Research Exploration upside We are aware that investors will need to be aware of the potential upside available through the exploration programme. With the myriad of prospects, we prefer to give a steer on potential values should a discovery be made. The value of the TE-5 discovery gives a value of US$2.4 million per BCF discovered. Therefore an additional 1 TCF net resources to Sound Energy discovered would be valued at US$2.4 billion equivalent to approximately 166 p/share. The current TE-10 well drilling is targeting gross gas in place of 2.8 TCF. Assuming a 50% recovery rate, this would give Sound Energy (with its 47.5% working interest) net recoverable reserves and resources of 665 BCF of gas equivalent to 110 p/share. Investor should be aware that these are a rough guides to give an idea of scale since other factors will play a part in the valuation such as size of the discovery, productivity of the wells and timing of the start of production. This should be put in context of the unrisked gross prospective resources available in Sound s exploration acreage. Using the mid case scenario, management has identified significant upside. In Tendrara it is believed that the prospects contain gross gas in place of 20 TCF. Assuming a 50% recovery factor this would give unrisked prospective reserves net to Sound of 4.75 TCF. In the Sidi Moktar licence the prospective gas in place is 8.9 TCF and using a 50% recovery factor this would given unrisked prospective reserves net to Sound of approximately 3.4 TCF. All in, prospective resources net to Sound could be over 8 TCF. Investors should be aware that exploration is a high risk business and that the expected outcome of a well is unsuccessful. 8
Prospective resources In place Recovery factor Recoverable Net to Sound TCF % TCF TCF Tendrara Low 7.0 50% 3.5 1.7 Best 20.0 50% 10.0 4.8 High 34.0 50% 17.0 8.1 Sidi Moktar Low 6.7 50% 3.4 2.5 Best 8.9 50% 4.5 3.3 High 11.2 50% 5.6 4.2 Source: Company information, Progressive Equity Research estimates 9
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