*Please read the disclaimers at the base of this report. The author may have a short position in the stock at any time. Does not constitute a recommendation to buy or sell the securities mentioned herein. Do your own due diligence.
Last week we saw Hurricane’s restructuring plan overturned by the High Court, which ruled in major shareholder, Crystal Amber’s favour. While it is rare for a court to overturn a bondholder lead restructuring plan, perhaps with hindsight it can be said that the plan was a little premature. Given that given the Lancaster field was still generating free cashflow and paying interest, and with the bond redemption payment still a year away, any default was a theoretical future event rather than a near term reality. However, the reality from a reservoir perspective, is unchanged. The P6 well is in decline, is cutting incrementally more water every month and there are no realistic plans in place to alter that outcome. The other well, the P7Z has effectively watered out and shut in, and the P6 well is approaching bubble point. The FPSO contract runs out next year in June, shortly before the bond is due to be redeemed. In turn, Crystal Amber face a wind-up vote this November, which is likely, as things stand, to result in the fund being liquidated (along with its Hurricane holding).
Financials
At $70 Brent we see the bondholders getting back at best around $190m, but more likely around $170m when other costs are taken into account. That would leave negative equity of around $40-60m. Given the costs of the High Court action (and those payable to Crystal Amber), along with other abandonment expenses, this outcome may prove optimistic. Below is our best case at $70 oil with equity value in $ on the right hand side. For what its worth it would take around $85 a barrel of Brent to get to breakeven on the equity. Having said that, we may have overestimated the unrestricted cash balance and underestimated any likely wind-down costs that would have to be incurred, so even that may be generous.
Furthermore, there is the question of the production. I believe even our estimates of production (blue column above) may prove generous given the reliance on the uptime of one well, with one functioning ESP (which we have seen can breakdown), and uncertainty as to how the water cut on the well will behave as we reach bubble point (and indeed the broader production behaviour).
And then, there is the question of the Xodus report, written on behalf of Crystal Amber, and which presents a potentially more benign outcome for the Lancaster field than we or company management, or indeed, ERCE, have painted. That has given some hope to shareholders, and may have even affected the outcome of the recent sanction hearing at the High Court.
The Xodus Report
Xodus appear to be dismissive of the the main conclusions of the April 2021 CPR undertaken by ERCE. Whilst there is general agreement about the oil water contact (OWC), thus limiting the range of uncertainties, Xodus question the structural model and thus GRV (gross rock volume) above the OWC. This would appear to throw some uncertainty on the mapped feature such that a greater GRV could be envisaged and therefore a larger “tank” to store the oil. However, with good 3D seismic coverage and a well defined basement reflector the structure at top basement level is relatively easy to map and the container well defined. Any uncertainty therefore, is primarily dependent on the depth conversion. However, given that the Lancaster field and surroundings has numerous well with good seismic velocity control, its likely that the depth structural model is fairly certain.
With this said, it appears that the last remaining bone of contention is the porosity assigned to the basement rock contained in the structure, which forms the overwhelming bulk of the rock within closure. As a Type 1 fractured reservoir, the fractures act as both porosity and permeability, and the density of the factures thus fundamentally drive the STOIIP (stock tank oil in place). There is no “traditional” porosity associated with the basement with the exception of the slim worn away carapace of the basement known as the “granite wash”. In their CPR, ERCE used a porosity (fracture density) range of 0.2, 0.3, to 0.45 (higher for the granite wash carapace). Xodus, by contrast appear to estimate most likely 3%, and that by applying best industry practice conclude an order of magnitude higher STOIIP and, therefore, by implication, more oil recovered.
ERCE derive their porosity estimate by history matching from production. Their porosity estimation is primarily based on history matching from production, tweaking the attributes of a reservoir model to produce the real reservoir performance results on a backtest and forward extrapolation basis. Xodus, on the other hand, rely solely on BHI (borehole images) of the fracture network determined in the borehole. They conclude that 3% fracture porosity is likely from the images they have analysed. However, this is a static process, and thus limited in scope: an image in a 7 or 9 inch hole is hardly likely to be reflective of the rock 10m away from the bore, let alone across the entire structure. This would lead to a much greater range of uncertainty in Xodus conclusions, and to rely on this alone, whilst ignoring the ERCE history matching approach does not suggest best industry practice, at least in the opinion of this writer.
More broadly ERCE discuss analogue fields such as brittle carbonate rocks. Most of these fields never attain even 0.7% fracture porosity, let alone 3%. Carbonate rocks are not direct analogues for basement rocks, but they do provide a guide, and suggest as a result that the upside from porosity is pretty limited.
Finally, and irrespective of the arguments about porosity and thus STOIIP, it is not possible to ignore that the current well is pulling in an increasing water cut (45% as of June water oil ratio, ie more than 30% of the total well fluids). This would suggest that the reservoir has almost certainly been compromised by coning water coming from the large open fractures/fissures in the basement. Even if Xodus claim pervasive micro fractures (highly questionable, as we argue above) as a means of replenishing the main fractures, the coning of the water will inhibit any bleed-in of oil from them, and even in the unlikely event that this micro-porosity exists and can feed into the well, any contribution of this oil will bleed in at a snails pace on a very long tail from P6 production (in other words well beyond the economic cut off of the well).
Conclusion
Once again then, we are left in a situation where, at best, we will reach the likely economic limit of the field in the next twelve to eighteen months, and the bondholders will not secure the return of 100% of their money at the redemption date next July unless oil prices spike and remain above mid-80s or even $90s. As a result, the recent recovery of the share price post sanction hearing doesn’t appear to make any sense: there are cheaper, and less risky options on $100 oil that are not reliant on the uptime of one well that is in decline, watering out, and inexorably losing pressure.
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