How Should Emerald Energy Shareholders Vote?

Until now, I have consciously tried to fashion this blog as a place where a great deal of research is assembled and presented in a more or less neutral fashion so that visitors and investors can make up their own mind about the company.

However, now that the Circular has been published, the time is rapidly approaching where investors have to make up their minds about whether to accept this 750p bid from Sinochem. So, I have decided to temporarily break my own rules and write an "editorial" about my specific views on the bid, and whether it should be accepted or not.

Background

There is some anecdotal evidence (for which I can give no reference so I cannot confirm its veracity) that Emerald received a bid approach of ~650p/share either shortly before or shortly after Christmas. As bids for oil companies are generally valued in US Dollars, and the $:£ was about $1.45 at that time, let us say it was the equivalent of $9.40/share. Apparently, this was dismissed out of hand without even consulting the wider board. At the time the oil price was ~$40/bbl, and we were in the teeth of the credit crunch.

For several years many investors (this investor not among them) have bemoaned the company's "low-key" approach to PR. However, since the alleged approach described above, the behaviour of the company has subtly changed from prior behaviour. The first example is that in the 2008 results presentation published on 16 March 2009, the company gave Oil-in-Place (P10 of 1.1bn barrels) estimates and contingent resources as well as 2P reserves for the Capella field. This is the first time current management has done such a thing for any of its prospects that I can remember. The second example is in the 30 April announcement of reserves for Block 26, they gave a "life of field" (as opposed to life of contract) estimate of reserves for Khurbet East and a contingent resource figure for Yousefieh. Interestingly, Gulfsands did not give either number in their corresponding release. I cannot recall a prior occasion where Emerald volunteered more information than their partner in relation to Block 26, in fact quite the contrary was often true. One may conclude that this change in behaviour was designed to support the share price, perhaps in anticipation of a further bid coming in.

Then, strangely, in April when the share price was starting to rise strongly, the company converted one tranche of the Convertible Bonds, which had the effect of temporarily depressing the share price. The true motive behind this move has never been properly explained, in my view.

At the AGM/EGM on 24 April, I was asked, along with another investor, by the senior NED what we thought Emerald was worth. My stance was I wouldn't give a value for what it was worth now, because I didn't think now was the time to sell, but that I would hope for £15-20/share in about 2 years time. I have attended a number of Emerald Energy formal meetings, and I've never been asked a question like that before. I thought it a little strange at the time, but thought no more of it.

Operational Progress

Since the formal reserves statements made for Colombia in March, and for Block 26, Syria made at the end of April, the company has made very significant operational progress that has not yet been quantified in terms of precise recoverable reserves, but nevertheless will have had a material impact on the value of the company.

First, in April, we received the results of the Capella-6 well which encountered a net hydrocarbon interval in the upper Mirador approximately 4 times thicker than other wells and with porosity of ~37% (about that of beach sand). The impact of this well has not yet been formally quantified, but it does not take a geological genius to come to the conclusion it must have made a very material improvement to the oil in place and recoverable reserves. Moreover, it was announced on 20 August that the planned horizontal well planned for the C-6 area had been postponed, that the company had commenced drilling two slim-hole wells to better delineate the extent of the thicker Upper Mirador area, that steam injection was due to start testing and they had received environmental clearance to drill the northern "Romero" section of the field. It seems the main purpose of this work is to prove up more of the field and determine the recovery factors with horizontal wells and steam injection. Given that this work is likely to add significant value to the field, it seems strange to accept a bid at this time when the results are unknown.

Second, the Gigante-2 well has been drilling and testing since December 2008. We know partial results from the Caballos horizon that look encouraging so far, and we await results from the Tetuan formation. The pre-drill prognosis for G-2 is 15mmbo from the Caballos and 4mmbo from Tetuan. However, we must also remember that the pre-drill prognosis for Capella was for some 30mmbo recoverable, so the published company estimates may well be conservative. As confirmed positive results from this well will likely have a very material impact on the value of the company, again it seems strange to agree a bid before the results are known.

Third, The Mirto-1 exploration well is still being tested, and the bid was agreed before the results were known. Moreover, according to the RNS today from La Cortez Energy – the partner in the Maranta block – indicated that Emerald had also identified several promising leads in Maranta. Presumably, the apparent success in the U-sands confirms the prospectivity of at least some of the play types. So, again it is very strange to accept an uncontested bid when the results of the well are not known, and no estimate of recoverable reserves has been given – pre-drill prognosis 5-15mmbo.

In Syria, the reserves statement given on April 30, apparently did not take account of the fact that the KHE-8 well flowed oil, apparently in commercial quantities. That fact that it has flowed, probably increases the recoverable reserves. Further, on 6 August, just before the bid was accepted, Emerald and Gulfsands said that they had just commenced drilling KHE-12; a well designed to further test the Southern limits of the field, and may, perhaps, lead to a further increase in reserves. Moreover, a workover programme on Yousefieh-1 & 2 and KHE-7 has commenced, again the primary purpose appears to stimulate the wells with acid, improve flow-rates and increase reserves. Although this may now be getting repetitive, why accept a bid when there is work going on, that will not take a great deal of time to conclude, that may have a material positive impact on the value of the company. In addition, the Khurbet East Kurrachine Dolomite and Butmah formations have still not yet been appraised, and we have not seen the results of the "Commercialisation Study" due to be completed in 2Q09. And finally, an extensive 3-D seismic programme has recently been completed over the Khurbet East fairway. So, far 10 leads and prospects have been identified, and the formal prospect inventory is due to be published in November – according to a broker note on Gulfsands published today.

The Bid

First we had the bid "courtship phase" as the approach was announced. As described above, the company embarked upon the furious work programme ostensibly with the purpose of increasing the value of the company. However, at a similar time, an interview with Michael Kroupeev was published where he was quoted as saying 750p was a "good number".

Then, before any of this work was concluded and before the results of the exploration wells were completed, the actual agreed bid was announced. It is usual, indeed some would say essential, for any first bid to be re-buffed in a show of mock outrage that the bidder puts such little value on such world class assets. However, in this case, the company seemingly accepted the first offer, apparently with some board members under a three-line whip, that was made at some 750p/share. Coincidentally at the same level that Mr. Kroupeev had indicated was "good". Just two days later, it was announced that Mr Kroupeev's investment vehicle, Waterford, was making a significant investment in Sterling Energy (SEY) and that Alastair Beardsall was going to take the position of Executive Chairman there. It is difficult to avoid the conclusion that both deals are in some way connected.

The 750p/share offer translates into ~$12.30/share (@$1.65/£) or some ~30% above the bid that was allegedly rebuffed out of hand earlier in the year. However, the world economy now seems to be starting to recover from the credit crunch, and oil is nearer $70/barrel.

This is in contrast to the 11 June 2009 note from joint broker Jefferies that calculated a core NAV for the company at some 863p/share, with total NAV of some 1,109p/share and unrisked NAV of 1,747p/share. The 1,109p/share is made up of 557p/share for Colombia, 485p/share for Syria and 67p/share of cash.

Furthermore, it has been rumoured in the Daily Mail, that Gulfsands has also received an approach (denied by the company, but not by official RNS) from Sinochem valuing Gulfsands at ~£400m. If this were true it would put a value on Emerald's Colombian assets of ~£130m (or less than £2/share), which given the sheer size of Capella, amongst other things looks way too low.

Conclusion

I have now come to the conclusion that the company is in rude health and has an impressive array of exploration, appraisal and development projects that can be progressed to add significant further value in the medium term. And the company's own broker has placed a much higher value on the company than has been agreed by the board.

Moreover, in the next few months, there are numerous current activities that will also add significant value to the company, namely:

a) Full Mirto results, plus an estimate of recoverable reserves and contingent resources and disclosure of the Maranta prospect inventory.
b) Full Gigante results and disclosure of estimated recoverable reserves and contingent resources plus disclosure of the anticipated prospectivity of the new VSM-32 block.
c) Results of the slim-hole programme in Capella together with results of the horizontal well, steam injection and drilling of Romero.
d) Workover programme in Syria
e) Prospect inventory for Block 26.

Accordingly, I will not accept this 750p/share offer as I think it is far too low and the company is too early in its lifecycle to succumb at this stage. And although I am not qualified to give financial advice, I would urge other investors to vote "No", and either hope for a counterbid or watch patiently as the talented management team continues to deliver. I am running a poll on the advfn thread that gives shareholders an opportunity to collectively express their view about their voting intentions.

However, I hold no grudge against Michael Kroupeev, Waterford or Alastair Beardsall. If Waterford wishes to sell, then in a free-market, it must be allowed to do so. It is not clear whether Sinochem will be temporarily happy with just his stake at 750p. Similarly, if after delivering such spectacular results over six years, Mr. Beardsall has decided it is time for a new challenge, then good luck to him.