A couple of oil plays

Disclaimer: The information provided in this post is not to be considered as any form of investment advice. I might buy or sell shares in any companies discussed in the post without notifying readers of the blog. I currently own shares in TGS-Nopec Geophysical Company.

I don´t think anyone even remotely interested in finance have missed what has happened with the oil price as a consequence of the drastic drop in demand due to the spread of the Corona virus, and the subsequent price war between Russia and Saudi Arabia. I will not go into details on that at all as I am no expert on oil by any means, and there is plenty of reading material out there on the subject if one wishes to get additional information on that subject.

However, I do like to be a little contrarian and look at things that people are avoiding at the moment, for one reason or another. As such, oil companies make for interesting hunting grounds having lost a significant portion of their market values in a short period of time. I would guess that the very best returns in the oil sector can be made if you identify levered companies that are valued as if they are going bankrupt but make it through, but since I have a preference for qualitative companies with strong balance sheet, that is not the route I have taken. Instead I will provide a brief overview of two companies with asset light business models and strong balance sheets that I think are attractively valued right now. This will not be in depth at all, and again, I am no export on oil so please do your own dilligence before buying anything I might have written about on the blog. I have no idea what the oil price will be in one month, six months, a year or even several years out, but I do think that the current oil price is unsustainably low, that the world will require oil for a long time to come, and that these two companies will be valued much higher when the oil price eventually regresses to a more normal level, with a very low probability of going bust in the interim.

TGS-Nopec Geophysical Company

This is a company listed on the Norwegian Oslo Exchange that I have owned for a long time, but that I have added to during the rapid fall in stock price from a high of over 280 NOK in mid December to around 138 NOK as I write this (it was tradig below 100 NOK at one point i March). TGS does not produce any oil, instead it collects, processes and provides seismic data to E&G companies. They are one of the leading global companies in the sphere with a multi-client business model where they collect the data once, and then sell the same data to several different clients. Generally, a decent portion of their revenues are pre-funded, meaning that the customer funds the exploration beforehand, reducing capital needs. The company does not own any vessels or crews for data gathering, instead they rent or do joint ventures with other companies that provides the vessels and crews. As a consequence, the fixed cost base is quite low and the company can be quite agile in crisis times like these and cut investment in the multi-client library quickly and remain cash flow positive.

Investments are continually made into growing the data library. Since the inception of new accounting rules in 2016, the library is being amortized aggressively, currently at a higher pace than new investments. As a consequence of this, the fact that a portion of the explorations are pre-funded by customers and the overall asset light, low fixed cost business model, the company generates a lot of cash flow compared to earnings. Free cash flow is typically higher than EPS. The company is free of debt and had net cash of abount 3 billion NOK at the end of Q4 2019. Free cash flow after investments in the multi-client library has been positive every year for as long as I have looked at the data in depth (2010).

During 2019, the company acquired Spectrum, another Norwegian company with a very similar business model but with a complementary data library, so to make reasonable predictions about the future, you need to look at the history of both companies and make some reasonable assumptions about future growth and potential synergies. Furthermore, the business is quite cyclical as customers investment behaviour with regards to new explorations are heavily influenced by the current oil price, so you need to use several years of data to estimate future earnings power, to get a sense of what the business will do over a full cycle. TGS has already warned that 2020 will be a challenging year, but thanks to their business model I still expect them to remain cash flow positive. Historically TGS has had a counter-cyclical investment policy where they invest more relative to peers in rough times for the industry to gain market share in the long-run. They have already announced a cut in investments in the multi-client library for FY2020 from 450 MUSD to 325 MUSD, which is still higher than the 250 MUSD that peers planned to spend on average before the Corona virus outbreak.

The company pays a quarterly dividend. They were planning to pay 0.375$ per share and quarter, but in light of recent events they decided to cut the next quarterly dividend to 0.125$ per share, and will evaluate the situation further going forward before deciding on what will happen to the divident for the rest of the year. They have historically also bought back stock continually, hopefully they felt confident enough to do so aggressively when the stock price plummeted in March. If not, I would have rather seen a complete suspension of the dividend in favor of buying back shares.

If we look briefly at valuation, EV should be around 13 billion NOK. Free cash flow defined as operating cash flow minus investments in the library for 2019 was about 2.1 billion NOK, and EBIT around 2.3 billion. These numbers only include Spectrum from the date the acquisition was closed in late August so on a full year basis were a bit higher for the combined entity. This gives multiples of EV/FCF2019 of a little over 6, and EV/EBIT2019 just under 6. Now, 2020 clearly wont resemble 2019, and judging a cyclical business on the results of a single year is probably not the best idea. Combining historical data for TGS and Spectrum with some assumptions on synergies based on what has been communicated, I end up with normalised FCF of around 1.6 billion NOK. This would give a EV/FCF of 13/1.6 = 8.125 or a a FCF-yield of over 12%. This might be a little aggressive given that 2020 will proably be quite weak, but given that I also expect the company to grow at maybe 3-4% a year over a full cycle I still think that a return of well over 10% seems very doable. If the stock price gets back to the December high (it has traded even higher previously) of 280 NOK in lets say five years, that would give a compounded annual return of almost 15% excluding any dividens or buybacks. This is certainly not the most explosive upside you can find in the industry, but it is a very safe company with a proven business model that generates a ton of cash. There are certainly risks here as in all businesses, but at least the risk of the stock going to 0 should be incredibly low.

Tethys Oil

I first started looking at Tethys in the fall, when it traded around levels of 80 SEK, and found it really cheap. Thankfully, for various reasons I didn´t pull the trigger, and now the stock has dropped to a price of around 47-48 SEK per share.

Tethys Oil is listed on the Stockholm Exchange in Sweden, is head quartered in Sweden and has a Swedish CEO. However, pretty much all of their revenue is generated in the sultanate of Oman. In fact, it is generated from one single source in Oman, namely their license to get a 30% production cut of the production in Blocks 3 & 4 in Oman. They are not the operator of the license, so they have very little tangible assets on the books. They do own a license in Block 49 in Oman where they are the operator and are currently about to start drilling for oil, but so far no commercial production has been commenced. The company also holds a share of the license in Block 56 where they are not the operator, and as in the case of Block 49, this has not generated any revenue to date.

Oman has historically been politically stable and has managed to stay out of any major wars despite their sensitive location. However, a quick search on Google makes it evident that human rights isn´t exactly on top of the agenda, and that the finances of the country are quite poor. To complicate things further, the government takes a share of all the production of oil in the country. In Tethys case, the license holders first get reimbursed for the costs of running the well. This is called cost oil. Any profits above costs are then shared beetween the government and the license holders. As far as I can tell, the budgets are made annually so Tethys share of output varies from year to year and could in theory vary all the way from 20% to 52% of the 30% of production that belongs to Tethys within their license. Historically though, Tethys share has been around 50-52% for most years, and they have guided towards a production share of 52% for FY2020. To date, Tethys seems to have had no problems at all operating in Oman and given that they are attaining more and more licenses in the country, they seem to have a good relationship with the state. That said, generating almost all revenue from a single license in a country located in a part of the world that has been very politically unstable for quite some time, with a leader that has absolute power of just about everything that goes on in the country, seems like something that deserves quite the risk premium.

So on to the numbers. For the last four years, Tethys share of production has been quite stable at around 2.2-2.3 million barrels of oil, so any differences that you might see in revenue is mostly due to volatility in the oil price. In 2019, with an average oil price of 64.2$, Tethys EBIT was 37.1 million USD which translates to about 374 million SEK. Average EBIT for the last three years is 45 million usd, for the last five years it´s around 32 million USD. In 2016, with an average oil price of 40.5$ they had negative EBIT of 0.4 million USD.

As I write this the stock price of about 48 gives a market cap of around 1.6 billion SEK. Tethys has no debt, and net cash of around 760 million SEK rendering an EV somewhere around 840 million SEK. EV/2019 EBIT is something silly like 2.4, EV/2019 FCF just over 3. So yeah, that’s incredibly cheap. If we use the five year average EBIT of roughly 320 million SEK we still get an EV/EBIT of less than 3.

As I mentioned, the company lost money in 2016 when the average oil price obtained was just over 40$. Cash flow was slightly positive. The company recently announced that they are taking measures to make sure they remain cash flow positive even at oil prices of 30$, so the risk of the company going bankrupt and the stock going to 0 should be incredibly small in this case as well. Clearly though, as is the case with TGS, in order for this bet to work out, oil prices need to revert to more normal historical levels eventually.

Tethys has historically returned a lot of capital to shareholders. In 2019 they paid an ordinairy dividend of 2 SEK and returned an additional 6 SEK per share through a mandatory redemption program. The plan was to do the same in 2020, but in light of recent events they have lowered the additional return to 3 SEK, while keeping the ordinariy dividend of 2 SEK, so 5 SEK in total will be returned to shareholders putting the ”dividend” yield above 10%.

As long as you believe that oil prices will eventually revery, then Tethys looks incredibly cheap, no matter how you slice or dice it. Still, I don´t own the stock. Why? Well, so far, I have had a hard time coming to terms with the geographical and political risk. Even though there have been no problems operating in Oman so far, and the country hasn’t been involved in any major conflicts yet, there is no guarantee that the same will hold true going forward. Also, any kind of force majeure event that could strike the region and wipe out production in the area would completely wipe out Tethys revenue along with it. Also, there is simply no way around the fact that the faith of Tethys is completely in the hands of the government of Oman, or more precisely, the sultan/chief of staff of armed forces/minister of defence/minister of foreign affairs/chairman of the central bank (yeah, it´s the same guy). Additionally, I don´t want to allocate to large of a portion of my portfolio into oil, and since I like TGS way better as a long term holding, that has been my choice in the sector so far.

That said, I am still interested in Tethys. First, I need to decide whether the risks described above makes the company uninvestable for me. If not, I need to figure out what price would make it worthwile to assume all these risks, which of course, is a function of the potential upside as well. A company with a single revenue generating asset like Tethys will probably never get any sort of premium valuation, as was evident in the share price even before this whole oil mess started. That said, even a defensive multiple of say 6 times normalised EBIT would generate a very nice return, as long as that normalised EBIT actually happens. For the sake of argument, if we assume that 2019 EBIT is a good approximation for a normalised EBIT, a 6 times EBIT multiple on that would indicate an upside of like 150% on todays stock price. Even if that takes five years to achieve, you´re looking at a 20% annual CAGR excluding any dividends.

As always, I greatly appreciate any feedback. This was not meant to be a deep dive in either company, but rather a brief pitch to provide you with two potential ideas to do further work on. Thank you for reading!

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