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How Close is the Africa Oil Bubble to Bursting?

Friday - 11/23/2012, 5:27pm  ET

Introduction

The investors often propel some companies' valuation at high levels making them a bubble. I like identifying and exposing these bubbles before they implode. The greed isn't a wise investment strategy. Many people are driven by greed and they want a bubble to go higher as they have a biased perception of reality. Once the implosion occurs, they recognize their mistake but it is too late. So I'll analyze the case of Africa Oil Corporation (TSXV: AOI). Is it a result of people's greed or ignorance?
 
Operations  Overview

Africa Oil is a Canadian energy company with assets in Kenya, Ethiopia, Mali and Somalia through its 45% stake in Horn Petroleum Corporation. Africa Oil's East African holdings are in excess of 300,000 square kilometers. The company doesn't have any production today and it is in a multi-well drilling campaign in Kenya and Ethiopia during the last months.

Corporate  Developments 

The company found oil with the first hit in March 2012. The initial successful results from Ngamia-1 well (AOI 50% WI, Tullow 50% WI) in Kenya encountered over 100 meters of net light oil in the Upper Lokhone Sand Section that grew during the next months finding an additional 43 meters of potential oil in the Lower Lokhone Sandstone Section. This was the first oil discovery in Kenya and this boosted the share price by more than 500%. However Tullow, Africa Oil's partner, indicated it would be at least a year before it knows whether its March discovery (Ngamia-1 well) can be extracted and exported.

The next well of Africa Oil, Twiga South-1, was drilled in September and it represents the next step in expanding the play and proving up the 'string of pearls' concept. The company said recently that it encountered oil but no further details have been provided yet so the commercial viability of this discovery has yet to be ascertained. 

The company will continuously drill high impact exploration targets for the remainder of 2012. In onshore Kenya, the Paipai-1 well in Block 10A, was drilled in October and the market still awaits for the results. In onshore Ethiopia, the exploration drilling campaign will commence with the Sabisa-1 well in the South Omo Block before year end.

Regarding Somalia, the first 2 wells drilled by Horn Petroleum (45% owned by Africa Oil) didn't find oil.
 
Valuation  

Africa Oil Corp trades with a price to book value of 9.3. The company has zero production so it has zero revenue and thus negative funds from operations. The company holds $55 million cash but the drilling cost in Kenya is about $15-20 million per well. The company also announced an increase at its reserves in Aug 2012. However they are Prospective reserves and they aren't Proven and Probable Reserves (2P). Prospective reserves means that there is no certainty that any portion of the Prospective Resources will be discovered. If discovered, there isn't certainty that the discovery will be commercially viable to produce any portion of the resources.
 
Some holders will debate that Africa Oil has a big acreage and new discoveries have been announced on all sides of Africa Oil's land position including the major Albert Graben oil discovery in neighboring Uganda. I'll comment that it's widely known in the oil & gas universe that you and I could be neighbors and you are sitting on 1 billion barrels recoverable and I have goat pasture. So this acreage statement lacks punch. 

Insiders

According to regulatory filings, the insiders have been selling since July 2012. I accept that the insiders sell for many reasons. The insiders also buy only for one reason and I havn't seen any of them buy since the share price has jumped to the current levels.
 
Geopolitical  risks

The geopolitical risks of Africa are well known. The social unrest, the political turmoil, the civil wars, the pirates attack, the lack of infrastructure are usual. "No matter where you are in the world, where there's no infrastructure and no history of the oil business, it will take at least half a dozen years to go from exploration phase to development concepts," Tim O'Hanlon, Tullow's vice president for Africa, told Reuters. 

In Uganda, the pipeline to get the oil to the coast for export will not be in place before 2018 at the earliest. In Kenya, the Government has already started to complain about its current 10% stake and they want a 25% share although the country has not found any commercially viable oil source yet. Tullow indicated it would be at least a year before it knows whether its March discovery with Africa Oil (Ngamia-1 well) can be extracted and exported.
 
Peers

Kodiak Oil and Gas has the same market cap like Africa Oil. Are these companies the same? Kodiak Oil is one of the most loved oil plays as it sits on the North Dakota Bakken formation and it operates in a stable jurisdiction. All this adds a significant premium on Kodiak. In addition, Kodiak is a producer and it is not an exploratory venture. Keeping in mind these additive factors, we see that Kodiak trades with a price to book value of 2.4 and 10x the annualized Funds from operations. Kodiak also trades for more than $200,000/boepds.

Let's consider now some other companies like WesternZagros (TSXV: WZR) and Mart Resources (TSXV: MMT) with recent significant oil discoveries in risky and unstable areas like Africa Oil's region. WesternZagros operates in Kurdistan and trades with a price to book value of 2. Mart operates in Nigeria and trades with price to book value of 4 and 4x the annualized Funds from operations but it is a producer and a dividend payer.

Are these multiples anywhere close to the whopping 8x book value of Africa Oil with the unknown production future?
 
Conclusion

I believe Africa Oil Corporation's current market cap defies any logic and I can't find any rationale behind it. I think long investors had better stay away from Africa Oil as there are significant downside risks. Speculative investors should consider a short position capitalizing on the asymmetric risk/reward proposition at these unsustainable levels. A sharp revaluation to the downside may be coming.

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