SDX Energy — Update 27 January 2017

SDX Energy is acquiring Circle Oil’s interest in the NW Gemsa block in Egypt (40% WI), the 75%-owned Moroccan licences (Sebou and Lalla Mimouna) and working capital connected with both assets (approximately $18m). For these assets, SDX will be paying $30m in cash, funded by equity. SDX is also taking the opportunity to raise a further $10m ($5m to drill two wells in Morocco, $2m to cover fees and the remainder for bank guarantees, severance costs and miscellaneous expenses), which means that SDX will have raised a total of $40m.

The assets are being bought at a discount to SDX’s metrics on an EV/boe and $/boe basis. A summary of the deal and metrics is below.

While the acquisition is being made at a steep discount to our estimate of the underlying discounted value of the assets on an NPV basis, SDX’s existing portfolio is also trading at a discount. As a result, to fund the acquisition of the assets, SDX is issuing paper at a discount to this value, in effect diluting the value of its existing portfolio for current investors to acquire the Circle assets.

SDX is acquiring the Moroccan assets of Circle, which comprise the Sebou and Lalla Mimouna areas. The Sebou permit (split into the Sebou Exploration Permit and four approved exploitation concessions) has existing gas production to a local industrial area (and exploration potential), while the Lalla Mimouna is still in the exploration and appraisal phase. Both are located in the Rharb Basin, onshore Morocco.

The assets are producing strong free cash flows and have contracts out to 2021 at high gas prices (relatively to global peers). Post-acquisition, SDX’s opportunity is to initially recycle these cash flows and explore/develop to grow reserve to supply the contracts after 2018-21 and then to explore to provide reserves to additional, longer-term contracts beyond the 2021 end date.

Sebou: Circle Oil signed a 10-year Exploration and Exploitation Agreement with ONHYM (Moroccan Government Energy Agency) for the Sebou permit (Rharb basin) in June 2006, holding 75% working interest (ONHYM holds the remaining 25%) and covering 296km2 – this has since fallen to 134km2 after relinquishments. There is an automatic right of conversion to an Exploitation Concession of up to 30 years duration for any commercial discovery; this can be extended if production continues at the end of the initial period. All necessary commitment wells have been drilled in these permits, with a high overall success rate. It is anticipated that the ongoing negotiations to renew this permit will soon be successful.

2D and 3D seismic surveys cover the majority of Sebou and 13 discovery wells resulted from 16 exploration wells (a success rate of 81%). Production operations continue on the majority of these wells. Current production is around 6.5-6.8mmcf/d gross and this is routed through a 75%-owned pipeline to the Kenitra industrial zone (we provide more details on the customers below). The capacity of the pipeline is 23.5mmcf/d (of which 7mmcf/d is currently utilised), giving the company significant headroom in adding to this if enough resources are discovered/developed and sold.

Lalla Mimouna is therefore much larger than Sebou (2,211km2 vs 134km2) and relatively poorly covered by 3D seismic, with only c 10% of the licence area covered by 3D seismic. However, the eight-year initial exploration term is due to end in January 2018, so SDX has relatively limited time to explore the area unless an extension can be agreed. The latest interim report (H116) from Circle indicated its intention to drill two wells on the Lalla Mimouna permit in 2017.

Circle was awarded the Lalla Mimouna permit in January 2010 (covering 2,211km2), which was subject to an initial eight-year life that could be extended to a maximum (but extendable) 25-year exploitation period for any commercial discoveries. Circle carried out an initial 80km2 3D survey in 2010, with a further 135km2 of 3D in 2011. These data are believed to be high quality.

A drilling campaign of three wells was planned in late 2012, but this was pushed into 2013, 2014 and then 2015. In 2015, three wells were drilled. The first (LAM-1) targeted Miocene gas-bearing sands (as seen in Sebou). The primary target flowed gas at a stabilised rate of 1.9mmcf/d, while the secondary target flowed at a stabilised rate of 1.1mmcf/d. Two other wells (ANS-2 and NFA-1) were drilled but neither yielded encouraging results (ANS-2 has reservoir but pressure tests were not sufficiently conclusive, while NFA-1 was dry). No drilling has occurred on the licence since then (understandably, Circle has concentrated on Sebou). SDX plans a two well exploration campaign if the licence is extended.

As can be seen in Exhibit 5, gas prices realised by sales thus far have been high by global standards and have averaged US$8.7/mcf since 2009. The prices are driven by the limited substitutability of the gas by the customers, which produce ceramics and paper in the Atlantic Free Trade Zone (in Kenitra) on the Moroccan coast. Many of the companies in the Kenitra area are using bottled gas at prices ($18/mcf) well above the contract prices, so we would expect any volumes that are lost would (almost) immediately be replaced by another customer (and that any additional volumes that the company can produce could be sold). We are therefore comfortable that gas prices will remain close to current prices given the existing contracts (which we imagine vary slightly on a customer-by-customer basis) and the macro pressures driving any renegotiation in future.

Sebou currently supplies three companies: Supercerame (ceramics), CMCP (paper) and SBS Porcher (ceramics). As an example of pricing, SBS Porcher may be taking 0.35mmcf/d at a price of around $12/mcf (according to Circle’s last AGM presentation) in 2017. Kenitra lies 50km north of Rabat and close to the southern border of the Lalla Mimouna licence. The project is well connected by highway to Tangiers and Rabat and offers tax and customs benefits for companies setting up in the area.

Together, these contracts lead to minimum gas take of 5-5.5mcf/d, although this will fall to around 3.8mcf/d in 2018 as contracts tail off. Production history indicates that the customers regularly take more than the minimum (2015 production was 5.9mcf/d), but still below the maximum (over 8mcf/d until 2018, falling to 6mcf/d thereafter until 2022. Even with four customers, concentration risk could superficially be seen as relatively high, leading to downside risk if one goes offline or out of business (Supercerame is the largest of these and the longest dated), however the demand from other business in Kenitra currently buying bottled gas for $18/mcf reduces the impact substantially.

Sebou 2P reserves were estimated to be 7.9bcf at the end of 2015, of which 5.6bcf were classified as proven. After 2016 production (and not allowing any reclassification, additions or other adjustments), we estimate year-end 2016 2P reserves of 5.7bcf (and 3.4bcf of 1P). This means that the company will have to convert some of its existing 3P or contingent resource/ reserves to supply the contracts as they currently stand. Current production cannot be sustained with the current well inventory indefinitely, so drilling will have to follow the deal to fulfil the contracts and/or provide for any extensions/additions after the contracts end in 2021.

For the moment we model that SDX will mirror Circle’s capital investment plan over 2017-21 to work over existing wells, drill new development wells to bolster reserves and improve facilities and pipeline capacity (and drill exploration wells where appropriate). Indeed, in our accelerated investment plan modelling we see over $30m invested in Morocco in the next five years. This is well within the cash flow generation of the asset, we which estimate to be over $60m in this period. In addition, the cost of drilling and service work has fallen materially, so capital efficiency will be far higher for SDX’s investment than it may have been a few years ago, while we expect SDX to introduce modern techniques that have not been implemented in Sebou previously.

Although the results of any given well cannot be guaranteed, Circle had a good success rate in drilling wells historically, so we are not overly concerned about the risk that future wells will not be able to fulfil the reserve estimates/contracts at this time, although this possibility always exists. We note that the 2015 change of auditor (to Senergy) re-categorised 2P reserves to contingent, reducing the 2P number significantly. If we include even a portion of these contingent reserves (given the extensive drilling plans), the 2P would likely rise to above our modelled reserve requirement (see below).

We model a budget of 10 wells, seven of which may be successful. This is below the historic success rate at Sebou of 80%. We do not explicitly include any value beyond this (either at Sebou or at Lalla Mimouna), but note that discoveries would likely be easily monetised. At $2-2.5m per well, these cash flows will fund many wells.

The acquisition gives SDX an additional 40% working interest in the NW Gemsa field (on top of its existing 10% stake). The other 50% will continue to be owned by ZhenHua Oil, which will remain operator. The field needs little additional capital to be invested and we expect the field to continue to decline over time, although the company will now receive half the cash flows (previously 10%).

The production of the field has been below our expectations in 2016, and we take the opportunity to reduce the forecast production for NW Gemsa. In particular, we had expected a levelling off of the production decline for a number of quarters following the workover programme in 2016, but the field has fallen from 7.8mb/d in Q116 to 6.5mb/d in Q3 (an annualised decline of 20%). We therefore move our modelling towards the 2P production profile, as our previous more optimistic case (above or around the 3P case) has not been realised. We note the company plans a 12 well workover programme starting in 2017 (eight producers and four injectors), so we expect an effect on production this year, hence the phasing of production profile vs the CPR numbers.

This does not detract from the cash generation and value of the asset, given its low opex and capex requirements. We expect these to be recycled into Meseda to fund the workover/waterflood programme over the next few years.

The acquisition has no impact on SDX’s Meseda stake, other than providing cash flows from NW Gemsa to fund investment in the workovers/waterflood. However, we have reduced our expectations on production from Meseda vs our previous modelling as work has been delayed on the workover/waterflood. We expect to update this as the waterflood programme commences and results start to come through this year (the work, including a facilities upgrade, well workover programme, infill well drilling and two exploration wells is due to start in Q117).

Our 2017 estimates require a notable increase from Q316 production rates of 3,657b/d to reach our modelled average rate of 5,500bbls/d. As a result, we will be watchful of the improvements that can be made in the early stages of 2017, but highlight that the prize at Meseda remains significant if the waterflood proves successful.

Independent of the acquisition, we have made a number of changes to our modelling and valuation (many of which have been mentioned earlier in the report). The primary changes are:

As a result, without the impact of the acquisition, our core valuation would have fallen from 39p/share to 29p/share (and from 68p/share to 55p/share for the RENAV).

After the deal, the revised valuation for the larger entity benefits from the additional working interest at Gemsa, but the cash flows from Sebou (Morocco) are the foundation of the bulk of the value, although a large working capital balance of $18m at acquisition contributes strongly; for the purposes of the valuation, we model that this $18m is released over four years (we assume the bulk of it is in Egypt, where Circle has experienced difficulties in receiving payment in US$). This situation should be eased by SDX as it is happier to receive payment in Egyptian pounds and recycle this within country.

Until well targets at Lalla Mimouna are announced and their impact on the company can be more properly assessed (including any costs and time to build extra pipeline), we exclude them. However, we would expect SDX to update the market in the relatively short term on its exact exploration plans in Morocco.

The additional absolute value is balanced by the new equity raised to fund the acquisition – the recent rise in the share price means that fewer shares should need to be issued, reducing share dilution. This leaves the larger entity with a notably higher valuation, as seen below.

The new asset additions have the potential to utterly change the cash flow profiles of SDX. The additional 40% interest in Meseda gives the company useful additional cash flows from the field that will have little capex requirements, but it is the interest in the Sebou field that provides for the step change in cash flow generation for the company.

Our modelling indicates that cash flows from Sebou alone would pay back the acquisition price in less than three years (excluding optional exploration wells after 2017). This free cash flow from Morocco will provide the company with enough resources to fund the material exploration and development activities. The acquisition, as can be seen below, is likely to have a material effect on company cash flows over the next few years.