Green Dragon Gas — Update 5 January 2016

GDG is uniquely focused on the exploitation of CBM resources in China. 427bcf of 2P reserves, and importantly 2.29tcf of 3P reserves, give it massive potential to drive production from current c 12bcf pa to firstly c 40bcf pa (from current 2P reserves) and on to 200bcf pa (with 3P upside).

$200m of third-party infrastructure (at no cost to GDG) will give it capacity to increase GSS production over the next four years to approaching 40bcf pa gross. GDG is also focused on optimising the pressure balancing of its producing well inventory to increase production that can reach external sales and reduce the need for external purchases for resale.

Beyond this, GDG needs to exploit 3P reserves to grow production that will, in part, require successful evaluation of the deeper Coal Seam #15. Results of this ongoing evaluation should be available on the conclusion of the 2015 reserves reporting cycle in early 2016.

Based on developing reserves from only two of GDG’s PSCs (GSS, including GCZ, and GSN) we estimate a core NAV of £3.28 and RENAV of £6.79. This RENAV could grow at 30% CAGR assuming successful evaluation of CS #15 and development of the 3P reserves from these blocks.

This clearly offers resource investors large upside to the current share price. However, equally importantly, we expect GDG to be able to move EBIDTA up to approaching $80m in 2017, which will make it attractive to a wider group of investors, and allow attractive valuations to be derived from a valuation multiple basis.

We consider our valuation to be robust to external factors; despite a slowing of Chinese GDP growth we believe underlying fundamentals remain sound for Chinese gas prices, while short-term development delays would have only a modest impact on valuation.

We expect GDG to turn a post-tax profit from early 2016, and with debt funding, EBITDA to grow towards $80m in 2017. We also expect a steady increase in the ratio of gas recovered from producing wells and converting to sales (GDG is looking to move this from a historical average of c 35% to 50%+ by end 2015) that will increase margins. Medium-term funding requirements will be substantial, with c $110m of additional funds required in 2016, increasing to c $300-450m over 2017-19 to replace existing bonds and convertible debt (both maturing in 2017). GDG will be seeking this funding via RBL and we expect discussions to be ongoing.

Green Dragon Gas (GDG) is a coal bed methane (CBM) -focused production, development and exploration company with assets in China. In total it has eight blocks over six PSCs; its GCZ block is in the greater Shizhuang South (GSS) PSC where GDG has a 60% interest (and an option to increase this to 70%). At GCZ (GDG 47% WI) GDG partners with Petrochina (a subsidiary of CNPC), while at all its other blocks it partners with CNOOC. GDG entered into the majority of its PSCs in 2003 with 30-year terms. However, due to challenges to title in 2012/13, which have since been fully resolved, the PSCs were extended by a further two years, ie until 2035.

At the end of 2014, GDG had 148bcf of net 1P reserves (all at GSS) and 427bcf of net 2P reserves (across GSS and GFC). However, the majority of the anticipated recoverable reserves remain in the 3P category, with 2.29tcf of 3P reserves booked at end 2014, most of these at GSS and in the GSN block immediately to the north.

These reserves are designated recoverable from a total original gas in place estimate of 25.2tcf across all blocks. It is worth noting that GDG has now used the same reserves auditor (Netherland, Sewell & Associates – NSAI) for more than 10 years and the latest reserves estimates represent the ninth consecutive upgrade in 1P reserve volumes and valuations since NSAI started to audit GDG’s assets.

While the 1P reserves growth has been impressive (33% CAGR 2008-14), growth has been consciously limited by GDG’s deliberate (and sensible) focus on monetisation rather than indiscriminately proving up the resource base. Exhibit 2 shows the evolution of what is effectively a corridor of activity at the company’s GSS block, as wells in a relatively tight pattern have been drilled close to available and to be commissioned infrastructure. However, with additional infrastructure being put into GSS as part of resolution of the PSC agreement with CUCBM in 2013/14 (see our November 2014 note for details), we expect the company’s 2015 wells to be more spread out and, by including previous exploration wells that can now access the increased infrastructure, there to be a distinct increase in 1P and 2P reserves. This will be confirmed in NSAI’s annual reserves report that, based on previous year timings, should be published in February 2016.

GDG is looking to accelerate the roll-out of its production at GSS during 2015 and in particular, 2016. The company has historically sought 18bcf pa of gross production, and based on a nominal 250mmcf/d (approximately the average deliverability of LiFaBriC wells drilled to date) this would have been achieved from c 200 of its proprietary LiFaBriC wells. GDG had already drilled 66 LiFaBriC wells across GSS through to end 2014, hence it was nominally looking at an additional c 135 LiFaBriC wells to reach its short-term production target. However, the reality is that having agreed to work together and make use of the third-party wells drilled by CUCBM/CNOOC on the GSS and GCZ blocks, GDG and its partners are now looking to much more rapidly develop GSS. This development will involve the exploitation of 1,977 wells drilled across its blocks, the majority drilled by partners (Exhibit 3).

In fact, GDG’s LiFaBriC wells only constitute 3% of the total well count available to GDG across its blocks. While we expect these wells to be more productive than the non-LiFaBriC wells, there is clearly scope for GDG and partners to exploit a unique well position to their advantage. CUCBM will largely benefit from the third-party wells due to accelerated cost recovery, although this also benefits GDG with CUCBM being incentivised to accelerate development of infrastructure across the block.

To accelerate the GSS development, GDG and its partners plan to increase gross gas processing capacity to 53bcf pa over 2015 to 2017. This will extend the corridor of production from the existing c 10bcf pa of capacity in the south and south-western corner of the block up to the north east and allow GDG to access the remainder of the 2P reserves (ie 400bcf net).

Latest timing for the construction of the additional gas processing capacity is shown in Exhibit 4. While it is not yet clear when this will be completed (either end 2016 or into 2017), in reality this is not critical to GDG as we expect there to be sufficient processing capacity from end 2015 to support even an accelerated drill programme across the GSS block.

CNOOC is finalising its ODP for GSS (and the other CUCBM blocks) and GDG is understandably confident that this will proceed, given the investment it is already putting into GSS infrastructure. We have no visibility on the timing for the ODP but we expect the plan to be a major share price catalyst for GDG as it will endorse third-party support to GDG’s development plans and potentially increase the debt capacity available to the company.

Beyond the 2P reserves already being targeted at GSS, GDG is also planning the exploitation of 3P reserves that would conceivably require production increased to as much as 150bcf pa. This would clearly require additional gas processing capacity, although in the first instance GDG must complete its evaluation of the Coal Seam #15 that forms the majority of 3P reserves.

We expect GDG and its partners to continue to work diligently on existing operations. However, having proven its deployment of capital across GSS and GCZ, current activities at these blocks are likely to be relatively simple to replicate. We therefore expect the partnership to focus efforts more on exploration and development upside, both at GSS/GCZ and further afield.

By far the biggest upside that GDG will target to its existing 2P reserves is from CS #15, both in its GSS and in its GSN blocks. This is a coal seam that is c 80m below the currently producing Coal Seam 3 (CS #3), hence there is little incremental cost to GDG to re-enter and target this coal seam (Exhibit 5). However, this does not mean that exploitation of CS #15 is necessarily simple.

CS #15 sits below a large section of limestone that acts as an effective seal (Exhibit 6). GDG had previously thought that the seam trended deeper as it moved northwards (into the GSN block), which would have made exploitation to the north more difficult. However, the company now thinks this is not the case, which will aid exploitation assuming evaluation of CS #15 is successful. We note that because of the limestone, it will be important to avoid water breakthrough, while due to the proximity of the brittle limestone it will not be possible to frack the seam.

NSAI does not split out the distribution of reserves between CS #3 and CS #15; however, GDG has indicated that c 70% of GSS 3P reserves sit in CS #15. As such, cracking the code for CS #15 will be a big component of unlocking the upside potential from GDG’s 3P reserves (and corresponding company valuation).

GDG indicated in its 2015 interim results that 11 wells have been successfully drilled and logged in CS #15 in H115. The company has committed to completing this CS #15 evaluation programme by end 2015, with results likely to be published in the annual reserves update in February 2016, after which it will be in a position to take a development decision on CS #15. Initially, this is likely to be based on vertical CS #15 wells as these have been on test for longer than CS #15 LiFaBriC wells. This also means that the 2016 upgrade may be relatively modest until results of CS #15 wells are available and understood.

GDG farmed-out 10% of its interest in GSN to partner CUCBM in 2013 (reducing its interest from 60% to 50%) in return for an additional $100m infrastructure investment on the block. Assuming CS #15 evaluation is encouraging, we expect this infrastructure can be used to start to move the existing 706bcf of net 3P reserves into the 1P and 2P category.

GDG’s immediate priorities are most clearly to monetise its existing and growing well position at GSS, drill its 30 planned and funded LiFaBriC wells at GSS, complete its evaluation of CS #15, and look towards upgrading its reserves at GSN.

However, the company also continues to make modest progress in its exploration blocks, Fengcheng ('GFC'), Qinyuan ('GQY'), Shizhuang North ('GSN'), Panxie East ('GPX') and Baotian Qingshan ('GGZ'). At end H115, GDG had drilled 348 wells across these blocks. Including 1,367 legacy CUCBM (CNOOC) wells at GSS, this brings the overall well count to 1,977 across all blocks. GDG recently indicated that farm-out discussions are underway to accelerate development of some of its exploration acreage.

GDG’s gross production in H115 was 4.87bcf, split 2.76bcf from GSS and 2.11bcf from GCZ. However, only a small fraction of this feeds through to sales. In 2014, only 5% of the gas sold through GDG’s distribution arm came from its GSS block, the remaining 95% came from third-party wells, including from the adjacent GCZ block, acquired from third parties. In H115 GDG sold 2.65bcf of piped natural gas (PNG) from its GSS and GCZ blocks, with an additional 0.335bcf sold through compressed natural gas (CNG).

One of the key targets for GDG will be to increase the ratio of gas it sells from its own production and the overall sales to production ratio. We make our assumptions around this in the next section.

Assuming planned GSS gas processing capacity is added and successful exploitation of CS #15 across GSS and GSN, we expect a strong increase in gross production across GDG’s blocks through 2016-20 (Exhibit 7). Initially, this will likely focus on GSS, although in time GDG and its partners will be seeking to more readily exploit the GSN current 3P. As part of an April 2014 farm-out agreement, GDG’s partners are investing $100m on GSN infrastructure to start to develop these resources; hence we are comfortable building them into our production assumptions (subject to CS #15 evaluation being successful). We do not presently include any exploitation of resources from exploration blocks GFC, GQY, GPX and GGZ in these production assumptions.

Our production assumptions are clearly ambitious and we reiterate that they reflect an unrisked outlook. However, investors should also note that these are still well below NSAI's forecasts, which inform the reserves assumptions for the company. GDG does not publish the full NSAI report on an annual basis; however, based on the information provided in the company’s prospectus for its 2014 London Main market listing, we can see that our net production assumptions are still well below that of NSAI (Exhibit 8). In keeping with standard CPR practice, NSAI will not take into account the economic constraints of the company when proposing production profiles; this explains the marked difference between our and NSAI's assumptions.

Our assumptions are based on historical well performance and a realistic schedule for drilling out its PSCs, assuming that infrastructure and CS #15 both progress to plan. This is shown in Exhibit 9.

Our models reflect a drilling schedule of 60 LiFaBriC we lls at GSS from 2016 (compared with 30 being drilled in 2015) until 2P reserves are produced. We anticipate development of GSN from 2017 with an evolving drilling campaign up to a peak of 160 LiFaBriC wells/year by 2020. Current GSS 3P reserves are assumed to migrate to 1P and 2P over 2015-17 (mainly proving up of CS #15) and will be developed from c 2020 onwards. We do not anticipate any substantial third-party drilling beyond the wells already drilled at GSS and GCZ.

In addition to building production, GDG is also focused on converting an increasing percentage of this production into sales. Over 2015 the company has achieved a ratio of its GSS production reaching the processing facility metering point of c 35%, although it is looking to grow this to 50% by year end (Exhibit 10). This will primarily be achieved by improving the pressure balance of its wells across the gas infrastructure, negating inefficiencies in gas flow from wells reaching the metering stations.

Longer-term, we assume that GDG will continue to improve the efficiency of its well network, slowly building this percentage to c 85% (we show our assumptions in Exhibit 11). We consider this to be a maximum sales/production ratio as GDG will require some of its gas production to be used for fuel.

China’s 12th Five Year Plan (2011-15) involved a series of initiatives to increase gas production and consumption targets from current levels (Exhibit 12), including increasing gas in the primary energy mix from 4% (2010) to 8% (2015) and above 10% by 2020. This plan has resulted in strong incentives from the Chinese government to promote domestic gas production and in particular CBM, including partial deregulation of the CBM market, doubling of central government subsidies (from $0.9/mscf to $1.8/mscf), beneficial tax treatments and priority treatment of CBM for pipeline and power station access.

Against this backdrop, GDG has consistently reiterated its confidence in a strong regulatory environment, both to protect and grow domestic gas prices/economics, and to ensure there is a captive market for its CBM gas production. We highlight the recognition and protection the company has had from Chinese authorities to historical challenges to its PSC titles as strong evidence of this.

However, on the demand side of the equation we would highlight the recent slowdown in Chinese GDP growth, with reported quarterly GDP growth in Q315 of 6.9% the lowest the country has seen since Q109. This may put some pressure on gas demand; however, the overwhelming fundamentals of continued GDP growth, above GDP gas demand (estimated to be 3% above GDP over 2015-20) and an increasing share of gas in the energy mix should give investors confidence that demand and prices for GDG’s gas should remain strong.

This has been reflected in the price assumptions GDG has provided to NSAI for its reserves reports, as shown in Exhibit 14. We assume a more conservative deck in our base case valuations, reflecting previous assumptions of actual well prices (2014 $10.87/mscf) inflated at 9% pa until reaching import price parity (ie LNG) that we estimate would be achieved in 2018.

GDG continues to be particularly tightly held for such a well-established company, with c 80% of the shares held by chairman and CEO Randeep Grewal, and long-time investment partner Chandler Corporation. These two shareholdings have been broadly consistent since Q113, with only a slight adjustment when the two main holders sold 1.5% of the shares in July 2014 to aid liquidity.

As such, liquidity remains particularly low with quarterly volumes of only c 2.3m shares traded on average over the last two to three years (0.025% daily) (Exhibit 15). However, this has not stopped some institutions building positions in the thin open market, most notably Aberdeen Asset Managers and Fidelity, which have built 5.99% and 3.69% positions respectively in the company by end-June 2015.

In addition to founder, chairman, CEO and majority shareholder Randeep Grewal, GDG has recently bolstered its management team with a COO and CAO.

GDG is at a critical point in its evolution. The company is potentially on the cusp of a dramatic uptick in production and profitability that would move it from predominantly a resource play to a serious production company. However, investors should recognise that there remain a number of uncertainties that could still affect this transformation:

In keeping with our previous coverage, we value GDG on a discounted cash flow (DCF) basis. We currently only value the reserves (2P and 3P) at GSS, GCZ and GSN where there is ongoing development activity. Eventually we would expect to also value the company’s exploration blocks (GFC, GQY, GSN, GPX and GGZ) as these are further appraised.

Our base assumptions include an inflating wellhead gas price until import price parity is reached (Exhibit 14) and a 10% discount rate. Consistent with our previous notes, we assume a 10-year life for existing vertical wells with a 7% decline rate, while for LiFaBriC wells we assume a 16-year life with flat production rates of 250mcf/d over the forecast period. This drives our core NAV and RENAV of £3.28 and £6.79/ share respectively (Exhibit 16).

By far the largest uncertainty to this valuation is the evaluation of CS #15, results of which we expect GDG to announce with its annual reserves update in February 2016. This is a key catalyst that could start to de-risk the value that we currently have ascribed to both GSN and GSS 3P (more than half our RENAV valuation).

Assuming this is successful and the assets are developed (and de-risked) in accordance with our model assumptions, we would expect our RENAV to move up quickly (see Exhibit 17). This equates to a c 30% CAGR through 2020, reflecting the excellent value creation potential from GDG’s portfolio if it can effectively monetise its reserves.

In addition to the uncertainties over monetisation schedule and CS #15 in particular, the most material sensitivities to our valuation are gas price and discount rate. For investors who wish to make different assumptions to ours, we provide the following table (Exhibit 18) to show the impact of these two parameters on our current core NAV and RENAV. This can also be used to assess the potential valuation if GDG is either unsuccessful with its exploitation of CS #15 or if the company has to incur more expensive costs of capital for longer than planned.

Note that the gas price assumptions here only include a 2.5% pa inflation assumption rather than an accelerated inflation assumption to import price parity, as per our standard valuation assumptions.

Until recently, it was difficult to assess the value of GDG’s assets on a relative basis to other companies. In previous research, we had compared EV/resource multiples for GDG against Far Eastern Energy (OTC micro-cap), Great Eastern Energy (LSE integrated CBM player but in India) and Sino Gas and Energy (ASX-listed but upstream only), but all of these companies are very different to GDG. However, this is now possible with the recent listing of AAG Energy Holdings on the Hong Kong stock exchange (ticker code 2686).

AAG has CBM assets in the southern Qinshui Basin and, like GDG, partners with both CUCBM and Petrochina. The company’s Panzhuang concession has already received ODP approval and, due to being marginally more advanced than GDG’s GSS block, is more profitable. However, a wider analysis of AAG’s assets, acreage and resource base shows that GDG remains significantly undervalued on key metrics such as EV/acreage and EV/3P plus prospective resources.

We would not want to draw too much from comparisons with only one other company, especially being listed on an exchange that does not have many oil and gas companies. However, it does give investors sight of what multiples may be achieved (eg EV/EBITDA) once GDG and its partners start to build on the 2P reserve base.

GDG’s financial performance continues to improve, albeit H115 was still loss-making with the company reporting a total net loss of $1.4m for the period. This compares with a normalised loss in 2014 of $5.7m (the H115 results are clean and therefore comparable with 2014’s normalised loss).

The company is on a trajectory to start to break even from a post-tax profitability perspective by end 2015; we estimate this could increase to c $20m in 2016 and c $60m in 2017. However, the true potential of GDG’s resource position is only likely to be seen in financial performance when 3P reserves at GSS and GSN are migrated to 1P and 2P and then into production. We reiterate that this scenario is contingent on successful evaluation of CS #15.

Not surprisingly, the immediate challenge for GDG is how to fund the activity that will generate the improvements in profitability and cash flow. We see this as a multi-stage process, which will require the company getting through a number of key investment stages, and will incorporate debt funding and farm-out of exploration acreage.

2016: Immediate requirements

We estimate that GDG will have had sufficient funds to complete its 30-well LiFaBriC drilling programme in 2015. However, in 2016 the company will need an additional c $110m of funds to maintain and accelerate its drilling trajectory at GSS, based on our base case drill programme (Exhibit 9). This also includes an assumption that GDG will exercise an option to increase its interest in GSS from 60% to 70%, triggering a $13m H216 payment.

Funding for 2016 will depend on a number of outcomes. We expect GDG will seek full RBL that will fund the ongoing drill programme. However, given the size of 1P reserves and the fact that CUCBM infrastructure capex is being deployed, we would also expect GDG to advance RBL discussions with banks ahead of ODP approval and the company could possibly secure transitional RBL finance via this route.

If ODP is not approved or RBL is delayed, it may be necessary for GDG to extend the period in which it is incurring higher costs of capital or pause its development programme for 2016. Investors can use the sensitivity tables to discount rate later in this report (Exhibit 18) to assess this risk; however, in general we believe that one to two years of the company carrying a more expensive capital structure would not significantly affect the long-term valuation. Equally, a pause in development drilling in 2016 would have only a minor impact on EBITDA and NAV, with our forecast 2017 EBITDA falling to c $70m (from c $80m). Any pause in development drilling would have minimal impact on NAV valuations

Our 2016 forecast debt requirements come in addition to a forecast end-2015 cash position of $27m, which is being funded from $86m of 10% bonds (4.5% discount end to end) and $48m of convertible debt ($9.34 conversion price, 7% coupon).

2017-19: GSS 2P development requirements

Moving into 2017-19, GDG is going to need to access more substantial levels of debt to complete development of reserves at GSS (LiFaBriC drilling) and prepare for the development of GSS and GSN 3P reserves. The company will also need to refinance the current $86m bonds and $48m convertibles due to mature in November 2017 and June 2017, respectively. As such, we see a peak debt requirement over 2017-19 of c $450m. This number could also be substantially higher if GDG and its partners choose to accelerate the development of GSN and the GSS 3P reserves.

Once again, the most logical funding route for this would be RBL, although it is far more likely (than the situation in 2016) that this will be a straightforward process, assuming ODP has been secured by this time (something we think is highly likely during 2016). Once the development plans are approved, we see a comfortable level of economic capacity available to underpin the RBL debt requirements (normally secured on 1P reserves and reduced commodity price basis).

2020 onwards: 3P development

We phase our models to show 3P development from GSN and GSS accelerating from 2020 onwards. This would allow GDG to fund development of these more substantial resources from cash flow. GDG may be tempted (with its partners) to accelerate development of these resources and this remains a possibility; however, this would require additional funding over and above our 2017-19 assumptions. Our base case assumptions would show GDG debt free by early 2026.

Given the strength of GDG’s forecast operating margins, we expect the company will look to offer dividends in time. Management may seek to accelerate this but we would prefer to see the company put itself on a stable footing with comfortable debt headroom before committing to dividend payments. This would likely mean that dividends could be paid from c 2018 or 2019.

Over the life of the PSCs in our valuation models, we estimate that cash flow could deliver dividends of up to $4/share on an annualised basis, although this would subject the balance sheet to uncomfortably large levels of gearing. Dividends of up to $1/share should be comfortably accommodated from 2019 onwards, assuming GDG is able to develop GSS and GSN as per our base case assumptions.