Shares digital

The City has been quick to sell on the first sign of bad news but Heritage’s exploration history bodes well

by Tom Sieber

In the ornate Victorian building opposite London’s Grosvenor House hotel that houses oil and gas firm Heritage Oil (HOIL), the company’s finance director, Paul Atherton, shakes my hand. A wiry man, Atherton conveys a sense of purpose and brisk intelligence, not surprising given Heritage has a very sharp strategic focus.

The group, which came to the market in March, is almost entirely focused on exploration and is drilling at least four potentially transformational wells in the next six months on its acreage in and around Lake Albert, Uganda and in Iraqi Kurdistan.

My interviewee bullishly proclaims ‘this is as good as it gets’ when it comes to exploration. Atherton points to success in 12 out of 12 wells drilled in Uganda and quotes an 88% success rate in Iraqi Kurdistan as a whole since the first wells were spudded there in the 1920s. When I ask him about the level of risk involved in any exploration project, he says: ‘We have a technical team that has demonstrated its ability. It was involved in the discovery of one of the largest onshore oilfields to be uncovered in sub-Saharan Africa in recent years – the M’Boundi field in the Democratic Republic of Congo (DRC) [currently producing 30,000 barrels of oil a day] – and one of the most exciting new plays in the world in Lake Albert.’

Heritage is most readily associated with its founder and chief executive Tony Buckingham. A former North Sea diver, he has attracted controversy thanks to his background as a security advisor in war-torn African states during the 1990s. The fact he once worked with Simon Mann – currently languishing in a jail in Equatorial Guinea – has drawn particular attention, though his association with both Mann and private military contractors ended ten years ago.

The money man

Atherton is also a somewhat unconventional figure for a finance director, if less dramatically so, having a technical grounding in oil and gas as well as the more typical background in accountancy. He studied geology to degree level, and when I quiz him on what personal qualities he brings to the company he highlights this mix of talents: ‘I think my blend of geology and corporate finance allows me to take on more of an operating role than a lot of CFOs,’ he says.

When we meet, Atherton is still reeling from the 17% decline in the share price earlier this month – dragging the company well below the issue price of 270p. This market sell off greeted a mixed update from Uganda, which included an appraisal well drilled on the Kingfisher prospect.

Atherton professes himself surprised by the reaction, particularly given the share price of Tullow Oil (TLW) (Heritage’s partner in Uganda) barely moved, but he should not be.

Heritage trades at a significant premium to its net asset value – 103p according to house broker Cazenove – due to the potential in its exploration portfolio and as Cazenove pointed out in its initiation note on the company, ‘investor sentiment is critically dependent on early exploration success – especially for a company like Heritage whose equity value is not supported by tangible asset value.’

That said, Atherton’s response to my question on the share price reaction, arguing that the Block 3-A (which includes Kingfisher) has been unfairly written off, is fairly convincing. ‘There were three items in the update from Uganda,’ he argues. ‘Two of which were positive and then there was disappointment on the deeper play.’

This lower-most zone was the original exploration target and the simple truth is the company did not find oil here. However, the well did confirm the discovery that had already been made last year and Tullow’s success, independent of Heritage, on the Kasamene-1 well is indirectly positive for the company.

Analyst backing

The analyst community backs Atherton up – mostly saying the market has focused disproportionately on the result in the deeper zone and not seen the bigger picture in Uganda.

Heritage commenced operations in the country in 1997 at a time when it was neglected by the industry. Until recently, there was a perception that there was almost certainly no oil in Uganda with the focus very much on West Africa instead.

As a consequence of the work done by Heritage and Tullow Oil, among others, the Albertine basin, situated underneath Lake Albert on the border with the DRC, is now recognised as one of the most exciting oil provinces in the world.

Heritage has 50% interests, an equal share with Tullow, in two blocks – the aforementioned 3-A and Block 1. The company is planning a high-impact drilling campaign on the latter next month – targeting the exotically named Buffalo, Giraffe and Warthog prospects.

Buffalo and Giraffe are assessed to contain as much as 420 million and 89 million barrels of oil respectively. And the exploration risk on these has been significantly lowered by Tullow’s successful Kasamene-1 well.

The company’s other key project is in Iraqi Kurdistan. In October last year Heritage executed a production-sharing agreement with the Kurdistan Regional Government (KRG) for the Miran block.

Into the wild

Investors may have twigged by now that the company is not afraid of working in some pretty hairy parts of the world. I asked Atherton how it mitigated the risks of working in these environments.

‘There is no doubt we are prepared to go to the sort of countries others might avoid,’ he says. ‘It is about having an appreciation of the risks involved and forging relationships with local partners. ‘Thanks to our early-mover position in Iraqi Kurdistan, for example, we have been able to cherry pick the best of the licences.’

Heritage has a 100% working interest in the Miran block, located just 55 kilometres from the giant Kirkuk oilfield, which has remaining reserves thought to be in excess of 10 billion barrels, It is 30 kilometres from the Taq Taq Field, on which recent wells have flow rates of 30,000 barrels of oil per day.

Having acquired seismic data on the acreage Heritage will drill a well on Miran in the first quarter of next year. I ask Atherton whether he has any concerns about the validity of the group’s licence in Iraqi Kurdistan, given the central government in Baghdad is still failing to recognise agreements between the KRG and international oil companies.

In response, Atherton points to the decision by the Korean National Oil Company (KNOC) to invest $2.1 billion in the region and adds: ‘There is a definite warming of the relationship between Baghdad and the KRG – there is a coming together.’

He also dismisses the threat posed to the company’s operations by the confrontation between Turkey and separatist militants from the PKK, even though the company would potentially have to construct a pipeline through Turkey in order to successfully commercialise any sizeable discovery in Iraqi Kurdistan.

It is worth noting the company faces a challenge in monetising any oil finds in both Uganda and Iraqi Kurdistan. Domestic demand in both countries is relatively limited. In Uganda an oil export pipeline through Kenya to the coast is the most likely solution – though as the oil is ‘waxy’ (meaning it contains paraffin hydrocarbons known as paraffin wax, and is harder to transport), this pipeline would have to be heated or the company would have to construct a treatment facility close to Lake Albert.

Given the company has in the past been prepared to divest assets that are moving into the development stage – with the best example being the M’boundi field – there is a chance it will let these issues be somebody else’s problem.

Elsewhere, the company has interests in the two blocks in Lake Albert which are located within the borders of the DRC, and exploration acreage in Mali, Malta, Pakistan and Tanzania – which according to Atherton provide some interesting options for the company in the long term.

In addition Heritage has limited output from Oman and Russia – oil revenues in 2007 were around $3.7 million.

Investors know what they are getting when they buy stock in Heritage. It is a high-risk, high-impact explorer and share price volatility comes with the territory.

The oil and gas sector as a whole currently faces the prospect of oil price weakness but by pursuing such potentially huge discoveries Heritage offers the best chance of overcoming these factors.

It has around $230 million in cash in the bank with which to fund its operations. Drilling can just as easily destroy value as create it but if Heritage is successful with drilling then Atherton’s ambition of joining Tullow in the FTSE 100 could well become reality.

CONCLUSION: Heritage Oil

Risk to earnings forecasts: 3 (5=upside risk, 1=downside risk)

Earnings predictability: 2 (5=very high, 1=very low)

Valuation: 4 (5=cheap, 1=expensive)

Balance sheet strength: 5 (5=cash rich, 1=heavily indebted)

Cashflow: 1 (5=very strong, 1=very weak)

Overlooked: 2 (5=all brokers negative, 1=all positive)

TOTAL 17/30

RATING: BUY