Dragon Oil: Preliminary Results Fail to Impress?

This morning Dragon Oil (LON:DGO) released their prelims for the year 2009. At first, the share price dropping 2.2% before recovering to where they currently stand at 465p, which is up approx 1%.  So why the indifference? Yes, profits were down but so were other oillies and this was expected, and cash was up significantly again, while volumes of oil produced increased by 40% - so what was the issue?

Let’s have a look at their accounts in more detail, starting with the figures reported.  Turnover was down 12% to $623m, whilst operating profit was down 34% to $314m, with profit for the year being down 30% to $259m.  The fact that these figures are down would normally be an issue, but for Dragon and other oil companies, it is to be expected due to the oil price being much lower this year.  So what was the difference in the oil price? Well, the 2008 average oil price for Dragon was $91 compared to a 2009 average oil price of $62, which is a 34% drop.  So quickly, let’s restate the 2008 results using $62 per barrel rather than $91. Firstly, turnover would be down to $465m from $704m, and this would mean that the operating profit for 2008 would have been $231m.  So if we use these figures, how much would Dragons turnover and profits have grown for the year 2009?  Turnover would be up 34%, and operating profit would be up 36% (also operating profit would have been better off if the attempted takeover by ENOC hadn’t increased admin expenses for the year – they increased by $10m and it would be a fair bet a large proportion of this increase came from the takeover attempt, as they state). 

Already the accounts are looking better, but is this the true picture?  Let’s look deeper again and have a look at the level of oil production they are achieving. They state that they increased sales volumes by 40% for the year - from 7.5m to 10.5m. They also state that gross production increased by 9% over the year increasing to 45,000 bopd from 41,000 bopd, and that they achieved their landmark production target of gross 50,000 bopd at the end of the year.  They also state that their net entitlement bopd had decreased from 60% to 58%, so you are probably wondering now how did they increase volumes by 40% when oil production only increased by 9%, and their entitlement margin dropped? 

First things first - one point they fail to actually emphasise is that they produced an average net 26,100 bopd over the year, up from 24,500 for 2008, which is an increase of only 7%.  If you are wondering how I worked this out, I simply used their average gross production figure for the year of 45,000 bopd, I then used the net entitlement of gross production of 58% to come to the answer (i.e. 58% of 45,000 is 26,100).  This figure is obviously a lot less than the 40% increase in sales of oil that they had, so where did the extra sales of oil come from?  That is an interesting question, and below is their explanation:

‘The higher sales were on account of increased production, changes in the lifting position and movement in inventory, slightly offset by lower entitlement production.’

So what does the above mean? Let’s have a look. In 2008, they sold 7.5m barrels of oil, yet they produced 9m (24,500 x 365 = 9).  This year they produced 9.6m (26,100 x 365 = 9.6), which is an increase of 0.6m or 7%.  After looking at this you can now see all the figures are coming together, as bopd produced per day increased by 7%, and volume produced per day increased by 7%, so now the accounts make sense.

So, from the above, you can see that they have not made that much progress in 2009 over 2008, with production coming in under expectations, and in fact second half 2009 production was actually less than the first half which was 27,800 net (as stated in their interims). So what has been the issue this year? The ENOC attempted takeover has meant a number of their plans got set back, while the very low oil price of early 2009 presented an issue as well.

The last figures that I wish to look at are the production costs, first depreciation increased by 19% to $19.8 from $16.7 a barrel, also cash costs have increased from $4.7 to $9.7, meaning total costs have increased by 38% to $29.5 from $21.4 a barrel.  This explains why production costs have increased so much when they in fact only produced an extra 0.6m barrels of oil this year

But enough about the past, let’s have a look at what their plans are. First, they state that they expect to see production increases of between 10-15% over the 2010-2012 period, and over this period they expect to spend between $750m and $870m to achieve this goal. However, these spends are not guaranteed, and below I will highlight what they state that they will spend this on, and what they state that they first need to be able to spend this (highlighted in bold):

‘The Group's capital spend on infrastructure for crude oil in 2010 is estimated at around US$250 million which includes platforms, trunkline, in field pipelines and upgrades to the Central Processing Facility. These expenditures will be internally funded. For the planning period of 2010-12, the total spending on infrastructure projects is expected to be around US$600-700 million. The level of capital expenditure is subject to approval of projects under the PSA and the availability of contractors in the Caspian Sea region. The amount of capital expenditure for drilling is mainly determined by the number of wells drilled. The progress of the drilling programme is dependent on availability of rigs.’

And:

‘For gas development, we envisage additional capital expenditure for the 2010-12 period in the range of US$150-170 million for the onshore Gas Treatment Plant including facilities. Commencement of this project would be dependent on the market conditions and the conclusion of the gas sales agreement.’

So if they do achieve the above, will this eat into their growing cash pile, which is now at over $1bn?  Probably not as 2009’s cash flow was $500m, and with the price of oil now above $70 and with many expecting the price to stay above this level, added to the fact that they expect production to increase by 10-15% this year (they are already currently producing a gross 50,000 bopd, meaning they are already producing 10% more than last year), then their cash flow should easily cover this expenditure, as with sale volumes likely increasing, and with the price of oil already above last year’s average, cash flow should actually increase from the already high $500m a year, meaning that it is likely that even after spending the earmarked money, they will still have enough left to actually add to their cash pile.

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So what are they going to do with all this cash? They state in their conference video that they are considering a dividend, but this is something that they have stated in the past, and yet not acted upon. They also state in the prelims that they are looking for potential opportunities to add instant reserve and production increases - see below:

‘Dragon Oil's New Ventures Team is actively reviewing opportunities in North Africa, Middle East and Central Asia (former Soviet Union Republics). Diversification of our portfolio may be achieved through joint ventures, corporate acquisitions or project farm-ins. It is our objective to participate in projects, which have the potential to offer both immediate and near-term production and reserves, with the upside of longer-term growth through exploration. ‘

But will they actually do any of above? This is a fair question since, in the past,  Dragon have talked a lot about looking at opportunities (as with the dividend), yet shareholders seem not to see much action.

Another thing mentioned is the fact that last year they planned to restructure the business and rebase it to Bermuda:

‘In early 2009, the Company announced a corporate restructuring whereby a Bermuda-incorporated company would be established as the new holding company of the Group. Following the approach received from Emirates National Oil Company Limited (ENOC) L.L.C. ("ENOC") the restructuring was put on hold. The Board is currently re-examining the proposal and reviewing options.’

Yet again, they offer no idea about if they will do it, and why they are only looking at it now. That is to say - why were they going to do it last year, before the ENOC takeover, yet now are only re-examining the idea, what has changed? You would think that they would just get on with it, but they are not doing so, and only they and likely ENOC know why.

What is Dragon's current value?  £2.3bn. How can this be? This company has over $1bn in cash, with this figure likely to continue to increase. They produced an average bopd of 26,100 in 2009, and expect this to increase by between 10-15% per annum over the next three year, and it’s not even that people fear that they may not achieve this, as production is actually already 10% above the 2009 figure. In addition, they have gas assets that have the potential in the future to produce 100,000 boepd, on top of this they have total net proven and probable recoverable reserves of 400mmbbloes.  So how can this company be valued at such a level? The issue is that first their gas assets seem no more nearer being fully utilised, then the last year, or the year before. This company seems to lack any real direction about what the directors are actually planning to do, add this to the worries many investors have about ENOC holding so much of the company, and the control that they seem to have, as well as the question as to what ENOC’s actual plans now are for Dragon after the failed takeover attempt, and you can start to see why people are concerned about investing.

In conclusion, Dragon's value is nearly 50% covered by cash, a company producing currently approx 30,000 bopd of low cost to produce oil, with 400mmbbloes in proven and probable reserves (with both figures expected to increased yearly in double digit figures,). The company's 2009 profits were $259m, or approx £150m meaning that they are on a P/E ratio of 15, and in fact if you take cash away, a P/E ratio of 7.5. Minus cash, this company's assets are only being valued at £1bn. You may start to think that people are mad for valuing the company at this level, even with ENOC being involved. 

Though one issue is political risk, in my view, that is not the main reason for why this share is valued at such a low level.  So what is the reason?  Unfortunately it is because there are just too many questions that need answering, for example:

• Why do you have so much cash? 
• What are you going to do with it? 
• How and when are you going to start returning value to shareholders? 
• When are you actually going to do something with the money rather than just say you are looking at opportunities? 

There are of course many other related questions that shareholders would like addressed and, until they are answered, it is likely that Dragon’s share price will continue to trade below its true value.  But, due to the growth potential that Dragon offers, I feel that they still deserve a place in Grays Shares to Watch, as even if they never make another purchase, they still have plenty of room for growth. Sometime in the future, no doubt, value will be returned to shareholders, not least because ENOC themselves will at some point want to see some return.

Disclosure of Interest: The Author has no position in Dragon Oil