Good progress at Afren as finals show maiden pre-tax profit

Afren (LON:AFR), the ambitious African based oil and gas production and exploration company whose current main prospect is the Nigerian Ebok acreage, have released their 2009 final results. These results are quite impressive and ahead of expectations, and though they actually only earned a net pre-tax profit for the year of $0.5m, considering that they suffered from a pre-tax loss of $37m for the first six months of the year, it is quite a turnaround. But the latter do not tell the full story and the the most impressive figures to come from their accounts is the cash generated from operations, which stands at $278.3m for the year, and the fact that they more than doubled proven reserves for the year to 90mmboe net.

So how did they manage this and what did their accounts show?

Production

To start, the main revenue for the year came from the fact that they increased boepd to 22,100 for the year from 3,900 in 2008 (this is less than the guidance figure given of 22,238 boepd, but they can be forgiven for being 138 out). This very sharp increase in boepd came from the fact that the 50% owned Nigerian Okoro field came online earlier in the year and contributed 18,800 bopd to production for the year yielding a turnover of near $300m for Afren. The other contributors to production came from their natural gas and natural liquefied gas operations in the Côte d'Ivoire, with the 47% owned CI-11 field producing gross 6,360 boepd (3,000 boepd net) for the year contributing $27.7m in revenue, and the 100% owned tax exempt Lion Gas Plant producing 1,140 boepd for the year contributing the remaining $16m in revenue. One important note that needs to be highlighted at this point in regards to their Okoro field is that currently though they only own 50% of the field, they get to keep all of the revenue and earnings. The below excerpt from their website explains why:

‘In June 2006, Afren signed a Financing and Production Sharing and Technical Services Agreement with Amni for participation in the development of Okoro and Setu. Under the terms of the agreement, Afren will finance the development programme. Afren will recover these costs with an uplift on its capital, from 95 per cent of the barrels produced, net of operating costs and royalties. Following cost recovery, Afren and Amni will share the production equally.’

From the above, you can see that they get to keep all the earnings from Okoro until they recover all start up costs which should be sometime over the next year or so, meaning that after this point they will only get half gross production, which is likely to fall year on year until the current 25m reserves come to an end. This is likely to be over the next 5-8 years, though they do plan to drill at least two infill targets 2010, where they hope to increase reserves and incremental production volumes (there is not much upside left in this field, and it will be a battle to keep reserves from the field above the 20m mark due to the current production rates).

Reserves

Afren currently have gross 1.1bn in total reserves and resources from the acreages that they own across six African nations (though it should be noted that only 189m of these are 2P, 86m net). What should be noted is that most of these estimated reserves and resources come from Nigeria (near 800mmbbls of the estimated figure comes from Nigeria). The only significant field that they own outside of Nigeria is the 68% owned Keta block in Ghana, which is a young exploration field which has an estimated unrisked 300mmbbls, and of course the proven Côte d'Ivoire blocks CI-11 (as discussed already) and C1-01 (Afren hold a 65% interest in the field which has a net proven resource of 17mmboe, and has a planned production start up of 2011/2012, with a drilling campaign due this year planning to further prove up this resource).

Nigeria

Afren holds a number of fields in Nigeria but four of these prospects really stand out currently for Afren and they are Ebok, Obwok, OPL 310 and OML 115. Discussed below is the progress made on these fields over the year.

Ebok

Ebok is the field that Afren are pinning their short term hopes on, the field is 50% owned by Afren and has similar terms to the Okoro field, below state’s the terms as shown on their website:

‘In March 2008, Afren signed a Farm-In Agreement with Oriental to participate in the development of Ebok. Under the terms of the agreement, Afren will be responsible for funding all capital and operating costs for the development of the field, and will recover the costs from 100% of net field revenues. Following cost recovery, the ExxonMobil JV will receive a Net Profit Interest, with Afren and Oriental sharing net revenues equally.’

To get an idea of how big the field is to Afren, below is an extract from their newly released finals showing the gross reserves and estimates:

‘Our appraisal drilling to date has confirmed a gross recoverable resource base of 107.5 mmbbls (source: NSAI), an incremental addition of 82.5 mmbbls.’

Most of the above reserves came from their 2009 drilling campaign as the 2008 final year Ebok reserves only stood at 20mmbbls, meaning that their drilling campaign, which had a 100% drilling success rate (which it has to be said is quite a feat) proved up a gross near 90mmbbls to add to reserves, meaning the Ebok field contains over 50% of their total proved up reserves.

Obwok

Obwok is 56% owned by Afren and again has commercial terms similar to their other fields, below is an extract from their site explaining the terms:

‘The joint venture agreement signed between Afren, Oriental and Addax Petroleum defines the commercial terms under which Afren will participate in the development of Okwok, and provides for Afren to acquire a 28 per cent. legal interest in Okwok (subject to requisite approvals). Under this agreement, Afren will fund 100 per cent. of the costs of an exploration or appraisal well (to a minimum depth of the Lower D2 horizon), after which Afren and Addax Petroleum will be required to fund all capital and operating costs for development of the field on a pro-rata basis (70 per cent. and 30 per cent. respectively). Afren will be entitled to 70 per cent. of net field revenues (pre cost recovery), reverting to 56 per cent. (post cost recovery), subject to gross volumes lifted.’

Obwok is the field that is expected to follow Ebok into production and it currently has reserves of 70mmbbls with upside potential estimated at 200mmbbls, they have stated themselves that they expect it to follow a similar development strategy to Ebok and plans as they stand currently are as stated in their accounts:

‘We plan to drill one well on the field during 2010. Detailed seismic interpretation work for this is already under way that will define a well location and trajectory to deliver minimum economic field size volumes so we can commence early development.’

This means that they are looking for the best location to drill to test for the bopd rate and reservoir size levels so that they can bring the field into development as soon as possible. There are hopes that this field could become a producer by late 2011, early 2012.

OPL 310

The 40% owned (Afren have a 70% working interest in this field, meaning that they get 70% of the revenues and earnings). OPL 310 is another field that has brought a lot of value to Afren this year. It is by far their biggest prospective field with estimated prospective reserves having been increased over the year from 329mmboe to 521mmboe. This is quite a jump it has to be said and again highlights the year they have been having, it is likely that this field will be their next focus after Obwok.

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OML 115

The 32.5% owned OML 115 has a prospective unrisked resource of 270mmbbls, and has similar terms to the other fields, though not as good as the extract below highlights:

'Under the terms of the farm-in agreement with EER, Afren as Technical Advisor will acquire a 32.5 per cent. legal interest. The effective economic interest of between 77 and 100 per cent. reverts to between 81.25 and 65 per cent. (post cost recovery associated with the initial exploration work programme).

Following cost recovery by both Afren and EER, Afren’s effective economic interest will revert to between 32.5 and 40.625 per cent. of field revenues. Afren has undertaken to fund the drilling of one exploration well, after which Afren and EER will jointly fund costs pro-rata (81.25 per cent. and 18.75 per cent. respectively).'

From the above, you can see that Afren will have to fund 81.25% of the costs of the field over the life of the field, but will  only receive 32.5% of the profits. Regardless, the field has a lot of potential. Although the terms are not as good as those of their other fields, the field still could be significant for Afren, especially as they plan to begin exploration drilling on the field in the second half of this year.

Finances

Income statement

Afren’s income statement shows quite a turnaround from the first half of the year, which thanks to a $22m hit from their hedging requirements caused them to suffer a pre-tax loss of $37m. The finals showed that even though they suffered a further hit of $12m from their hedging, they still managed to show a pre-tax profit of $0.5m. Although after tax this turns into a loss of $17m, it still shows very good progress for Afren. Just a note, this turnaround mainly came from the fact that the price of oil increased substantially in the second half of the year (the hedging prices are not locked in until the expiry date of the financial instruments so they only earn market rates initially).

At this point again, I wish to highlight an important point, the fact that Afren are required to hedge the price of oil under the terms of their loan agreements. The extract below highlights the terms stated in their accounts:

‘In May 2007, as part of the financing arrangements for the Okoro field, Afren entered into a series of swaps and call options to economically protect against exposure to the variability in the price of around 14% of expected Okoro oil production through to the end of 2010. This arrangement partly protects the Group against the risk of a significant fall in the price of crude by establishing a minimum swap price for a proportion of the Okoro crude. However, the Group will receive a set discount from the market price if the oil price is above that minimum. In this way, no up-front costs are payable and the Group enjoys the benefits of the majority of any oil price upside whilst there is only a cost to the Group if the oil price is sufficiently firm. In September 2008, a similar set of instruments was entered into in relation to the oil production from the Côte d'Ivoire assets covering the period from October 2008 to mid-2012. Essentially all the base net CI-11 oil production is hedged in this period (approximately 925,000 barrels) at prices between US$79 and US$85 per barrel. In June 2009 a further set of instruments were entered into related to an additional tranche of Okoro production, covering around a further 10% of production and extending out to the end of 2011.’

As you can see from the above, Afren will continue to suffer from these hedging requirements for quite some time yet (that is if oil continues to be volatile, if it stays in its current range it should not cause much trouble). In terms of how they will affect Afren, the segment below from their accounts explains quite well what to expect:

‘The value of these derivative instruments are marked to market for each period and the gains and losses arising out of the changes in fair value are accounted for in the income statement. During 2009 the oil price strengthened, reducing the value of these instruments, with Brent moving from circa US$40 per barrel in December 2008 to circa US$80 per barrel in December 2009. The change in fair value of the instruments equates to a loss of US$15.3 million relating to Okoro and a loss of US$18.3 million relating to Côte d'Ivoire net of actual realisations (2008: a gain of US$13.4 million and a gain of US$41.3 million respectively). The actual realisation from these instruments for 2009 was a gain of US$11.4 million, compared with a gain in 2008 of US$3.6 million, as market prices have been consistently below the hedged price for Côte d'Ivoire production and were below the hedged price for Okoro production until the third quarter. These positions are likely to remain volatile as they are marked to market at each balance sheet date and their value will depend on both the spot price and the forward curve.’

Without going into any details (as the above hedging facilities are quite complex), this means is that because they have hedges in place, their income statement will be quite volatile depending on the price of oil (as said). It may be wise to rebuild their accounts without the hedges to gain a better idea as to what is going on with their income statement (as remember as said the hedging does not result in any cash gains/losses until they expire). This year, if you take out the non cash loss of $33m, they actually made a pre tax profit of $33.5m and an after tax profit of $10.5m, and the same goes for last year. If it were not for the substantial gains highlighted above, Afren would have made even larger losses for the year (though just a note, you should never ignore hedging gains and losses, as they are important but it would be wise to always look at the balance sheet and the notes to see what their current worth is, as any big losses, or gains could mean, depending on the type of hedges they are, that the holder could be in for a big cash windfall/loss at some point in the future. In Afren's case, currently the hedges are at near breakeven due to the current oil price, hence their small values in the balance sheet).

Balance sheet

Afren’s finances are another thing to have substantially improved this year thanks to a very substantial uplift in cash flow from operations from minus $28m to $280m which came from the Okoro field coming online, and a $200m rights issue. This inflow of $480m for the year helped to move them from having a negative net cash position of near minus $300m to a positive net cash position of over $50m. Another thing that these increases did was to move them from having a current asset over current liabilities position of minus $50m to a positive position of near $160m. Current assets over all liabilities is now only minus $25m versus’s 2008’s position of minus $370m, which again is quite an improvement and shows that they now have quite a strong balance sheet (against last year’s week looking balance sheet).

The future

Ebok began first production in Q1 this year and is currently producing gross 15,000 bopd. It is expected that, by the year end, the field will be producing gross 35,000 bopd. Better still, Afren will get the full 35,000 bopd of this until the start up costs are repaid. This means that by the year end Afren will be producing near 55,000 bopd from Ebok and Okoro, i.e. they should be enjoying substantial cash flow. This will dwindle as production slowly deteriorates from both fields, and it will fall even sharper once Afren earn back their start up costs from the fields (which  for Okoro should be over the next year or so, and for Ebok will be in approximately a couple of years time). It is important to note that these timescales are estimates and any changes to the price of oil will change the payback timescales – these estimates use $65. The latter shows that Afren could be in for a very good year as if all goes to plan they could have an average production total for the year of over 40,000 bopd (current is near 35,000 bopd), and at an oil price of over $70 that means that cash flow could easily double this year from last, with a high maiden after tax profit possible if all goes well.

The year also holds a lot of potential from the drill, as they plan to drill a number of fields this year, with the most significant liekly being Ebok, C1-01 and Obwok.  If drilling on these three fields goes well, it is likely that they could see their proven reserves increase substantially, as well as gaining an idea (in regards of C1-01 and Obwok) into what the future production potential of the fields will be, and when this production can start.

Conclusion

Of course Afren are not without their risks. Many investors will not like the fact that they have such a large amount of hedges in place which can have quite large effects on the balance sheet and income statement (for example currently if the price of oil continues to rise they will have to report a loss, but if it falls again they will book a profit meaning that Afren are a bet on the price of oil also). Of course, there is no guarantee that they will continue their current exceptional run of results. They do have large capital requirements (hence why they have recently raised $200m via a rights issue and secured a $450m debt facility). Although they are fully funded for the foreseeable future, if things do not go their way their balance sheet could easily deteriorate again (the hedges do help protect them against the risk of a low oil price, though they are not protected against potential technical difficulties or dry wells). With their main operations being in Nigeria, there is always the chance not only of political risk, but risks of terrorist attacks from rebels (although Afren are arguably less likely to suffer from these as they are more closely connected to the government than, say, Shell).

Overall, with the potential news flow over the next couple of years, and the fact that Afren have such ambitious plans (they have a target of being producing over 100,000 bopd and having proved reserves of over 500mmboe by 2012), they do just seem to be going from strength to with strength. The recent entry to the FTSE 250 backs this up (which is not bad considering they only gained a full listing a few months ago), so they still warrant a place in Grays Stocks to Watch.

Disclosure of Interest: The author has no interest in Afren