2023-07-25 07:30:06 ET
Summary
- Gulf Keystone, an independent oil and gas E&P company operating in Iraqi Kurdistan, is facing a complex situation involving multiple parties, including the Kurdistan Regional Government, Iraq, and Turkey.
- The company's sole asset, the Shaikan field, has recently stopped production after Turkey halted pipeline exports.
- Gulf Keystone is trading at below 2x normalized earnings and <0.3x NAV, and could offer 100%+ upside in a positive resolution scenario.
We present our note on Gulf Keystone (GUKYF), a London Stock Exchange-listed independent oil and gas exploration and production company operating in Iraqi Kurdistan. A highly cash-generative quality asset is seemingly at a discount. However, any value realization is subject to an ongoing complex situation involving multiple parties, including the Kurdistan Regional Government, Iraq, Turkey, etc. We will do a deep dive into the situation, analyze key issues and drivers, and assess the potential implications for investors.
Overview
Gulf Keystone was founded in 2004, and it was awarded the Shaikan Production Sharing Contract ((PSC)) in 2007. The first discovery was made in 2009 and commercial production started in 2013. In FY 2016, after payment delays from the Kurdistan Regional government due to difficulties faced by the KRG to sell oil, low oil prices, and the cost of war with jihadi group ISIS, Gulf Keystone underwent a financial restructuring which led to bondholders owning $500 million of worth of bonds obtaining 95% of the equity of the company.
Gulf Keystone currently has an 80% working interest in its sole asset, the Shaikan field. The remaining 20% is owned by Kalegran BV, a subsidiary of MOL Hungarian Oil & Gas PLC. In FY 2022, Gulf Keystone had an average production of 44,202 bopd, and generated $266 million of FCF, out of which $215 million were distributed as dividends. Against a current market capitalization of $321 million, that is equivalent to an 80%+ Free Cash Flow yield and a 67% dividend yield. From 2019-2023, GKP has returned a cumulative amount of $440 million of capital to shareholders as dividends and buybacks. Moreover, in 2022 GKP redeemed its $100 million bond, leaving the company debt free, with a $119 million net cash position.
The Shaikan field is a long-life asset with a proven track record of low-cost production. As per the latest investor presentation, Shaikan has a total of 506 MMstb of Gross 2P reserves - associated with the Jurassic reservoir, and 817 MMstb 2P+2C reserves. There is a forecasted expansion to ca. 90k bopd of production by the end of 2025, which requires ca. $900 million of investment to realize, pending approval. The majority of the reserves are categorized as heavy oil with an API gravity between 14 and 20 degrees. The oil is shipped via the Atrush pipeline, then connected to the Kurdistan Export Pipeline and transported through Turkey on the Ceyhan terminal in the Mediterranean coast. Over the last few years, 2016 - until recently, production had been steady despite major political uncertainties that characterize KRG.
Kurdistan, Iraq, And Turkey
The operation of the Shaikan oil field, like other fields in KRG, is subject to a complex agreement with the regional government. The government charges a 10% royalty fee of gross revenues, that is paid in kind. 90% remains as net revenue. 40% of the net revenue is utilized to recover costs related to the development of the asset and the production of oil. The remaining 60% of net revenue is recognized as profit oil. Depending on the ratio of cumulative revenue to cumulative costs, with acronym R, that falls on a linear scale between 1 and 2, the profit oil is distributed to the Kurdistan Regional Government and the Contractor, in this case GKP; on a ratio of 70-85% and 15-30% respectively.
All revenue from oil sales is either received by or on behalf of the Kurdistan Regional Government, which then later makes payments to the contractor for both cost oil and profit oil in compliance with the Production Sharing Agreement.
We would like to point out to our readers that KRG has a complex multifaceted relationship with the Central Government of Iraq, that depends on a multitude of factors. These complex dynamics also give rise to the issues faced by Gulf Keystone and other E&Ps operating in Kurdistan.
In February 2022 the Shia-controlled Federal Court ruled that the 2007 law was unconstitutional and ordered the Iraqi government to take measures to force KRG to hand their crude production to the central government, granting Baghdad the power to nullify contracts signed with international oil companies. Since then, KRG has found it harder to find buyers for crude and the political risk discount has risen.
Moreover, a case at the International Chamber of Commerce's International Court of Arbitration in Paris that had been running for 9 years was ruled in March 2023. In 2014, the KRG connected its oilfields to Turkey, tapping into the existing Iraq-Turkey pipeline, and soon thereafter Iraq filed a complaint with the Paris Arbitration Court. Iraq claimed that Turkey was violating a pipeline transit agreement by allowing crude exports from the Kurdistan Region without the consent of the Iraqi Central Government, using a clause from the annex of a 1973 agreement requiring Turkey to only buy oil from Iraq's state-owned oil marketer. We believe the motivation of Iraq is likely to weaken the autonomy of the KRG, in this case by reducing its economic independence through delegitimizing and weakening oil exports.
Iraq was seeking up to $90 billion in damages, while some feared Turkey could have to pay up to $20 billion. However, Turkey managed to get out of this unscathed, with only a few hundred million dollars in fines, which will have to be eventually paid from the KRG due to an indemnity clause in the Turkey-KRG agreement.
Subsequently, Turkey stopped pumping oil through that pipeline from KRG and from the rest of Iraq (using that pipeline), respectively 400k barrels per day and 75k barrels per day each. In early April an agreement was reached between Iraq's Central Government and Kurdistan's Regional Government that would make possible the flow of oil to Turkey by the KRG and Iraq's State Marketing Corporation. However, the flow has not resumed. The resumption was allegedly delayed due to the Turkish elections and the earthquake. However, some speculate that potentially Turkey may be looking to renegotiate payments. In June, Iraq passed its federal budget, obliging KRG to sell 400k barrels of oil through Iraq's national oil marketing company. If the current halt continues, Iraq will take Kurdish oil for internal use.
On the 12th of July, Turkish President Erdogan responded to a question by a journalist in a conference in Vilnius, regarding the pipeline. He stated that Turkey does not have an issue with receiving the oil from Iraq and that the issue originates from tensions between the KRG and the Iraqi Central Government. A few days later, on the 17th of July, the Iraqi government responded to that statement through the Oil Ministry's undersecretary for extraction affairs Mr. Khudair, by saying that Baghdad does not have any issues with the KRG, and they are on the same page regarding oil exports. "No, we do not have any political issue [with KRG], we, and the KRG, share the same view regarding the exportation of Kurdistan Region's oil, which is in the public interest". Iraqi officials claim that Turkey does not want to start the flow of the pipeline until Iraq forgives the penalty imposed by the Arbitration Court.
It is important to note that the KRG depends on oil income for 80% of its budget and over the last year its economic autonomy has been under severe pressure.
The Shaikan field produced into storage tanks at reduced rates until April 13th, 2023, when it fully stopped production. Moreover, the KRG owes GKP $151 million in outstanding net receivables. Despite KRG's track record of always having paid receivables GKP is seeking clarity. There is absolutely no certainty on the timeline of the resumption of production, but the company believes the suspension will be temporary and payments will resume. The company has reduced capex, opex, and G&A to an average monthly run rate of c.$6m from July 2023. Net capex has been reduced to $70-75 million.
Valuation And Investment Recommendation
Production since April 2023 has been deferred and not lost and Gulf Keystone is able to recommence production as soon as the situation gets resolved and there is a consensus to resume exports through the pipeline. With a net cash position of $119 million, a market capitalization of $321 million, and an enterprise value of $202 million, GKP is trading at very low multiples. Assuming normal operations at $80 crude we would expect around $170 million of net income on a normalized basis. This implies a 1.8x PE multiple, with an even lower EV/EBIT multiple. Moreover, we calculate a 2P Net Asset Value in the range of $600-750 million (depending on oil price assumptions). The NAV of 2C hovers around $100 million. EV/NAV is on the <0.3x.
Under normal conditions GKP should have been roughly worth 0.6-0.7x NAV or 4x+ EPS, implying a share price of close to 100% higher than now, effectively in line with the valuation GKP commanded before the halt of the pipeline.
However, we have absolutely no clarity on the materialization of the catalyst that would allow such a rerating to happen. The situation is stuck in a "one step forward, two steps backward" mode with multiple actors with competing and often obscure interests at play. At the moment, given the lack of clarity regarding the resumption of the oil flow on the pipeline, as well as the liquidity situation - which so far seems manageable - we would refrain from making a Buy recommendation. We can very well see the bear case whereby the status quo is extended and GKP keeps burning through cash for a few more quarters, undermining its financial position, leaving equity holders bearing the brunt.
On the other hand, it can be very attractive if the situation resolves. We would highly recommend our readers, especially those passionate about the energy sector, to flag this situation and closely follow any developments regarding the flow of the pipeline. We are closely monitoring the situation and will make future posts about Kurdistan-focused E&P, as we think this a special situation that could have a significant potential upside if issues are resolved.
Risks
Risks include but are not limited to no recommencement of oil flow in the Turkish pipeline, annulment of the contracts by KRG or Iraq's central government, a liquidity crunch, a decline in crude oil prices, rising operational costs, war, terrorism, political instability, accidents, and weather events.
Conclusion
Lacking any clarity on the resolution of the current situation, we issue a Hold recommendation. However, we would suggest our readers closely monitor this situation as any positive outcome could lead to a major rerating and as much as 100% upside.
For further details see:
Gulf Keystone: 100% Upside Trapped In A Geopolitical Quagmire