Ocean: Deepwater Drilling and High Potential
By John Kartsonas
Ocean Energy (OEI ), one of the 10 largest independent oil-and-gas exploration and production companies in the U.S., has posted impressive double-digit production and reserve growth since its 1999 merger with Seagull Energy -- while maintaining a low cost structure. The stock carries S&P's highest investment ranking, 5 STARS (buy).
With natural-gas prices close to revisiting the $4 per million BTU mark (last seen in June, 2001) -- and with oil prices near their highest levels since September 11 -- the energy sector has already started to feel the benefits of higher commodity prices. The S&P Exploration & Production (E&P) Index is up 9% for the year and 23% from its lows in late January. And low-cost producers like Ocean are poised to benefit the most if prices remain high.
Ocean's expertise is primarily in deepwater exploration (more than 1,000 feet down) in the Gulf of Mexico (which accounted for 30% of 2001 production) and West Africa (25%). However, it also holds U.S. onshore properties primarily in Texas and Western Oklahoma (35%), as well as interests in Egypt, Brazil, Cote d'Ivoire, Indonesia, Russia, and offshore Pakistan. As the natural-gas reserves in the shallow waters in the Gulf of Mexico are rapidly depleting, the deepwater region, where Ocean is one of the largest leaseholders among companies its size, is likely to provide most of future U.S. gas growth.
Among Ocean's portfolio of assets are two of the most promising discoveries in recent years in the deepwater Gulf of Mexico: the Nansen and Boomvang fields in the East Breaks area. Ocean holds a 50% interest in the Nansen field (Kerr-McGee owns the rest and is the operator), with estimated reserves of 140 million to 180 million barrels of oil equivalent (BOE). Production from the Nansen field began in late January. Daily rates are expected to reach 40,000 barrels of oil and 80 million cubic feet of gas by yearend, which should boost Ocean's annual net production by some 20%.
In addition, Ocean owns a 20% interest in the Boomvang field (the other two owners are Kerr-McGee -- the field's operator -- and Enterprise Oil) with estimated recoverable reserves of 70 million to 100 million BOE. Boomvang should begin producing late in the second quarter.
Both fields were developed using a floating production system technology, called truss spars, that was employed for the first time anywhere. Truss spars are lighter and yet more stable than traditional production systems, thus providing additional cost benefits. Production capacity for each spar is 40,000 barrels per day and 200 million cubic feet of gas per day, so the excess production capacity should be used for the nearby Navajo field (in which Ocean holds a 50% interest) expected to come online later this year.
At their peak, the Nansen and Boomvang fields should provide close to 400 billion cubic feet of gas per day, or almost 1% of total U.S. daily production. This gas will be transported to an onshore facility through a 96-mile pipeline system.
Ocean has another important property in offshore Equatorial Guinea, the Zafiro field. It holds a 23.75% interest there, with ExxonMobil, which operates the property, owning the rest. Zafiro should provide most of Ocean's international production growth in 2003. Recoverable reserve estimates exceed 1 billion BOE (for comparison, Ocean reported 2001 proven reserves of 601 million BOE).
Zafiro now produces 160,000 barrels per day (about 22% of Ocean's production). Ocean's recent efforts to remove production bottlenecks by installing new facilities and freeing capacity in existing ones should increase production by about 15% by yearend -- and enable it to almost double production from current levels by late 2003.
Adding to Ocean's major projects are the promising Red Hawk (50% interest) with estimated reserves of 300 billion to 500 billion cubic feet of gas equivalent, and the Zia (67% interest) and Magnolia (25% interest) fields in the deepwater Gulf of Mexico. Ocean should increase production rates at 12% to 15% annually, reaching more than 200,000 barrels of oil equivalent per day by 2004.
During the last three years, Ocean has managed to strengthen its balance sheet and reduce its debt from 78% of total capitalization to 47% as of the end of March, 2002. Following last year's credit-rating upgrade, Ocean joined the other eight independent exploration and production companies that carry an investment grade rating from Standard & Poor's.
Despite their impressive rise in recent months, Ocean shares remain attractive. We at S&P expect the company's earnings per share to decline 48% in 2002 because of lower realized commodity prices, to $0.80, but increase 50% in 2003, to $1.20, mainly reflecting higher production and an improved price environment. The shares currently trade in line with our net asset value per share calculation, compared with a 10% average premium for Ocean's peers.
From another valuation standpoint, enterprise value (market value of equity, plus long-term debt, minus cash) to discretionary cash flow, Ocean trades at 8.2 times and 5.0 times our 2002 and 2003 estimates, respectively. This is a way to measure the cash flow generation capacity of the company relative to the total funds invested that it is using to generate this cash. Ocean's peer group of exploration and production companies trades at average multiples of 8.7 and 5.1 to our respective estimates.
Finally, Ocean has an enterprise value to 2001 proven reserves measure of $8.45 per BOE, which compared to the historical peer-group average, stands at a 10% to 15% discount. This ratio measures how much the market values the company's existing proven reserves (or the amount of oil and gas that it makes economic sense to extract given current market prices). Assuming a 15% proven reserve growth rate for 2002, and applying a multiple of 9 to our yearend proven reserve estimate, we arrive at a nine-month share price target of $26, or about 20% above the current level.
Analyst Kartsonas follows oil & gas exploration and production stocks for Standard & Poor's