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PetroFalcon Corporation: Contrarian hydrocarbon play in Venezuela
By Pietro Donatello Pitts, LatinPetroleum.com         August 19, 2008    06:06:00 AM
While multinationals with assets in Venezuela ponder whether to stay there during the volatile times that have accompanied the hydrocarbon, telecommunications, cement and steel nationalizations spearheaded by Venezuelan President Hugo Chávez Frias, one micro cap Canadian company has seized opportunities and grown to become both the largest acreage holder and independent producer in Venezuela.
 
That company, PetroFalcon Corporation, is an exploration and production outfit with a $207.6 million market cap and which operates in Venezuela through its 100%-owned subsidiary, Vinccler Oil and Gas. Even though PetroFalcon’s shares are traded on the Toronto Stock Exchange (TSX), the company is headquartered in Caracas. Maybe that’s just the breathing room its needs to make headways in Venezuela.
 
The outlook for Venezuela’s hydrocarbon industry remains indecisive due to recent changes in ownership profiles, increased royalties and income taxes, just to mention a few. Still, the management team at PetroFalcon believes this has created an opportunity for it to acquire assets on the cheap from multinationals looking to sell down their interest.
 
“There are still some opportunities to consolidate assets from the existing shareholders of the new Venezuelan ‘empresa mixtas’ or joint venture companies,” said PetroFalcon Chief Financial Officer Garrett Soden. “That is to say, I think there are other international companies like Anadarko Petroleum which have non-core assets, limited management on the ground and are looking to exit Venezuela.”
 
Recently, OMV E&P GmbH announced plans to divest its remaining assets in Venezuela held by its wholly-owned subsidiary, PEI Venezuela GmbH, which holds a 13.334% interest in Boquerón. As of December 31, 2007, Boquerón had estimated gross proved reserves of 103 million barrels of oil equivalents (MMboe) and 127 MMboe of Proved plus Probable (2P) reserves.
 
Since 2004, PetroFalcon has managed to grow its asset base to 332.9 million barrels (MMbbls) of crude oil or 69.3 MMbbls net to its interest. PetroFalcon has done this acquiring 2P reserves for less than $4 per barrel.
 
The company has an interest in over 1.9 million acres onshore and offshore Venezuela, which offer the prospect of large reserve and production upside through further development and exploration drilling. Also, the company is partnered up with multinationals such as Chevron, Repsol-YPF, Eni, and Petrobras, among others.
 
PetroFalcon’s two-year drilling and work over program consists of drilling 73 development wells, 156 work-overs and 8 exploration wells. The company expects to have 4-5 rigs running non-stop during this time frame.
 
Considering the low-risk geology particular to Venezuela and a drilling program that is skewed 90% to development and only 10% to exploratory drilling, the upside potential looks attractive.
 
“Obviously, there is perceived political risk in Venezuela,” said Soden. “But I view that as our opportunity. I think people are slowly starting to recognize that we are purchasing assets at a discount, and that we have a self-funding business model that is throwing off significant dividends from our joint ventures. Furthermore, we have high impact exploration upside that is not currently priced into our stock price.”
 
SIDE BOX: BUILDING CRITICAL MASS IN VENEZUELA
 
In the last three years PetroFalcon has grown its asset base in Venezuela. While three of its deals are pending Ministry approval, it is the only company in Venezuela to receive Ministry approval for an M&A transaction since 2004. A summary of the company’s acquisitions follows:
 
Effective April 1, 2006, Vinccler Venezuela’s East Falcon OSA and West Falcon OSA, acquired from Samson, became a 40% investment in the mixed company, PetroCumarebo. The PetroCumarebo assets included 76.5 million gross 2P reserves and gross production of 1,200 barrels per day (b/d) and 15 million cubic feet per day (MMcf/d). The book value of the assets was $40.6 million as of June 30, 2008.
 
On February 26, 2007, PetroFalcon announced a ground-floor farm-in agreement to acquire, subject to Ministry approval, a 30% working interest from Chevron Corporation in the offshore natural gas license for the Cardon III Block in the Gulf of Venezuela. Chevron will remain operator and majority partner with a 70% interest. The Cardon III Block has estimated unrisked natural gas reserves of 2.5 trillion cubic feet (Tcf). PDVSA retains the right to acquire up to 35% of the project after declaration of commerciality.
 
On July 18, 2007, PetroFalcon announced the acquisition of 100% of the issued and outstanding shares of Lundin Venezuela from Lundin Petroleum BV, as well as a private placement with Lundin BV. Lundin Venezuela owned a 5% interest in Baripetrol, S.A., a joint venture company comprised of PDVSA, Tecpetrol de Venezuela, S.A., and Perenco Oil and Gas International Limited. The Baripetrol assets included 57.4 million gross 2P reserves and current gross production of 10,500 b/d and 5 MMcf/d. The book value of the assets was $21.3 million as of June 30, 2008.
 
On March 12, 2008, PetroFalcon announced the signing of an agreement to acquire, subject to Ministry approval, a 25% working interest from Repsol-YPF in the offshore natural gas license for Cardon IV Block in the Gulf of Venezuela. PetroFalcon will not pay any amounts to Repsol-YPF for past sunk costs, but will pay a 2-for-1 promote on the first exploration well. Eni will retain a 50% interest in the block, while Repsol-YPF will own the remaining 25% interest.
 
On April 7, 2008, PetroFalcon announced the acquisition of 100% of the issued and outstanding shares of Anadarko Venezuela for $200 million in cash, subject to Ministry approval. Anadarko owns an 18% interest in Petroritupano, a joint venture company between Venezuela’s state oil company, Petróleos de Venezuela (PDVSA), and Petrobras of Brazil. Anadarko also holds a $58 million voucher that can be used as a credit with the Venezuelan government for new oil and gas investment opportunities.
 
The Anadarko assets include 199 million gross 2P reserves and current gross production of 38,000 b/d and 20 MMcf/d. Development drilling to take place over the next two years is expected to increase oil production to 50,000+ b/d, while six prospects hold the potential to boost the reserves by another 45 million barrels.
 
VENEZUELA’S HYDROCARBON INDUSTRY
 
With crude oil and natural gas reserves of 80.0 billion barrels and 152.3 Tcf, respectively, worldwide Venezuela ranks as the seventh largest holder of crude oil reserves and the fifth largest holder of natural gas reserves. Further, Venezuela’s Ministry of Energy and Petroleum (MENPET), estimates that the Orinoco Heavy Oil Belt, also known as the Faja, contains an additional 235.3 billion barrels, while the offshore natural gas potential is estimated at around 95 Tcf.
 
If that were not enough, nearly three years ago the MENPET announced an expansion plan to increase PDVSA’s production of crude oil from 3.3 million barrels per day (MMb/d) to 5.8 MMb/d and its production of natural gas from 6.2 Bcf/d to 12.2 Bcf/d, both by 2012.
 
However, despite the sheer size of the natural gas and crude oil resources Venezuela has, the recent nationalizations have heightened fears among many long time investors. As part of the nationalizations, Chávez has stated that Venezuela will have a minimum 60% interest in all joint venture or mixed companies, an announcement that required PDVSA to acquire interests in a number of nationalized companies.
 
While many of the affected companies have agreed to accept a number of across the board changes -- including but not limited to increases in income taxes and royalties -- that will affect the new joint venture companies, some have not. PetroCanada decided to terminate its activities in Venezuela for unknown reasons while Anadarko Petroleum decided to divest of its assets in Venezuela as they were not seen as being part of its core business. Two US-based companies, ConocoPhillips and ExxonMobil, continue to negotiate a fair compensation package with the Venezuelan government for their expropriated assets. Also during the ‘empresa mixta’ transition phase, Eni of Italy and Total of France both threatened to take the Venezuelan government to arbitration over their expropriated assets. However, both companies have since reconsidered and remain committed to Venezuela. In fact, Eni recently announced a multi-billion commitment to the Faja despite losing the Dacion field during the transition.
 
Although it might seem that Chavez’s alienation for foreign companies he claims are backed by “imperialistic governments” has been limited to US companies, Soden argues against what many would call “anti-American sentiment” in Venezuela.
 
“I think business here is specific to how you build your relationship with the government and PDVSA. One of the more successful companies in Venezuela is Chevron and they are an American company. So I don’t think it’s an anti-American policy, and I don’t think any company has been given preferential treatment nor had harder times than the other in regards to negotiations. I think certain companies have negotiated and built relationships better than others,” said Soden. “We trade as a Canadian public company, which is somewhat neutral politically, but we are really a Venezuelan company because 100% of our business is here, we operate under a Venezuelan name with a long history in the country and we are staffed mostly by Venezuelans.”
 
PETROFALCON VALUATION
 
To any oil and gas investor, the mention of a small cap energy company with current working interest production [pro forma for the Anadarko acquisition] onshore of 7,845 b/d and 9.9 MMcf/d; current net 2P reserves of 69.3 MMbbls; net unrisked upside potential of 150 MMbbls; interest in two offshore blocks which have net unrisked natural gas reserves potential of 2.5 Tcf; a $22 net back based on a $100 per barrel oil price; no debt (before funding the Anadarko acquisition), $30 million in cash, a $58 million voucher to be used in Venezuela; a current price of less than $2 per share and oil prices above $100 per barrel, might be reason enough to get a broker on the phone to grab some shares on the cheap, right?
 
“We are a contrarian play,” said Soden. “We are 100% focused on Venezuela because we are a Venezuelan company, and this is where the resources are. We see more opportunities here at attractive valuations than anywhere else. We think we have a strategic advantage here operating under the Vinncler name with almost all of our management being Venezuelan with intimate knowledge of the geology and business environment here,” he said.
 
According to a LatinPetroleum analysis, PetroFalcon’s net asset value (NAV) based on book values, and not giving value for the upside potential, is estimated at $348.8 million or $2.20 per common share or $2.02 per fully diluted share.
 
Still, the shares of PetroFalcon are trading at a discount to NAV and for one obvious reason, the political uncertainty associated with its operations in Venezuela.
 
LatinPetroleum estimates that at $1.31 per share that the PetroFalcon shares already reflect this “Venezuelan” political risk as the company’s stock has declined from a high of $6.20 reached in 2005 to as low as $0.54 last July.
 
“We would like PetroFalcon to be a significantly larger company down the road. Our strategy is to continue to build value for shareholders [here in Venezuela] by consolidating assets which we think could be very valuable in the future,” said Soden.
 
MOVING FORWARD
 
It appears that the Venezuelan nationalization process has passed as the government has regained control of its hydrocarbon industry and strategic assets. Although the threat of further expropriations seems to have subsided for now, there is always the lingering chance that Chávez decides to impose additional taxes or royalties in some form or other on the multinationals operating in his country.
 
“I think any political risk specific to Venezuela is behind us. There is not much more that can happen in the Venezuelan hydrocarbon sector. Even with the implementation of the recent windfall profits tax, PetroFalcon has significant pro-forma free cash from the joint ventures and we have a lot of upside in the company. The thing I would worry about -- like anywhere else worldwide -- would be delays in our ability to fulfill our joint venture business plans.”
 
Further changes to Venezuela’s hydrocarbon industry could seriously affect the country’s ability to attract continued foreign direct investment and make it impossible for the country to reach is optimistic aforementioned production goals. Despite successfully completing the nationalization process, Venezuela’s production of crude oil fell to 3.3 MMb/d in 2007, down 3.1% from 3.4 MMb/d in 2006.
 
Even though the dust from the hydrocarbon nationalizations continues to settle, the horizon looks optimistic for PetroFalcon as the only Venezuelan pure play -- Harvest Natural Resources being the closest comparable.
 
Despite all the bad press about Venezuela, Soden said his company has no plans of leaving. “We do not have an exit strategy. Our strategy is to remain in Venezuela for the long term. This is where the resources are. This is where we want to be and this is where we think we can grow our business best.”
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Pietro Donatello Pitts, is the Editor-in-Chief of LatinPetroleum Magazine. Prior thereto, he was the Associate Vice President of Equity Research at the investment banking firm, Morgan Keegan & Company and prior thereto with Jefferies & Company.
 
NOTE: This article along with a detailed NAV valuation will appear in the upcoming print edition of LatinPetroleum Magazine.
 
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LatinPetroleum.com, www.latinpetroleum.com, Venezuela news, 19.August.2008, Source: LatinPetroleum.com