The Rising Influence of Rising Affluence

[DewDiligence]

This is a Credit Suisse report on HES from 7/1/09 (a few days before
the dry hole at the Guarani well became official). There are lots of
assumptions here that are debatable, but the basic premise is that,
at the current price, HES shares have very little value baked in for
the BM-S-22 lot in particular and for Brazil in general. Thus, there
is a substantial upside if Brazil comes through after all, and not
much risk to shareholders if it doesn’t.

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Rating: OUTPERFORM; 1-year target price: $64.00

Analysts: Mark Flannery; Michael Mannarino, CFA; Rakesh Advani; Nathali Tirado

* The HES stock has recently been battered by a series of disappointing stories surrounding the drilling results from the BM-S-22 block in Brazil. In June alone, the stock lost around 20% of its value.

* We have witnessed a sudden change of course in Hess’s exploration story, with an associated sharp downward move in the share price. While certainly disappointing, the results from BM-S-22 are not a conclusive negative verdict on this block. There is almost certainly considerable remaining value for Hess in Brazil, but the timeline is now longer. After recent price moves, Hess offers a cheap (long-dated) option on the pre-salt.

* The focus of the exploration story will shift in the near term to Australia. In 2H09 Hess will begin its second drilling campaign on the 100% owned WA-390-P block, and WPL will resume drilling on WA-404-P around the same time. Success in Australia is not as impactful as Brazil would have been given the difficulty of commercializing discovered gas down there.

* We identify around $71 of asset value in the Hess shares today, including a modest amount for Brazil (under $4 per share). However, with momentum fading from the exploration story, realizing this underlying value is going to take some time, we think.

* For those with 12 months to wait, the stock still deserves to be rated Outperform, and we maintain our $64 target price (which incorporates a discount due to volatility). Those requiring a quicker return on their investment may need to look elsewhere.

The BM-S-22 operator, ExxonMobil, reported earlier this year that the first well in the block, Azulao, contained hydrocarbon shows in two horizons. However, it seems that net oil pay was substantially smaller than the100-meter-like oil columns seen at at Tupi, Guara, Iara and Jupiter. In addition, there were reports that that an oil-water contact was found in the second horizon at Azulao, reducing the chances of there being a lot more recoverable oil in deeper horizons. Finally, the amount of CO2 found in Azulao was reported to be much lower than it was in the previous successful pre-salt wells.

As for the second well on BM-S-22, known as Guarani, the results posted on the website of the Brazilian regulator (the ANP) showed the completion of the well without any indication of hydrocarbons. A sidetrack well has now been drilled and completed, and still no indication of discovery has been filed. The implication is that Guarani is a dry hole, though there has been no official announcement to this effect [it became official a few days later], and the operator is still reported to be cutting and examining core samples.

We expect that ExxonMobil will now need to rethink its approach to this block and to the play in general. The operator will need to go back to the drawing board, re-examine the results of the well corings, reprocess the seismic where necessary and identify a new set of targets to drill up next year. Hess now a long-dated option on BM-S-22. We believe all value associated with Brazil has exited the HES share price since June 1st, leaving investors with a cheap option on BM-S-22 eventually coming good.

The huge potential of Brazil’s pre-salt play is undoubted, and with 550 square miles of surface area in BM-S-22 and a complex structure made up of multiple rock fascias, it is much too early to say anything conclusive about what kind of discovery will eventually be made there.

However, with very long lead times to production (particularly now for BM-S-22) and considerable uncertainty over reservoir performance and financing requirements, the immediate value of the block is modest.

Currently in our SOTP model for Hess, we are assuming 3bn barrels in gross possible reserves (1.2bn net to HES) valued at $1/boe. This accounts for $1.2bn or $3.71 of HES’ $70.81 NAV (just over 5%). We arrive at this number by building a model of what we think a typical pre-salt development will look like.

We assume that 3bn barrels of recoverable oil reserves will eventually be discovered in BM-S-22. Our model suggests that each of these discovered barrels will be slightly above NPV breakeven at $60 oil, be worth $1.00/bbl at $70 oil and $2.53/bbl at $80 oil, after making some adjustments for drilling costs amongst others at each oil price level.

Estimated value of a BM-S-22 discovery on a per-barrel basis:

 
 Size of discovery   ------NPV per barrel----- 
 (billion barrels)   $60 oil  $70 oil  $80 oil 
         1            ($5.60)  ($4.34)  ($3.11) 
         2            ($0.51)   $0.57    $1.63 
         3             $0.08    $1.00    $2.53 
         4             $0.61    $1.36    $2.09 
         5             $0.61    $1.35    $2.07

If BMS-22 were to contain 5bn barrels of oil (in the middle of the range of initial results from other blocks in the area, but difficult to support right now) then we calculate the impact to Hess would be close to $7 per share accretion assuming $70 oil and a 2017 start-up:

Estimated value of a BM-S-22 discovery per HES share:

  
 Size of discovery   ----NPV per HES share---- 
 (billion barrels)   $60 oil  $70 oil  $80 oil 
         1            ($6.93)  ($5.38)  ($3.85) 
         2            ($1.27)   $1.41    $4.04 
         3             $0.30    $3.71    $9.42 
         4             $3.01    $6.74   $10.36 
         5             $3.08    $6.82   $10.44 

Some news possible on BM-ES-30 late this summer. Hess also has a 60% stake in the BM-ES-30 block in the Espiritu Santo Basin to the North of the Santos Basin. BM-ES-30 contains a middling-sized above-salt target with potentially very favorable NPV, and Hess as operator is schedules to drill the target over the summer.

A concentrated exploration portfolio - The exploration story is likely to remain the driver of momentum in the Hess stock, we think. Judging the likely success of a future exploration program is surprisingly difficult, but the last several years of results from Hess have been reasonable and the company has some significant remaining opportunities. Hess has large stakes in meaningful prospects (100% of Ghana, 40% of BMS-22, 100% of Libya Block 54), making the Hess exploration program rather concentrated for an integrated oil company. This can raise concerns over Hess’s future ability to finance any discoveries, but the recent recovery in the oil price should ensure a sufficiently liquid farm-out market for Hess should it need to monetize discoveries.

The problem recently is that impactful discoveries have been less frequent than expected. The stream of multi-billion barrel discoveries in Brazil’s Santos Basin pre-salt play dominated global exploration newsflow from end-2007 through mid-2008, driving company valuations sharply upwards, before it turned into a drag on stock prices in 2H08. Hess participated in both the up and the down of this trade, all before actually drilling a well on its block.
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