Vast Exploration (VST CN): Another Elephant Hunter in Kurdistan with Vast Option Value

Similar to WesternZagros (WZR CN), Vast Exploration (VST CN) is another Canada-based pure play on oil in Kurdistan. VST signed its Profit Sharing Contract (PSC) with the Kurdistan Regional Government (KRG) in May 2008 and has just commenced seismic work on its exploration block in February 2009.

Investment Thesis

Despite its much smaller market cap and earlier stage in its exploration efforts, VST shares many of the same attractive investment characteristics with WZR; it is arguably a “mini” version of its neighbor:

High scarcity value. Kurdistan holds one of the world’s most coveted oil fields, which up until recently was off limits, protected from foreign ownership. Just like WZR, VST was one of the first movers, and because it took a large risk as a foreign investor at such an early stage, its potential reward is sky high.

Kurdistan is actually safe. Kurdistan is no tropical island for the long distance traveler, but it is arguably a true “security oasis” within the war-battered Iraq, and it is ranked “secure” by the US military. Over 20 E&P companies have been operating in the region over the past several years with no major interruptions, which makes this a safe haven among prospective untapped oil reservoirs. Click here for a detailed blog on geo-political issues in Kurdistan region.

Additionally, VST provides its own unique risk/reward profile:

Adjacent to world class discoveries. In early February 2009, VST started a seismic acquisition program for a minimum of 350 km of 2D seismic data. The process will take 4-5 months, and at its conclusion, VST will be able to generate an initial reserve estimate for its block – this creates potentially very market moving news flow this summer. VST’s block is bordering both the WesternZagros block and the Heritage Oil (HOIL LN) block, which are considered among the 2 most promising blocks in Kurdistan (and in the world for that matter). WZR just a couple weeks ago spudded its second exploration well , and its block has a P90 reserve estimate of 1.6 billion barrels (most definitely “elephant” size). Heritage Oil announced a major oil discovery in its Miran West-1 well early May with estimated oil-in-place of between 2.3 to 4.2 billion barrels. Click here for a detailed blog about WesternZagros block.

Chart 1 Kurdistan license map

Source: Company website.

Chart 2 Oil discoveries in Kurdistan

Source: Company presentation.

A call option on Niko Resources’ (NKO) Kurdistan assets. NKO is one of the larger E&P companies in Canada with a market cap of CAD 3.6 billion. It is not only VST’s business partner (36% working interest) in the PSC block, but also VST’s largest shareholder (17% ownership). Combining both, NKO’s actual working interest in the block is over 42% (36%+36%*17%). Therefore, buying VST stock is essentially a call option on NKO’s Kurdistan business or the eventual consolidation into NKO. The likelihood that NKO eventually acquires VST in whole is arguably quite high, which provides another very direct catalyst.

Table 1 VST Shareholders List

Source: Bloomberg.

Another interesting point worth mentioning is NKO acquired VST’s stake in June 2008 as part of VST’s $35 million deal financing. In addition to common shares, NKO also received purchase warrants that are exercisable at a price of $0.90 per warrant until June 12, 2010. In other words, NKO has the incentive to increase its stake in VST through exercising those warrants over the next 12 months if Kurdistan project proceeds well and VST stock starts to perform.  Connecting the dots, NKO has engineered a very clear path to future ownership of VST with a “heads I win, tails I win” structure.

VST is currently in the market with an additional $7.5 million deal financing priced at $0.40 per unit (including one half of a share purchase warrant which is exercisable at $0.50/share 24 months after the deal closing day). This deal is expected to close around June 4, 2009. It is not clear whether NKO will buy into this deal or not, but it would not be a surprising development if it does.

A correlation play with WZR and Heritage Oil. Since VST has not provided a reserve estimate on its block, it is premature for us to make a reasonable forecast of its NAV. However, VST’s block is located right next to those controlled by WZR and HOIL, and any news about these two companies will very likely lead to a correlated move in VST stock.

Company Profile: VST

Vast Exploration Inc. (VST) is in the business of exploring, developing and producing conventional and non-conventional oil and gas reserves. During the fiscal year ended January 31, 2008, the Company began the process of business development and exploring the possibility of acquiring oil and gas concessions in the Kurdistan region of Iraq.

VST signed a PSC contract with the KRG in May 2008 for the Qara Dagh Block which covers an area of 846 square kilometers. Under the terms of the PSC, Vast and Niko Resources Ltd. (NKO CN) each hold a 36% working interest in the block, and Groundstar Resources Ltd. (GSA CN), has a minority interest of 8%. The KRG has a direct 20% interest which will be carried exclusively by the consortium. NKO acts as operator for the block.

Company Profile: Niko Resources

Niko Resources Ltd. (NKO) is engaged in the exploration for, and the development and production of, natural gas and oil in India, Bangladesh and Pakistan and Kudistan. In India it holds interests in three onshore and three offshore blocks. In Bangladesh, it holds interests in three onshore blocks. In Pakistan it holds interests in four offshore blocks and in Kurdistan it holds an interest in one onshore block. The Company also has minor interests in oil and gas properties in Canada. During the fiscal year ended March 31, 2008 (fiscal 2008), approximately 41% of the Company’s total revenue was derived from natural gas production from the Hazira Field in India and approximately 39% of the Company’s total revenue was derived from natural gas production from the Block 9 Field in Bangladesh in fiscal 2008.

NKO’s 3P reserves were 290 mm boe  at the end of fiscal 2008 (March 31, 2008) which implies an EV/3p reserves ratio of C$13/boe . Given that oil prices fell by about 51% and natural gas prices fell by 63% from 3/31/08 to 3/31/09, NKO’s 3P reserves may well have fallen as of the end of fiscal 2009 (which will be released late June), implying an even greater EV/3P reserves value.  For comparison, incidentally, WZR’s estimated future 3P reserves (which at this stage are just “resources” as exploratory wells are not yet completed) have an implied value at C$1.75/share of C$1.7/boe, which partly explains our interest in WZR.  The 3P reserves estimate for WZR uses a long run US $60/bbl oil price, while NKO’s uses 3/31/08 blended oil/gas prices equivalent to US $73/bbl oil.

DISCLAIMER: the author is long Vast Exploration.

WesternZagros: Hunting Elephants in one of the Largest Untapped Oil Fields on Earth

Executive Summary

The Kurdistan region of Iraq is a geological extension of the world’s richest petroleum fairway, which extends from Saudi Arabia to Syria.  Due to geo-political conflicts, the resources in Kurdistan have been essentially untapped.  Upon the overthrow of Saddam Hussein’s regime in Iraq, however, Kurdistan began to open itself to foreign investment (the tapping of the Kurdistan keg).  Those lucky enough to sign the first contracts received their pick of the most attractive exploration blocks and the most generous terms.  One such company was Calgary-based Western Oil Sands (WTO CN).  Upon its sale to Marathon Oil (MRO) in 2007, WTO’s Kurdistan assets were spun out into what is now the public “pure play” on oil in Kurdistan, WesternZagros Resources Ltd (WZR CN or WZGRF).

stock chart

Investment Thesis

Our attraction to WZR, the elephant hunter, can be summed up as follows:

• Extreme undervaluation.  We believe that the fair value of this stock (details to follow) is conservatively about C$3.60, or roughly 3X its current price.  There are many cheap lottery tickets in the E&P universe, but what makes this one unique is its high likelihood of success.
• High scarcity value.  As mentioned above, Kurdistan holds one of the world’s most coveted oil fields, which up until recently was locked away, protected from foreign ownership.  WZR was one of the first movers, and because it took incalculable risk as a foreign investor at such an early stage, its potential reward is near limitless.
• “Elephant” potential.  An “elephant” oil field is one whose recoverable reserves are at least 100 million barrels.  According to the well respected oil and gas consultancy Sproule and Associates, as of March 31, 2009, WZR’s exploration block has P90 prospective resources of 1.6 billion barrels.  P90, for those unfamiliar with the industry jargon, refers to reserves that have a 90% certainty of actually being produced.  WZR’s find, if “proved” would count among the 100 largest producing oil fields in the world.
• Kurdistan is actually safe.  Kurdistan is by no means a recommended destination for Spring Break or a family vacation, but it is certainly an enviable “security oasis” within the war-battered Iraq, and it is ranked “secure” by the US military.  Over 20 E&P companies have been operating in the region over the past several years with no major interruptions, which makes this a safe haven among prospective untapped oil reservoirs.
• Terrific takeout potential.  WZR, although well capitalized for a “junior” oil exploration company, with $130 million in cash and no debt, is extremely unlikely to remain independent long term.  Its exploration partner, Talisman Energy (TLM CN), with $8 billion of revenue and a $16 billion market cap, is better suited to take on this elephant, and may wish to increase its stake by acquiring WZR itself.  Other large oil companies who either have been waiting on the sidelines due to lack of a clear regulatory framework or who already have small stakes, are undoubtedly eying WZR’s prized oil fields hungrily.

Valuation

We used two methods to value this pre-production company: discounted cash flow and comparable peers analysis.  To build an additional margin of safety, a probability weighted price was calculated based on different scenarios of timing and magnitude of success.

Discounted Cash Flow Valuation

WZR finalized the terms of its Production Sharing Contract (PSC) with the Kurdistan Regional Government (KRG) in 1Q09, which helped shorten the list of major assumptions to success rate, oil price, discount rate and capex schedule (see Table 1).  Please note that a relatively high discount rate is used in the model simply because in a high default rate market environment, it is reasonable and prudent to apply a higher than normal rate and discount essentially the investment grade asset with a high yield rate.

Table 1 Model Assumptions

Key Variables	Assumptions	Comment
P90 reserves	1.6 bn bbl	Audited data from the company
Success rate	60%	Average success rate in Iraq is about 70-75%
First production year	2010	Its second exploration well won’t have any results until Oct 2009.  2010 thus seems reasonable for production start.  2nd scenario assumes first production year is 2011
Oil price	60	Conservative relative to the current curve, see chart below
Bonus pmt ($million)	25	PSC term
Inflation	2.0%	Inflation, what inflation?
KRG+ Talisman take	60%	PSC term
Royalty	10%	PSC term
Max share of profit	35%	PSC term
Min share of profit	16%	PSC term
Corporate tax rate	0%	It is already included in KRG’s take and federal government in Baghdad has no legal power to impose additional tax.
Discount rate	15.5%	As a reference, peak yield of Iraqi treasuries was almost 16% (see chart below).  If Kurdistan had treasuries, the yield would be lower due to its lower credit risk profile.

Table 2 Capex Assumptions

Total recovered oil (mboe)	1,039
F&D per barrel	3.13
F&D per barrel adjusted for ownership	1.25
2009	39million
2010 (if first production is 2011)	40million
Year 1 %	25%
Year 2 %	25%
Year 3 %	20%
Year 4 %	15%
Year 5 %	10%
Year 6 %	5%
Maintenance capex ($million)	50

Chart 1 ICE Brent Oil Price Curve

Chart 2 Iraqi 5.8% 2038 Government Bond Yield

It is also assumed that the first discovery is made in early 4Q09 and first production starts in 2Q10.  However, we assume the production will not ramp up to 200k bpd until 2014, which builds in enough cushion for potential infrastructure uncertainties (pipeline primarily).  An output plateau is assumed to be around 280k bpd in 2016.  The decline rate is set at 13% based on empirical precedent.

Based on the above mentioned assumptions, WZR is valued at CAD 3.57/share, representing almost 200% upside from the close of 1.20/share on May 25, 2009.  In other words, if the upside of holding the stock is 3.57/share and the downside is zero, the current price of 1.20/share implies a 66% probability of the downside scenario happening.  Below are the sensitivity tables.

Table 3 NPV/Share Sensitivity Analysis (assuming first production in 2010)

If the first production year is postponed to 2011, the valuation will be CAD 2.92/share, representing 140% upside from the May 25 close of 1.20/share.  Please note that WZR has a clean and healthy balance sheet and should have no liquidity problem if there is a delay in the first production year.  As of 1Q09, WZR has $106.5 million of working capital, more than covering the company’s projected $39 million in capex in 2009 and our assumption of $40 million in 2010.  WZR has no debt outstanding.

Table 4 NPV/Share Sensitivity Analysis (assuming first production in 2011)

Comps Valuation based on EV/3P Reserves

WZR has two groups of comparable peers: 1) foreign E&P companies that have made discoveries in Kurdistan; 2) foreign E&P companies that are not operating in Kurdistan but are deemed speculative by the market, due to the early stage nature of their productive fields, and/or the riskiness of their assets due to geopolitical concerns

There are currently 20 plus international companies in the Kurdistan region and 7 of them are meaningful comparables to WZR in terms of production status and market cap (see Table 5).  Please note that none of them is a pure play company in Kurdistan, and information about their Kurdistan-specific asset valuation is also sporadic.  Addax and DNO, however, do provide good reference points in Table 6.

Table 5 Kurdistan Comps

Table 6 Pure Kurdistan Asset Comps

• Addax has a 45% working interest in a currently producing oil field: Taq Taq and another 26.67% interest in the Sangaw North PSC.  Addax provided year-end NPV estimates for all of its assets without a geographic breakdown – the average NPV/ 3P boe is CAD 13.7 in 2008, but it is difficult to tell whether the Taq Taq specific NPV is close to this level.
• DNO entered into a PSC with the KRG as early as 2004.  It has a 55% working interest in the producing Tawke field.  In 2Q07, DNO received and subsequently rejected an unsolicited offer ($700 million) for its Kurdistan assets from an unidentified international oil company.  Based on DNO’s reserve data as of 2Q07, the offer represented CAD 8.3/3P boe.

Table 7 Speculative E&P Comps

Based on EV/reserve multiples from both peers groups, 4-12x seems to be a reasonable range.  To further discount the uncertainties, 5x is used for the valuation of WZR, yielding a price of CAD 3.68/share.  This represents a 206% premium over the 1.20/share close on May 25, 2009.

Table 8 Comps Valuation

Probability Weighted Price

For our final valuation methodology, we assign probabilities to several potential scenarios to calculate a weighted target price.  Due to the fact that WZR’s exploration block contains oil on the surface of the ground (in pools, or “seeps”) we assign a 90% probability of finding oil.  It is also assumed that there is a 40% probability that production starts in 2010 and 60% in 2011, just to be conservative.  The probability-weighted price therefore is CAD 2.86/share (based on DCF analysis), a 138% upside from the close price on May 25; or CAD 3.04/share (based on comps analysis), a 154% upside.

Table 9 Probability-weighted NPV/Share price analysis

One final point of reference: WZR stock has been trailing both its peers with E&P operations in Kurdistan and those outside of Kurdistan, but considered “speculative” by the investment community (see Chart 3).  This chart should also remind the reader that in the short run all speculative oil companies will be correlated to each other (as well as to the price of oil itself).  However, what will differentiate each speculative E&P stock from the others is ultimately going to depend on the success of their respective discoveries.

Chart 3 Relative Equity Performance

Notes:

- Prices on 5/20/08= 100

- Kurdex  = index for E&P companies with operations in Kurdistan, including Addax, DNO, DANA Gas, Heritage Oil, Gulf Keystone, Sterling Energy, HKN, MOL, OMV and Talisman

- SEPex=Speculative E&P companies index, including BRY, BBG, COG, XEC, CXO, DPTR, DNR, KWK, RRC, SM and WLL

Catalysts

Near term catalysts include

• positive results from Kurdamir-1 exploration well
• positive policy development for exporting oil from Kurdistan
• Kurdistan elections on July 25, 2009
• Iraqi federal election in November 2009

Long term catalysts include

• the passage of the Iraqi Federal Petroleum Law
• any other meaningful geopolitical improvement, e.g.  peaceful solution for PKK conflicts with Turkey

Major Shareholders

Note: Paulson & Co built their original position as an offshoot from the merger arbitrage of Western Oil Sands / Marathon Oil completed on 10/22/07.  The recent addition to their position shows conviction in the long term value of WZR.

Management Team

WZR’s management and the Board have extensive experience in both domestic and international E&P companies. Its chairman, CEO, and other E&P related executives all have work experience of over 30 years.

Management Team Profile

Fred Dyment – Executive Chairman

Mr. Fred Dyment has over 30 years of experience in the oil and gas industry. As Executive Chairman, Mr. Dyment provides direction and leadership to management and chairs the Board. Prior to WZR, he was CEO at Ranger Oil Limited and Maxx Petroleum Company.

Simon Hatfield – CEO

Mr. Simon Hatfield has over 30 years of international and domestic experience in technical, managerial and executive positions with Imperial Oil, Exxon Production Research Company, Petro-Canada, Chauvco Resources, Talisman Energy and Western Oil Sands. He initiated the Kurdistan opportunity for WesternZagros and led the technical and business process which successfully concluded the signing and ratification of the Company’s Production Sharing Contract.

Robert Theriault – Senior Vice President Engineering & Operations

Mr. Robert Theriault has over 30 years of international and domestic experience in upstream and midstream oil and gas operations for several companies, including Cairn India Limited, Husky Oil, CSR Petroleum and Suncor.

Greg Stevenson – Vice President, Finance

Mr. Greg Stevenson is a Chartered Accountant with over 11 years’ work experience. Prior to joining WesternZagros, he was Controller at Western Oil Sands.

Dr. George Pinckney – Vice President, Exploration

Dr. Pinckney has spent the majority of his 32 year career with Mobil Oil and ExxonMobil in locations throughout Canada, the United States and Southeast Asia. He holds a PhD degree in Geology.

David Reeve – General Manager, Petroleum Engineering

Mr. Reeve has over 30 years experience in consulting and staff positions in the engineering and operation of projects in China, Iran, Australia, Indonesia and domestic. Prior to joining WesternZagros, Mr. Reeve held the position of General Manager with Ivanhoe Energy in China.

Board of Directors

David Boone President & CEO of Barrick Energy Inc, former executive for EnCana Corporation, PanCanadian Energy and Escavar Energy.

Fred Dyment, former CEO of Ranger Oil and Maxx Petroleum Company.

John Frangos, co-founder and former COO of Western Oil Sands.

Simon Hatfield, former executive with WesternZagros, Imperial Oil, Exxon Production Research Company, Petro-Canada, Chauvco Resources and Talisman Energy.

Jim Houck, President and CEO of The Churchill Corporation, former President and CEO of Western Oil Sands.

Randall Oliphant, Chairman of Western Goldfields Inc. and President and CEO of Silver Bear Resources Inc., former President and CEO of Barrick Gold Corporation.

William Wallace, former President and Chief Operating Officer of Barrett Resources/Plains Petroleum Company; former Regional Vice President and Vice President Exploration with Texaco; and former Group Vice President of CSX Oil and Gas Company.

DISCLAIMER: THE AUTHOR IS LONG WESTERNZAGROS STOCK.

WesternZagros: Hunting Elephants in one of the Largest Untapped Oil Fields on Earth (Appendix I)

Appendix I: PSC Exploration Assets

Iraq has the second largest oil endowment in the world with approximately 115 billion barrels (75 billion barrels undeveloped) of proven oil reserves and 220 billion barrels of proven and probable reserves.  However, it only ranks 13^th in oil production and still has numerous large undeveloped fields and unexplored areas.  Out of the 73 oil fields discovered so far, only 15 are producing.  Six of the 73 oil fields are classified as super-giant (over 5 billion barrels), 23 as giant (500 million to 4 billion barrels) and 44 as medium-to-large (50 to 500 million barrels) or small (less than 50 million barrels). 

The Kurdistan Regional Government (KRG) controls the Iraqi Kurdistan area bordering Turkey and Iran.  It is estimated to have around 45 billion barrels of oil reserves making it sixth largest in the world, mostly recently discovered.  These are excluding those of Kirkuk and Mosul, cities claimed by the KRG to be included in its territory, though in these two cities oil was extracted predominantly by Iraq’s former Baath regime.  The Iraqi Kurdistan area has been both under-explored and under-developed relative to the rest of Iraq and it provides an early-stage opportunity on trend with several large fields, including the Kirkuk field.

Map 1 WZR PSC Location and Zagros Fold Belt Oil Field Map

WZR started to examine oil exploration opportunities in Kurdistan in 2003.  It currently holds a Production Sharing Contract (PSC) with the KRG, which is a 2,120 square kilometer (one of the largest in the region) exploration block (see Map 1 above) in the southern end of Kurdistan.  WZR’s PSC lands are considered to be in the right zip code for a potential large discovery.

• They are within the Zagros Fold Belt Zagros Fold Belt which extends from northern Iraq through Iran to the north tip of Gulf of Oman, which historically is one of the most prolific structures in the world (see Map 1 above). 
• They are on trend with, and adjacent to, a number of historic oil and gas discoveries.  The prolific Kirkuk – Kor Mor – Chia Surkh structural trend runs through the PSC lands, and the Jambur – Pulkhana – Qamar trend skirts along the southern margin of the block.  These discoveries are all located within 60 kilometers of WesternZagros’ block (See Table 1 which shows the distance from other fields).
• Most reservoirs are Tertiary and Cretaceous aged carbonates.  Stacked reservoirs are common within a single field and single zone discoveries are rare.  Most reservoirs are highly fractured and fracturing is a key factor to well productivity and can significantly enhance flow rates. 
• There are over 20 international oil companies with PSCs in Kurdistan (see Map 3).  Among them, DNO, Addax and Dana Gas have made successful discoveries and are ready to export.  Heritage Oil announced a huge discovery in its Miran site early Monday and is expected to start trucking production for sale at the end of 2009.  The Miran well, which is also listed in Table 1, is 65 km from WZR’s PSC and has an estimated oil-in-place of between 2.3 to 4.5 billion barrels.
• According to the resource assessment as of 1Q09 (audited by Sproule and Associates, one of Canada’s leading independent reserves engineers), WZR’s block has P90 prospective resources of 1.6 billion barrels (see Table 2 below). 

Table 1 Reservoirs adjacent to WZR Exploration Wells

Map 2 Companies with PSCs in Kurdistan

 

 

 

 

 

 

 

 

 

 

 

Table 2 Reserves Assessment

WZR completed its Phase I and Phase II seismic programs during the summer of 2008 and acquired a total of 1,547 kilometers of seismic.  Based on seismic interpretation and analysis, WZR has selected and constructed two wildcat exploration wells: Sarqala-1 and Kurdamir-1. 

Sarqala-1 was unfortunately suspended due to a wellbore obstruction and the feasibility and merits of future drilling options are under evaluation.  Drilling of Kurdamir-1 just started early May 2009 and is expected to take 5-6 months.  Based on the numerous records from drilling Sarqala-1, the indication of oil is light (34 to 35 degrees API) and sweet (less than one percent sulphur) and has been geochemically matched to the oil from the giant and super-giant fields in the Kirkuk production area.

Map 3 WZR’s Exploration Wells

Source: Company presentation.

DISCLAIMER: THE AUTHOR IS LONG WESTERNZAGROS STOCK.

WesternZagros: Hunting Elephants in one of the Largest Untapped Oil Fields on Earth (Appendix II & III)

Appendix II: PSC Terms

Under the terms of its PSC, WZR has a 40 percent working interest and the KRG has a 20 percent interest in the PSC which is carried by WZR.  The remaining 40 percent was allocated to Talisman Inc (TLM CN) in June 2008 by the KRG.  WZR, the KRG and Talisman are collectively the “Contractor Group” under the PSC.  WZR is the operator of the PSC lands until the end of the first operating sub-period of the PSC ending December 31, 2010, when a Joint Operating Committee may be established if so elected by the Contractor Group.

Under the PSC, the sharing of oil occurs as follows: of the total oil produced, operations oil is available to WZR for use in carrying out its obligations under the PSC; the remaining oil is subject to a 10 percent royalty payable to the KRG (the residual is considered to be “net available oil”).The net available oil is determined on a development by development basis.  Up to 45 percent of the net available oil is available for cost recovery with the remainder as “profit oil”.  Costs subject to cost recovery include all costs and expenditures incurred by the Contractor Group for exploration, development, production and decommissioning operations, as well as any other costs and expenditures incurred directly or indirectly with these activities.  The portion of profit oil available to the Contractor Group is based on a sliding scale from 35 percent to 16 percent depending on a calculated R-Factor.  The R-Factor is established by reference to the ratio of cumulative revenues over cumulative costs.  When the ratio is below one, the Contractor Group is entitled to 35 percent of the profit oil.  The percentage is then reduced on a linear sliding scale to a minimum of 16 percent at an R-Factor ratio of two or greater.

The PSC contemplates two exploration sub-periods of three years and two years, respectively, with two possible one-year extensions.  The first exploration sub-period ends December 31, 2010.  During such time, the Contractor Group (WZR, the KRG and Talisman) is required to complete a minimum of 1,150 kilometers of seismic surveying (which has been completed), drill three exploration wells and committ a minimum of US$75 million in the aggregate on these activities.  At the end of the first exploration sub-period, WZR and the other parties to the PSC may relinquish the entire contract area (other than any discovery or development areas), or continue further exploration operations during the second exploration sub-period which ends December 31, 2012.

 Chart 1 PSC Structure

Chart 2 PSC Obligations

Source: company presentation.

 

Appendix III: Pipeline Options

Chart 3 Pipelines in Iraq

Given the location of WZR’s block, WZR has three existing pipeline options, all of which need to tie into the pipeline infrastructure around Kirkuk field (see map above)

• Kirkuk-CeyhanSystem(1.6 mm bbls/d)
• Kirkuk-Basra(1.4 mm bbls/d)
• Baniyas-Syria System(250 kbbls/d)

Another route has also been suggested is a Kurdistan system linking between Taq Taq field and Tawke field, both are producing and ready to export.  The system then will tie into the existing Iraq-Turkey Pipeline (ITP) running north into Turkey.  WZR will only need to build up the connection between its oil field to Taq Taq. 

All the options mentioned above will eventually be tied into the pipeline network controlled and operated by the Iraqi National Oil Company, therefore it is essential to have the Federal Oil Law passed before any company can legally export Kurdistan oil through the network.  DNO has been notified by the KRG to start exporting oil on June 1^st, 2009, it remains to be seen whether it is a real concession by the federal government, but it is certainly a significant step forward.  Any progress on DNO’s oil exporting arrangement will certainly provide a future roadmap for WZR. 

Disclaimer: The Author Is Long WesternZagros.

WesternZagros: Hunting Elephants in one of the Largest Untapped Oil Fields on Earth (Appendix IV)

Appendix IV: Geopolitical Issues in Iraq

Safety and Security in the Kurdistan Region

Prior to the US-led invasion in 2003, Baghdad channeled little foreign investment into the Kurdistan region and essentially left the area unexplored.  Following the removal of Saddam Hussein’s administration, the Kurds were back in control and have since kept the region largely insulated from the unrest in other parts of Iraq.  The highly trained Kurdistan Region National Guard “the Peshmerga” are in full charge of the local security.  According to the KRG’s official website, “since March 2003, not a single coalition soldier has lost their life nor a single foreigner been kidnapped in the area administered by the Kurdistan Regional Government”.

The three provinces fully under the KRG’s control were the only three in Iraq to be ranked “secure” by the US military and there are fewer than 200 US soldiers stationed there.  The US Department of Defense also provides quarterly security updates in its report titled Measuring Stability and Security in Iraq (available on its website http://www.defenselink.mil/home/features/Iraq_Reports/index.html).  The following four charts were from the 4Q06, 4Q07, 4Q08 and 1Q09 reports.  The general trend is clear: the number of attacks in Kurdistan provinces (Erbil, Dahuk and As Sulaymaniyah) has been consistently low while the vast majority of attacks, though subsiding, occurred in the middle part of Iraq. 

WZR’s latest 10K shed additional color on the security situation in the region, “WesternZagros believes the Kurdistan Region maintains the safest operating environment within Iraq.  The security in the Kurdistan Region is a direct result of the influence of the KRG through its Kurdistan Region National Guard (the “Peshmerga”) and the Internal Security Agency of the KRG (the “Asaiysh”).  Through the effective deployment of the Peshmerga and the Asaiysh, the KRG has been able to control its regional and international borders and maintain security.  As a standard precautionary measure, WesternZagros has an Emergency and Security Response Plan in place with respect to its operations in the Kurdistan Region.”

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Federal Petroleum Law

The KRG has been fighting with the federal government in Baghdad over control of its oil assets through the negotiation process of the Federal Petroleum Law.  Though a draft Federal Petroleum Law was approved by the Iraqi Cabinet in February 2007, it has never been formally passed due to unsolved issues on how to allocate management of oil fields and exploration areas between the KRG and a new national oil company.  In the face of the deadlock, the KRG passed its own oil law in August 2007 to attract foreign investment and has awarded over 20 exploration contracts (PSCs).  The disputed areas are not in the provinces in which the KRG has full control, but in its partially controlled Kirkuk and parts of Nineveh and Diyala.  The KRG still wants a referendum to decide whether those three provinces should become part of its self-ruling region.  According to the constitution, this referendum should have been held by the end of 2007, but it has been postponed repeatedly.  The KRG is also worried about the potential emergence of another Saddam Hussein type strong man in Baghdad after the US withdraws its troops in 2010, which would potentially jeopardize the KRG’s booming oil economy.

It is still not clear as to when and whether the draft law will be discussed and ratified in the upcoming national elections, but it is in the best economic interest of Baghdad to solve the issue:

• Since 95% of Iraqi government income is from oil, the significant slump in oil prices has forced Baghdad to cut its budget three times already and to seek sources for more cash.  The current oil revenue sharing agreement between Kurdistan and Baghdad is population-weighted, i.e. Kurdistan has 17% of Iraq’s population and will have to give 83% of its oil revenue to the federal government.  It is in the draft oil law and the KRG has committed to support it.  With passage of the oil law and consequently more oil production and exports, cash-starved Baghdad will get more oil revenue from the Kurdistan region. 
• An enacted oil law will also clear the hurdle to export oil from the Kurdistan region to Turkey.  The Turkish government will not take oil from the Kurdistan region without the federal government consent, as the Turkish government does not want to leave the wrong impression that it wants to support Iraqi Kurds.
• There is increasing interest from big international oil companies in the underexplored oilfields in both Iraq and Kurdistan.  According to media reports, several international and government-controlled oil companies are in talks with Baghdad about oilfields in southern Iraq, they include ENI, Chevron, Lukoil, Nippon Oil, Repsol, Statoil Hydro, Royal Dutch Shell, and Total.  China National Petroleum is one step ahead and has already signed a contract for the Ahdab field.  These big oil companies have been waiting on the sidelines for Kurdistan fields due to lack of a clear regulatory framework.  However, they are likely losing patience as more and more discoveries are announced, and the may start to focus more on the lost opportunities by starting to work with the KRG directly. 

This strained relationship between the KRG and Baghdad is currently more of a war of words than a war of swords.  One bit of evidence of gradual progress is Baghdad’s recent approval for DNO to export crude oil from its Kurdistan Tawke field on June 1^st.  

Weblink to the Draft Federal Petroleum Law: http://www.krg.org/articles/detail.asp?rnr=107&lngnr=12&smap=04030000&anr=20267

Relations With Turkey

There are two separate issues in Turkey Kurdistan relations:

• PKK (Kurdistan Workers’ Party) – this is a Kurdistan-Turk rebel group seeking refuge in the Iraqi side of the Kurdistan region.  Turkey sent troops last year to attack PKK’s stronghold in the Iraqi mountains.  The group has no influence on, nor is it a member of the KRG.  It is rumored that the Turkish government even worked with the KRG to seek a diplomatic solution for the PKK issue.  PKK is only active in the northern part of the Kurdistan region, which is far away from WZR’s block.  Escalation of future Turkey / PKK conflicts will have little economic impact on WZR.
• Turkey and the KRG – There are 14 million Kurds in Turkey and therefore the Turkish government has been wary about the potential impact from the self-ruling KRG.  However, there have been signals that both sides are trying to mend fences and to cultivate a friendship out of necessity: For the KRG, Turkey can provide a reliable pipeline route for the KRG to export oil, and more importantly, a potential new security umbrella after the US troops leave Iraq.  For Turkey, Kurdistan is already an important trading partner ($7 billion/year) and there will be much more to come with Iraqi oil exports.  Two Turkey-related E&P companies, PetPrime and A&T Energy even have PSC exploration blocks in Kurdistan.  Politically improving ties between Turkey and the KRG can also effectively contain Iran’s influence in the region. 

Additional Risk Worth Mentioning

The valuation above has priced in a lot of idiosyncratic risks associated with WZR.  One additional risk is a significant systemic selloff or massive de-risking by investors.  This is by no means a Green Shoots or Yellow Roubini type of macro discussion, however another 30-40% selloff is still a clear and present danger at this stage of the economic cycle.  During the selloff in March 2009, WZR hit a new low of CAD 0.29.  Unless there is a significant fundamental change in WZR’s prospects, if that kind of price move repeats itself, we recommend you hit the “buy” button.

DISCLAIMER: THE AUTHOR IS LONG WESTERNZAGROS STOCK.

One Takeway from Berkshire Hathaway Annual Meeting