“Kudos In Kurdistan”

Could a dip in oil prices provide the perfect entry point for Gulf Keystone and Genel Energy?

After a tremendously difficult couple of years, strong oil prices and relative geopolitical stability in Kurdistan have led shares in Gulf Keystone (LSE:GKP) and Genel Energy (LSE:GENL) to soar so far this year. With renewed stability in payments from the region’s government leading both firms to see their cash balances fly and their debt fall, we believe a correction in oil prices could present a great buying opportunity.

Volatile times

Both Gulf and Genel were floored in 2015/16 by geopolitical tensions in the Iraqi region of Kurdistan. The ongoing threat of attack from Daesh meant that security forces were forced to defend the region’s border for a long-time, leading its financial position to suffer in the process. As a result, the Kurdistan Regional Government (KRG) was frequently unable to pay for the oil provided to it by companies operating in its jurisdiction, and balance sheets suffered heavily in the process.

Things reached a head for Gulf, which operates the Shaikan Field in Kurdistan, in April 2016 when it defaulted on a $26m debt payment. The widespread disruption led the firm, previously a much-hyped name among punters, to see its shares drop from it’s high to lows of sub 90p in just over a year. Likewise, Genel, which is the largest holder of reserves and resources in the Kurdistan Region of Iraq, saw its shares drop from highs of 559p in 2015 to lows of 77p the following year.

In the years since then, both companies have benefitted as geopolitical tensions have cooled and the Kurdistan government has set about repaying debts ensuring it regularly pays both firms for their oil. In 2017, Gulf received 11 payments from the KRG amounting to $132 million net, allowing it to report its first profit since entering Kurdistan. Likewise, Genel received subsidies for oil from the KRG in every month of 2017, totaling over $260 million net which represents a large proportion of the market cap today.

These moves forward have continued into 2018 as well, with both firms soaring after signing landmark sales agreements with the KRG in January this year. So far in 2018, Gulf has seen its shares soar by 95pc to 210.5p while Genel has risen by 156pc to 282.5p.

Debt/cash

Crucially, these government payments are generating vast amounts of cash flow for both firms, allowing them to cut their debt and increase their cash balance majorly. For example, in 2017, Genel generated $140 million of free cash flow, up from $59.1m in 2016, allowing it to cut total debt from $674.6m to $300m. Meanwhile, its cash balance stood at a whopping $162m at the end of the year. Likewise, as at 10 April, Gulf Keystone had a cash balance of $203m (£151.7m), more than double its $100m debt and nearly a third of its current £491m market cap.

These strong cash balances are allowing both firms to increase their operational ambitions going forward as well. Genel plans to take tangible steps to further de-risk gas resources and unlock value from its Bina Bawi and Miran fields, including high-value oil resources. In its results, the company added that, based on a continuation of payments throughout 2018, it expects to generate material free cash flow over the year – could dividends be on the cards? Similarly, subject to finalising certain commercial and contractual matters, Gulf Keystone has said it is ready to resume investment into Shaikan in 2018.

Neither firm is likely to reach their pre-2016 valuations again any time soon, but the fact that they are both even considering further investment shows how much progress they have made over the past 18 months.

Oil market

Another factor bolstering both firms is the recent strength of the oil market. With oil companies typically selling their oil at future prices, they are likely to benefit from the recent spike in prices when they come out of their last hedged contracts.

Given the strong prospects of both businesses and the fact they can generate profits when oil prices are weak thanks to low operating costs, we believe a correction in the oil price will present a buying opportunity. Like many analysts, we think that a drop is due imminently given how quickly they have risen from lows of $28/bbl to their current, unsustainable highs. When this happens and both firms re-rate to a lower price, the sheer volume of cash they have on their books will both provide protection and attract investment as prices rebuild. That being said, they will also benefit if the bulls are right and prices continue to rise.

Despite this potential upside, one, of course, needs to consider the fact that companies like Genel and Gulf do carry inherent risks. If oil prices tank as they did in 2014 or Kurdistan experiences another period of heightened volatility, then both businesses are likely to suffer – in this case, it worth getting out at the first opportunity. If experience has taught us anything, it is that things usually end up getting worse.

These are both perfectly realistic disaster scenarios faced by oil companies operating around the globe. If you are comfortable with stomaching them, then, on the flipside, Genel and Gulf could offer some excellent upside potential.

 



Categories: Bulletin