March 8, 2014

A contingent stock

A few disclosures – This is a borrowed idea. I will not use the word steal, as I got it from a friend J

This idea was published by Ayush on his blog (see here) and then he mentioned it to me via an email. I was intrigued by the extremely low valuation (which is not obvious) and some medium to long term triggers.
I started looking at the company in the month of December, and before I could create a full position, the stock price ran up. Inspite of the run up, the company is an interesting, though speculative opportunity.

Another disclaimer – I hold a small position in my personal portfolio, but as it is a speculative idea, I have not added it to my family or the model portfolio.
The company
The name of the Company is Selan exploration and it is an E&P (exploration and production) company. The company has five oilfields – Bakrol, Indrora, Lohar, Ognaj and Karjisan
As part of the NELP policy, the company has the rights to explore and develop these oil fields. The company was among the first private sector players to get the rights to do so and if successful in finding oil and gas reserves, they have to pay a certain level of royalty to the government. In addition, the entire production of the company is taken up by the government or PSU under the production sharing contracts

The E&P business
The basics of exploration and production are actually quite simple to understand – The government grants the license to explore and exploit a specific area which may be rich in hydrocarbons, under a specific contract. The company winning the contract then undertakes exploration of the area using various advanced technologies such as 3D seismic surveys and exploratory drilling to identify the size of the reserves and the best location to drill wells to exploit these reserves.

Once the reserves are delineated (identified), the company applies for the various clearances (such as environmental) which once approved, allows the company to drill production wells. Although the technology is quite advanced and allows a company to identify deposits accurately, it is not a precise science and hence a certain percentage of the wells may turn out to be dry wells (not enough oil in that particular location). These dry wells have to be abandoned and the cost has to be written off (similar to a product which fails in the market).
The productive wells, once online produce oil and gas which is transported via pipelines or other means to oil refineries.

The problems
Let’s start with the problems which have caused the stock price to stagnate over the last few years. That will also give us an idea of the medium and long term triggers for the company.

The company was granted the exploration rights in the 90s and has been able to increase the production from 62000 BOE in 2004 (barrel of oil equivalent) to roughly 2.82 Lac BOE in 2009. I described the process of license, survey, clearances and approvals to get to the final production stage of drilling the production wells and pumping out the oil.
As you see from the process, we have government involvement at each step and anything where the government is involved means lack of clarity and uncertain timelines.

As has happened for multiple sectors in the economy, the clearances for drilling production wells came to a halt in the last four years. Due to the nature of oil exploration and production, the current wells start getting exhausted in time and if you are not drilling new wells, the overall production starts dropping.
In case of Selan exploration, production dropped from 2.8Lac BOE in 2009 to 1.64 Lac BOE in 2013. The revenue dropped from 99 Crs to around 97 Crs in 2013 and the net profit was roughly the same (at around 45Crs)

A mumbo jumbo of terms
Before I get into what is the opportunity here, let’s talk about a few terms for the Oil and gas industry. For starters, barring Selan and Cairn (I), I don’t think the PSUs in this sector are worth considering as investments. These companies are run as piggybanks by the government to subsidize fuel in the country. It is debatable on how good that is for me as a citizen, but I am clear that it is a disaster for a shareholder.

If you want to understand how the industry works (without the chaos of government interventions), you may want to look at US and Canada based companies such as Chesapeake, Devon energy or Exxon Mobil. If you are looking at a pure play E&P Company, there are several small companies such as Novus energy or Jones energy.
Why bring up these non Indian companies? Any US or Canada based company has to declare several key parameters which help an investor to analyze an exploration company. Some of those parameters are

2P reserves (proved and probable reserves)
Operating netback per BOE : revenue minus cost

NPV10: DCF valuation of the reserves (revenue based)
EV/BOED: Enterprise value/ Barrel of oil equivalent in reserves (valuation measure)

Cost curves, EUR, Exploration cost and well IRR (for each field)
Current oil flow rate (BOED) to understand the current revenue levels

You can find the definitions easily by doing a Google search for these terms.
So which of this data is provided by Selan exploration? None!

Are they doing anything illegal? No, because I don’t think there are clear disclosure norms on the above for Oil and gas companies in India (none that I could find). In comparison, Cairn (I) has more disclosures and communication.
The thesis
In absence of this disclosure, why even bother and move on to something else? That is a valid point and hence I have called it a speculative bet as I am making it with minimal information.

What do we know here?
For starters, it seems that the company has 79.2 Million (7.9 Crore) BOE of reserves in two fields alone (Bakrol and Lohar). The company sells at around 1.2 dollar/ BOE (EV/2P) versus 5.5 for cairn (I). Comparable companies in the US/Canada sell at around 8-12 dollar/BOE. Of course the foreign companies are not comparable, due to a very different regulatory environment.

In addition to this valuation gap, we are not even considering the potential reserves in the other fields (which seem to be bigger than the ones in production). So we are talking of a situation where the market is valuing the company based on the current production rate (Which is suppressed due to lack of approvals) and is not giving any credit for its reserves.
The company is able to generate a pre-tax profit of around 70 dollars / BOE versus 10-25 Dollars for the US/ Canada companies. The huge difference is due to the fact that Selan produces mostly oil compared to oil and gas in case of other companies.

So the company is very cheap based on known reserves and is also quite profitable. In addition the company has spent close to 65 Crs in the last three years on exploration expense (remember the surveys to find the oil and gas reserves?). Once it starts getting the approvals, it can start drilling the wells and start pumping out money …sorry oil.
So why is this still speculative or contingent? It is contingent on the company receiving approvals - Which is seems to be getting recently based on the update in the latest quarterly report. These approvals are based on the whims and fancy of our government and one can never be sure what will the scenario be next year.

Why is it speculative – because there is so little disclosure and we are using the reserve numbers from a past annual report? We do not have any clear updates in the latest reports and so it is like driving with a foggy windshield window.
I have taken a small bet on the company to track the company and may buy or sell in the future based on new developments. As always, please do your homework and make your own decisions.

Stocks discussed in this post are for educational purpose only and not recommendations to buy or sell. Please contact a certified investment adviser for your investment decisions. Please read disclaimer towards the end of blog


Anonymous said...

Hi Rohit,

Thank you for the post. Had a small query. You had written that Selan sells at around 1.2 dollar/ BOE (EV/2P)whereas a pre-tax profit of around 70 dollars / BOE. Am i reading it correctly or missing out something here. Kindly help. Thanks

Samir Shah said...


Thanks for highlighting the lack of disclosure.

Just wanted to add a couple of points:

a) Selan was given these fields as part of a policy to give away "discovered fields" with marginal quantities of oil/gas, which would not interest a bigger player like ONGC.

Unlike other Production Sharing Contracts (PSC's, like Cairn or Reliance)under NELP, the profit petroleum that selan has to share is only around USD 5 per barrel. In the NELP contracts, the profit petroleum is based on a percentage of the revenues, and this percentage keeps increasing once the operator has recovered an investment multiple. For example, it might mean that the govt. keeps 85% of the revenue once the operator has recovered 300% of the cost of exploration and development. Cairn already pays close to 30%. Unless it keeps spending more on Capex, this percentage will keep going up. This is not the case with Selan. It also means, in theory, that the government (read DGH) is not bothered about the costs that Selan incurs. Theoretically, this should mean easier approvals for digging wells, as the government does not lose anything. In practice, of course, these approvals were delayed, even if from an environmental perspective.

b)However, to compare EV/2P for a company like selan, which is operating in a marginal field, to the EV/2P of a field like Barmer, which is much richer, is like comparing apples to oranges. The oil flow per well is higher for Cairn, and the prospect of recovering much of the oil is higher. So it deserves a higher valuation.
c) I think that one thing that most people don't realize for exploration plays is that these licenses are given for a certain length of time. For example Cairn's license for Barmer expires in 2020. Now, in theory, the license should simply be extended. After all, around this time, much of the revenue for the fields should belong to the government anyway. However, as we have seen in the expiring spectrum case, this may not mean an automatic extension. In which case, projecting revenues and profits beyond the license period may be fraught with some risk.

I think for Selan this issue will be relevant in 2028, so there is less of an issue here than with Cairn.

Rohit Chauhan said...

Hi anon
yes you are reading it right. however 2P reserves are estimated reserves in the ground. there is a lot of cost in getting to them and risk too. so its not as profitable as it looks


Rohit Chauhan said...

Hi Samir
great points.

I agree one cannot do a precise comparison with cairn india due to difference in reserves. actually each oil field is different.

at the same time , look at the operating netbacks of the cost and royalty both the companies make roughly the same pre-tax profit per BOE. so although the fields are different, economics are similar

in addition, we have a few fields which are large but reserves are not known and should be more than 0

the biggest concern for me is lack of disclosure and regulation. we are driving blind here


SAIBOT said...


Taking the current state of the global oil market(oversupply, etc.) where does selan stand now?

Even if they get proper clearances and start producing oil, will the market take it up positivly. If the crude price is going to stay low for long then what is the future of selan we are looking at?

What are your thoughts on this?