Ideas Lab: Karoon Gas

The mission of every value investor is to buy a dollar for fifty cents. If only life were so simple. Such opportunities, if they arise, tend to be situations plagued by problems and uncertainty – not suitable for conservative investors but perfect targets for our Ideas Lab, where we highlight unusual opportunities with a wide range of outcomes.

The opportunity today is clear. Wannabe oil producer Karoon Gas currently sports a market capitalisation of $590m, or $2.40 a share, having fallen from highs of over $10 a share in 2011 and over $4 a share as recently as September.

Karoon generates no revenue and will have to spend billions to bring new oil discoveries to production. Still not interested? This might change your mind: the business has no debt and cash in the bank of $680m. Yep, you read that right folks. Karoon is trading at a 15% discount to its cash backing.

So why is this an Ideas Lab and not a screaming Buy? That huge cash pile is already earmarked for additional drilling and won't be allocated to shareholders. Karoon is statistically cheaply but, make no mistake, this is still a risky oil business.

This isn't a case where a cash rich business is being ignored by a neglectful market. As a one-time market darling – the company had a market cap of almost $4bn at its peak – Karoon is well understood. It is cheap not because is it neglected but because low oil prices have decimated the value of its assets.

Assets for cash

Most oil businesses work to churn oil into cash. Karoon has no production assets and won't be generating revenue for a while. Instead, it is rich with assets and its strategy is to sell equity stakes in those assets to ultimately fund development.

The company's track record is good. Last year Karoon sold a stake in the Poseidon gas field, off the WA coast, to Origin Energy for US$800m (including an upfront cash payment of US$600m). A year earlier, Karoon had sold a stake in the same field to PetroChina for $410m.

These sales have built the company's current cash horde. The company is using some of that cash to buy back shares but shareholders should understand that they are unlikely to see much returned in the way of dividends. In a market hungry for yield and spooked by low oil prices, it's easy to see why there is a gap between the cash on the balance sheet and the value of the business.

Instead, Karoon will plough cash into field development, an activity the market is telling us will waste a colossal amount of money. We don't think that's the case. At least, it's no certainty.

Oil discovery

Karoon holds exploration assets off the coast of Brazil and Western Australia. Having sold out of Poseidon, its key asset is now the Kangaroo oil discovery in the Santos Basin, offshore Brazil. In waters 400m deep, Karoon has found oil flowing at a terrific clip (6,000 barrels a day from a production test).

The company has drilled an additional well, Kangaroo-2, which also came up with oil. With 65% equity in the permit, Karoon has an enormous exposure to the discovery and suggests it could contain 330m barrels of oil. These aren't confirmed numbers, just a best guess from early tests.

As an undeveloped but commercial asset, we think Karoon's stake should attract a net present value of $5–10 per barrel of oil. In dollar terms, that's a potential value of $1.6–3.3bn – multiples of today's share price. If the company develops the field and is able generate cash from it, it would be worth even more. There are two obstacles to making the project commercial.

Firstly, significant expenditure needs to be made by the joint venture. Karoon plans to use its cash pile and the proceeds from additional equity sales to fund that expense. The second obstacle, unless cleared, would make the first impossible to achieve. To be commercial, Karoon needs a higher oil price. Our best guess is an oil price of US$60 will deliver acceptable economics but prices of about US$80 would be ideal to encourage buyers to take a stake.

No-one is going to stump up billions of dollars for an uneconomic oil project. Funding the project is a small risk; the oil price is the big risk.

Enter the Ideas Lab

The risks are clear and so is the opportunity. At today's oil price, Karoon is potentially worthless. The market is valuing its assets at zero, a valuation that is easy to justify. At higher oil prices, however, the company should be able to sell equity in the Kangaroo field which could be worth multiples of today's market value. Karoon is an effective option on oil. That option is going cheap thanks to a huge cash pile. It also means Karoon can stay afloat if prices remain lower for longer. The business is very agressive and has already outlined plans to spend $100m next quarter drilling. It is unlikely to sit out the slump. Karoon will succeed or it will go bust.

We aren't formally recommending the stock today because the business generates no revenue and is not expected to for years. It faces huge capital expenditure commitments that only pay off if the price of oil goes up. Such binary outcomes are high risk speculation which means this Ideas Lab is not for everyone. For those who are looking for exposure to the oil price, however, this appears an attractive way to get it.