Tap Oil's broken thesis

The start of production from the Manora oil project was supposed to be a breakthrough for beleaguered Tap Oil. For years, the business had struggled without production and was living off revenue from (lucrative) gas contracts due to expire in 2016.

Renewed oil production should have brought swelling cash flow and a higher share price – and it would have, had oil prices stayed close to US$100 a barrel. We all know what happened instead: production from Manora has coincided with a vicious fall in prices that has slashed revenues and decimated the share price.

Debt facilities, tied to Manora revenue, have also been reduced, lowering cash available to Tap from US$90m to less than US$70m. The shortfall would not have mattered except that higher than expected costs are due to be paid with lower than expected revenue. Manora – supposedly the saviour of the business – hasn't worked as planned.

Although that debt facility has now increased, Tap will pay higher interest rates and take on hedging to ensure it has cash flow to meet additional costs and repayments. About 40% of production for the rest of 2015 will be fixed at US$62 oil, reducing the upside from the project considerably. Although the probability of operating losses are now low so are the returns from higher prices.

Possible takeover

In three years, the company will have to repay about US$80m in debt so it is under some pressure to raise revenue from production or from asset sales. To that end, management announced a strategic review to sell assets or the company itself.

Much of Tap's value lies in undeveloped gas fields that could supply large production facilities after 2020. Those assets, however, provide no immediate revenue and will be a tough sell in an environment where producers are preserving cash. If they are sold at all, it is likely to be on the cheap.

Recognising the company is wounded, Tap's joint venture partner at Manora, Thai-based Northern Gulf Petroleum, has snapped up 20% of Tap's shares and announced a shareholder meeting to remove a number of directors and replace them with its own nominations.

Northern Gulf would have close knowledge of the value of Manora and their actions suggest there is latent value in Tap. We wouldn't be surprised to see a takeover offer made at some stage although at today's oil price and cash flow restrictions, it isn't going to be a pretty price. Tap has become another casualty of the oil price fall.

Broken thesis

We don't recommend supporting Northern Gulf's action to change the board. If they want control of Tap, we'd prefer they make a bid and pay a premium for it.

Our investment case for Tap was that fresh production would lift the value of the business and hard asset value – from undeveloped gas assets that the company could leisurely sell – provided some downside protection. That thesis is now broken.

At current oil prices, returns from Manora are marginal and hedging limits improvement in the event of higher prices. Tap is now a forced seller and is unlikely to realise full value for its suite of gas assets.

That a business flush with cash two years ago will struggle to survive independently shows how ruthless this industry can be. We got this one wrong but, with a takeover a strong possibility, a sales process underway and no immediate balance sheet concerns, it's worth hanging on to see what happens next. We're forgoing a recommendation guide at this stage but will revisit Tap as events unfold. For now, HOLD.