JS Securities Limited – Morning Briefing

Karachi, December 05, 2017 (PPI-OT): PPL: Our new top pick in the sector – ‘Buy’ with TP of Rs245

We reinstate coverage on Pakistan Petroleum Limited (PPL) with NAV based June 2018 Target Price of Rs245. Our Target Price translates into an upside of 28% from last closing price.

The stock has appreciated by 29% during YTD FY18 mainly on the back of improvement in international crude oil prices (benchmark Arab Light crude up 34% during YTD FY18). Nonetheless, we flag PPL as our top pick in the sector as other E and Ps fall behind in the list of return potential.

Work on Gas Processing Facility (GPF) 3 and 4 continues in full swing and their commissioning may serve as a near term catalyst for stock price performance. In addition, commissioning of Nashpa-Mela project by Dec-17 may also provide a boost.

The stock currently trades at FY18E/FY19F P/E of 8.8x/8.1x respectively and provides D/Y of 5.8%/6.1% for the same period.

‘Buy’ into company’s potential

We reinstate our coverage on Pakistan Petroleum Limited (PPL) with NAV based June 2018 Target Price of Rs245. Our NAV based Target Price incorporates ~Rs162/share DCF contribution from company’s existing reserves portfolio (66% of total NAV), Rs60/share value from exploration potential (24% of total) and Rs23/share cash (10% contribution). Our Target Price translates into an upside of 28% from last closing price, compelling us to tag a “Buy” rating.

Our conviction in the stock’s potential stems from (1) 3yr CAGR (FY18E-FY20F) of 11% in earnings on the back of expected improvement in oil and gas production, (2) improving exploration program helping sustain a relatively old asset base, (3) recent re-pricing of Sui gas field to Petroleum Policy 2012, and (4) outlook of Gambat South Block after installation of GPF III and GPF IV. Our valuations point toward decent upside as despite appreciating oil prices, we remain conservative in our assumptions and assume oil prices of US$58/bbl, US$60/bbl and US$65/bbl for FY18E, FY19F and FY20F period. Beyond FY20F as well, we assume conservative long-term oil prices of US$65/bbl.

The stock has appreciated by 29% during YTD FY18 (outperformance of a massive 43% vis-a-vis benchmark KSE-100 index) mainly on the back of recovery in international crude oil prices (benchmark Arab Light crude up 34% during YTD FY18) and recent developments in Sui and Tal block field re- pricing. Despite steep appreciation, we flag PPL as our top pick in the sector as other E and Ps fall behind in the pecking order of lowest to highest return potential, in our view. The stock currently trades at FY18E/FY19F P/E of 8.8x/8.1x respectively and provides D/Y of 5.8%/6.1% for the same period.

Improving production profile is an encouraging factor

PPL’s reliance on Sui Gas fields has always remained a point of concern as 44% of Company’s natural gas sales come from the same. However, production from other blocks such as Tal and Gambat South has picked up, diversifying company’s revenue base and reducing Sui’s contribution to 39% by FY19. With new discoveries, especially at Tal block, we foresee FY18E crude oil production increasing by ~10% to 17,869bpd. Gas production should also inch up by ~24% to 978mmcfd, courtesy enhanced offtake of Kandhkot field, additions from Gambat South and Tal Block. We expect key discoveries in Tal Block contributing towards production growth in FY18 will be (1) Makori Deep (652bpd oil and 1.87mmcfd gas) and (2) Mardankhel (1,120bpd oil and 11mmcfd gas).

Apart from production growth in Tal block, enhanced offtake from Kandhkot to the tune of 250mmcfd (full year FY18 sales expected to clock-in at 244mmcfd) should help PPL further boost its bottom-line. A minor but helpful contribution will also come from increase in LPG production by 6% YoY to 236tpd (contributing ~4% to company’s net sales). Production additions should help PPL offset reserves depletion from old assets such as (1) Latif (reserves expected to deplete by 4QFY18) and (2) Mamikhel (reserves depleting in FY19F keeping current gas/oil production of ~24mmcfd/695bpd into consideration).

We remain comfortable with outlook of company’s exploration program where strong balance sheet strength is helping the company venture into difficult and largely untapped territories of tight/shale gas. For our valuations, we assume an average of 11 exploratory wells for the company every year with conservative success ratio rate of 20% (~3 discoveries every year with average size of 15mmboe).

Sui fields re-pricing is a major gain

Sui gas field was recently granted approval for re-pricing from 50% of Petroleum Policy (PP) 2001 to 55% of PP2012. The conversion was applicable on production from 1st June-2015 onwards (for incremental gas price) for which the one-off retrospective revenue impact of Rs31.124bn (Rs15.79/share before taxes) has been booked in FY17. This re-pricing will fetch higher prices over US$4/mmbtu at current oil prices. Additional revenues from Sui will help the company put greater focus on reserve replacement at Sui fields and elsewhere. That said, two development wells were drilled and completed in FY17 at the Sui field with total incremental production addition of 16mmcfd. Sui’s mining lease (expired since May 31, 2015) extension remains issue for the time being and company continues to operate on the basis of half yearly extensions (recent was granted on June 01, 2017).

However, we only see it as regulatory delay and expect this issue to be resolved soon as the MoA signed between the Government of Pakistan (GoP) and Government of Balochistan (GoB) has already been approved by the Economic Coordination Committee (ECC) and award is expected to be made soon. Apart from Sui field conversion, pricing regimes of Tal Block fields namely Mamikhel (converted to PP2007 from PP2001), Maramzai and Makori East (converted to average of PP2001 and PP2009) were revised recently and retrospective revenue impact of Rs4.2bn was booked in 1QFY8 accounts. Going forward, higher gas prices along with increased production should help boost company’s bottom-line.

Gambat South – a goldmine for PPL

The potential of Gambat South Block remains untapped for the time being, given gas-processing constraints at the field. To address this issue, PPL continues to work on Gas Processing Facility (GPF) III (expected commissioning in Mar 2018) and IV (expected commissioning in 4QFY19). Work on GPF II with capacity of 50mmcfd has already been completed and completion of GPF III and IV will likely result in combined installed capacity of 180mmcfd by the end of FY18. In this regard, company’s 1QFY18 report highlights that plan for relocation of recently acquired Rehmat Gas Plant (now treated as GPF-IV) has already been made and letter of agreement has been signed with Sui Southern Gas Company Limited (SSGC) for supply of gas from the block.

The work on both GPF III (presently under procurement and construction phase) and IV continues in full swing and their commissioning may serve as a near term catalyst for stock price performance. Completion of these projects will enable PPL to add recently discovered assets such as Wafiq, Kinza and Kabir into production. We assume increase in production from Gambat South to the tune of 70mmcfd (10mmcfd from increased production from Shahdad and remaining from Faiz and Nasr) with commissioning of GPF-III which will help PPL boost its topline. Accordingly, during FY18, we expect Gambat South block to contribute ~10% to company’s gross natural gas sales, which is likely to improve to ~15% during FY19. Apart from GPF project, commissioning of Oil and Gas Development Company’s (OGDC) Nashpa-Mela project by Dec-17 may also provide a boost with production addition to the tune of 1,200bpd from 2HFY18 onwards.

Key risks and sensitivities

Key risks to our valuations include (1) sharp drop in international crude oil prices, (2) delays in commissioning of GPF III and GPF IV, (3) higher than expected dry- wells cost, (4) delays in approval of Sui mining lease (extensions require bonus payments) and (5) appreciation of Pak Rupee vis-à-vis the greenback. Our sensitivity analysis suggests that every US$5/bbl change in our oil price assumption changes our earnings forecasts by +/-6% for the company.

For our valuations, we have incorporated average exchange rate assumptions of Rs108/US$, Rs120/US$ and Rs125/US$ for FY18E, FY19F and FY20F period respectively. Beyond FY20F, we incorporate exchange rate depreciation of 4% per annum. As revenues of E and Ps remain denominated in US$, our earnings estimates are sensitive to changes in our PKR/US$ assumptions. That said, our sensitivity analysis suggests +/-7% change in our annual earnings estimates for every 5% change in our PKR/US$ assumptions.

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