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Northern Petroleum – Downward reserve estimate hits the share price: Buy at 72.5p with a 120p target price

On Friday 27th May Northern Petroleum shocked the market with a downward revision of its reserves estimates in Holland and its 2011 output forecasts – however we believed that the market has over-reacted in a big way, giving investors a highly attractive entry point. We have reduced our target price from 167p to 120p but with the shares at just 72.5p our stance is very firmly buy.

The company has revised down its 2P reserves by 12.97 million barrels of oil equivalents (mmboe) from the 2P reserves of 102.67 mmboe reported at the end of the first half in 2010. The problem has been in The Netherlands where three of the four gas fields has not produced as much gas as anticipated; and all these reserve reductions have all come in the Dutch 2P gas reserves which have been lowered from 153.86 Bscf to 78.62 Bscf. Such a move suggests that previous future production targets might not be met. However there is long term testing at Ottoland is expected in the third quarter of this year with the first Papekop oil development well is planned for later on this year. What seems to have spooked the market is a possible further revision to come, future gas production below expectations and a loss for the year due to additional non-cash depletion and impairment charges. Coming ahead of the final results this was in all effects a profit warning.

An on-going economic and technical valuation has been carried out by the company for some time now which has involved reprocessing the 3D seismic data over the Geesbrug and Wijk en Aalburg fields as well as much of the rest of the Netherlands acreage. This downgrade of the reserves was made for the sake of prudence and the board seemingly pointed out that when all this data has been received and interpreted, the static and dynamic field models will be updated with the production data later this year and then it will be possible to make a further assessment of the reserves. Following the change in reserve estimates for Geesbrug, Grollo and Wijk en Aalburg the company expects to make a loss for 2010 due to additional non-cash depletion and impairment charges; and no guidance on this was provided to investors.

The pill was slightly sugared by production numbers, Markwells Wood and Italy average production for 2010 was approximately 1,200 barrels of oil equivalent per day (boepd) and 2010 revenue is expected to be €15 million, which is in line with market estimates. Production has been rising significantly as in the first four months of 2011 average production was just over 1,900 boepd. Over the same period average gas prices have increased by 13%. At Markwells Wood in the UK, the production test is expected to commence in late July/early August summer of the oil discovery that was made in December 2010. Progress continues to be made in Italy to move towards drilling some of the exploration prospects. In the Southern Adriatic plans are being advanced to acquire 2D seismic survey over permits F.R35.NP and F.R40.NP which contain the Giove and Rovesti discoveries as well as two 3D seismic surveys will be acquired over these two oil fields and a number of exploration prospects later on this year. Blackwatch Petroleum Services in 2007 reported 2P Reserves of 53.16 million barrels for these two fields and a post-tax Net Present Value of £610 million at $70 a barrel.

Northern has never seemed to have been given recognition by the market for a series of potential half a billion plus barrel prospects to explore off the coast of Italy. These are potentially high impact exploration prospects where success could be transformational for the Company. These exciting prospects lie within four core areas, one of which has already been snapped up by Shell, leaving three more core areas to trade. Northern has acquired a large number of key licences in prospective areas in offshore Italy, which is equivalent in size to more than 85 North Sea blocks. With applications pending, it could be that the Company ends up with a licence area about the same size as that of ENI, the Italian multinational oil and gas company. Northern is now beginning the process of unlocking value offshore in Italy with drilling. Its partner Shell is expected to make a drilling decision shortly on the West Sicily Thrust Belt for a well to be drilled in 2012 which could led to a strong re-rating of the shares.

During the past decade, Northern has consistently added shareholder value by growing its portfolio of good quality oil and gas prospects without paying high entry costs. The real focus has been on low priced assets where value can be added at a relatively low cost. At the heart of the strategy is the winning of valuable exploration licences which is followed by the Company undertaking the necessary geological, geophysical and engineering work to dramatically add value before inviting larger players to farm in into the projects at an exploration or development stage, or traded to acquire production. The plans to acquiring more seismic data are a clear sign that the board is accelerating it’s the development of its assets in Italy which should allow farmouts to be agreed at better terms. We await news on whether Shell wishes to progress its joint venture with Northern on six permits on the Company’s acreage off-shore Sicily. Seismic data has been processed and a go ahead decision on drilling by Shell would be transformational for Northern. The team is also seeking to agree farmout deals on the other three core areas which are: Sicily Channel Basins, the Durres Basin in the South Adriatic Sea and the Crotone Basin in the Ionian Sea. The recent proposed ban of any oil production within 5 miles of the Italian shoreline will have little material effect on Northern as its most of its acreage is further away from the coastline.

The City does not appear to really understand Northern’s focus on accelerating exploration activities in Italy whilst seeking to increase production in The Netherlands. The board had its sights set on a producing 5,500 boepd in 2015, but the likelihood is that the forthcoming results might come with a downgrade of future production targets. Although production is currently running at 1,900 boepd so far this year, it is still short of the 2,250 boepd that had been expected in early 2011. Our pre-tax profit forecast is probably wrong as it is difficult to quantify the loss expected for 2010 with such provisioning as the company might take the opportunity to kitchen sink it. Our 2011 numbers will be revisited following the announcement of the final results.

Northern has actually always traded at a big discount to the sector based both on EV/2P and EV/sales ratio. To keep matters in perspective, the fall in 2P reserves represents 15% of the complete portfolio although it accounts for almost half of the Dutch 2P gas reserves. So the latest weakness in the share price has simply served to increase these discounts still further. Even assigning Northern a rating equivalent to 30-40% of EV/2011 figures for peers Europa Oil & Gas or Faroe Petroleum, would give us a target price of 120p. Although it might take some time for the company to regain the confidence of investors it now looks as though compared to any valuation metric that the stock appears to have been oversold. Northern must now be seen as a bid target as – after this downgrade – we believe that a cash offer at even 120p a share might be hard to defend. Our stance is a buy with a 120p target price.

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