JCO

The oil price is recovering, but that’s Jericho Oil’s (JCO.V) worst enemy. As the company is employing a ‘growth through acquisition’ strategy, a longer period of low oil prices would have helped Jericho to acquire more assets at fire-sale prices.

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The third quarter of 2016 was pretty much business as usual

As mentioned before, you could easily disregard the company’s income statement. As the total revenue was just $102,000 with a net loss of C$1.33M (due to stock compensation expenses booked in the third quarter), the income statement definitely shouldn’t be relied upon to make an investment decision. After all, the official ‘revenue’ numbers only take the company’s Kansas operations into account, and under International Financial Reporting Standards (‘IFRS’) Jericho is forced to report on its Oklahoma ventures as ‘investments in joint ventures’.

Fortunately the company provided a comprehensive review of the Oklahoma assets in its MD&A report, and the total net production rate for the JV partners (based on the respective net well interests and after allowing for the loss of some gas during the transportation process) was 566 boe/day. The oil was sold at an average of $42.87/barrel whilst the partners were able to sell the gas at $2.56/Mcf. That’s encouraging as A) the oil price is now substantially higher and B) with the natural gas price trading strongly above $3/Mcf, Jericho should be able to benefit. Also keep in mind the acquisition of the Enervest assets in August has only been taken into account from August 1st on.

The total lease operating expenses were US$1.1M, resulting in an operating income of $0.7M for the quarter and even after paying the production taxes and covering the G&A expenses, the partnership was profitable and the only thing pushing the bottom line into the red territory was the depreciation rate which is a non-cash charge.

The total lease operating expenses were $21.24/boe, and with an average sales price of $36.47/boe, the operating netback was approximately $15/barrel, and that’s almost exactly in line with our expectations.

The results of the partnership also clearly show why economies of scale will be extremely important for Jericho and its private partner. In Q3, the G&A expenses were almost $6/barrel and if Jericho would be able to double its production rate whilst allowing the G&A expenses to increase by just 25% (which is reasonable, as the oil production sector isn’t a human resource-intensive process), the G&A cost per barrel would fall to less than $4, with the $2/boe cost saving directly benefiting the shareholders.

Two new additions to the team

Jericho Oil was also able to capitalize on the weak oil market in its human resources department. The company attracted James Palastak as its Director of Engineering whilst Shane Matson has been appointed as Director of Geology. Both gentlemen have a tremendous amount of experience in Oklahoma.

James Palastak used to work for Devon Energy (DVN) where he was the lead engineer responsible for Devon’s Mississippi Lime and Woodford horizontal drill programs on a 200,000 acre land position with a total production of in excess of 10,000 barrels of oil-equivalent per day.

Shane Matson is coming over from Midstates Petroleum which went bankrupt last year. Matson appears to be the specialist in discovering viable oil reservoirs that had never been discovered before, so his appointment could be very important for Jericho as it intends to explore its large land package.

What will 2017 bring?

2017 might actually be the most important year in Jericho’s history. Should the oil price remain above $50 per barrel, the M&A potential might disappear fast. After all, Jericho’s main advantage was to be a ‘new player’ in the Oklahoma oil sector with the financial means to purchase assets out of bankruptcy, or from distressed producers.

At $28 oil, virtually none of the producers were making any money. The same remark was valid at $40 oil, as the interest expenses were eating away the entire operating margin of debt-ridden companies. However, with the oil price back at $55 most companies will now once again be able to service their debt, whilst the size of their credit facilities will no longer be cut.

This doesn’t mean Jericho won’t be able to opportunistically acquire more assets, but it does look like the era of real bargains is over. We aren’t expecting a huge acquisition which could turn Jericho overnight into a sizeable producer anymore, but we do think Jericho will fall back on its strategy to acquire mid-sized oil projects. The M&A market should remain open for properties which are too expensive for an individual, but too small for a large producer. And THAT is the sweet spot Jericho will focus on.

The higher oil price also offers some advantages for Jericho Oil. First of all, should it be able to find a new acquisition target, it will be able to fund a higher portion of the acquisition price in debt. Lenders are looking at the energy markets again, whereas their cheque books remained closed twelve months ago. Additionally, a higher oil price could also mean sellers would be inclined to take (a portion) of the sales price in Jericho stock as it would allow the seller to continue to benefit from the sold properties.

Secondly, the higher oil price could (and should) incentivize Jericho Oil to start working on its own properties. We would expect some minimal work-overs (having another look at shut-in wells and re-fracking some wells) with oil trading in the $50 range, but should the oil price increase to in excess of $60 again, Jericho could easily drill a few wells on its own. Drilling these wells could be funded by the East West Bank credit facility which will very likely be upsized as the oil prices rise.

And finally, a higher oil price and higher strip price will increase the value of the company’s reserves. We will probably have to wait another month or so before seeing the 2016 year-end reserves, but it will be interesting to see the expected PV10 after the recent acquisition in August. A better strip pricing could also incentivize the company to hedge an additional part of its expected oil production to protect its cash flows.

Should you worry about the lawsuit?

In November of last year, Jericho Oil was named in a class action lawsuit in Oklahoma along with 26 other defendants. The petition, filed in Pawnee County, alleges the 27 oil and gas companies caused the earthquakes through the disposal of fracking wastewater.

Facing a lawsuit in the USA never is a fun thing to experience, but for now, we aren’t too worried about the class action suit. First of all, the lawsuit seems to be specifically targeting how companies are disposing their wastewater, and this could actually be a positive for Jericho Oil.

As part of its Enervest acquisition which was completed in August, the company acquired a 100 kilometer long pipeline system and Jericho Oil has enjoyed some interest from third parties exploring the possibility to use the pipeline to dispose of their wastewater. So if anything, the increased attention for how companies are dealing with fracking wastewater could be a positive for Jericho Oil.

Secondly, Jericho Oil was transparent enough to release the news of the lawsuit before closing the first tranche of its private placement in November. Not only is it positive to see this level of upfront-ness, the company also approached every participant in the private placement to make sure they had seen the news. All participants had the chance to withdraw their investment, and none of them did so. A lot of smart money came in in the previous financing, and none of them seemed to be rattled by the pending lawsuit.

It’s a nuisance, for sure, and we would prefer the company to spend cash on the properties rather than having to defend itself in court, but we aren’t losing any sleep over it.

Conclusion

Jericho’s original plan was to grow by acquiring producing properties, but as the oil price is increasing it might make sense to drill some new wells as well. After all, the joint venture partners had over 75,000 acres in Oklahoma and is also increasing its technical know-how after having hired two new people for the engineering and geology division with strong credentials and experience at Devon Energy and Midstates Petroleum.

For 2017, we are looking forward to see Jericho Oil to continue its (attributable) production growth rate by acquiring an additional 25% stake in the Seminole county assets and its updated reserve report.

Disclosure: Jericho Oil is a sponsoring company, we have a long position. Please read the disclaimer

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