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Bond of the Week: 28 January 2013

Enquest PLC 5.5% 2022


The first retail bond of the year has been launched. The issuer is Enquest, an independent North Sea oil operator.

Issuer: Enquest PLC
Type:  Senior, unsecured
Coupon: 5.5% (semi-annual 15th August and 15th Feb.)
Maturity:  15th Feb 2022 (9 years)
Books open: 24th January and close 8th or February or earlier
Settlement: Euroclear/ Clearstream and Crest
ISIN: XS0880578728
Listing: LSE ORB
Min. sub: £2,000
Denominations: £100
Lead Manager: Numis

An issuer from this sector is a pleasant surprise as it provides a diversification away from the steady supply of property specialists and financial companies (not that I have anything against either sector). Amongst rival issuing houses there is always much fevered speculation about where the next issue will come from. Few if any would have expected an oil company. The oil sector is perceived to be divided between the oil majors, the likes of BP and Shell, for whom the retail bond market is a mere pin prick on the surface of the financial markets and then oil exploration companies. Many of you may have made an investment in the latter sector. I am told a favourite is a flutter on Rockhopper and other explorers of the Southern Ocean where great riches beckon and come with the additional prospect of socking one to the Argies. Around here there is a penchant for GKP, the Kurdistan based exploration company. Todd Kozel the CEO fights off first his wife (a divorce lawyer!) in the courts (lurid tales of strip bars and Todd being shacked up with a 28 year old Lithuania lap dancer) and now a shadowy company, Excalibur, who supposedly is entitled to 30% of the equity. Meanwhile the company sits atop billions of barrels of proven reserves. But how to get the stuff out as war and revolution swirl all around and there is no Iraqi oil law governing who is entitled to what? Exciting stuff all round; you might fancy an equity flutter but would you want to lend any of them money? No; and nor would anyone else.

However, there is a middle path in the oil sector. It may be boring but boring is good for the bond investor. It is here we find Enquest. They are a profitable FTSE 250 company, making £100 million last year, and have a market cap of £1 billion. Their speciality is eking out a profitable return from the last days of declining oil fields (or as they describe them; mature assets) in the North Sea. They are not alone in this sector but they are the biggest UK domiciled company. For many oil majors and exploration companies it does not make sense to continue producing from these declining fields and therefore they dispose of them and move on to more exciting prospects. This is how the opportunity arises for these specialists who, I suppose we might say, make a living from scraping the bottom of the barrel.

Here is a short overview of the main North Sea operators and a more detailed description of Enquest’s business. Nexen, a Canadian company is the biggest producer in the North Sea (10 ¼ million tonnes per annum) followed by BP with 6.5million tons and Apache with 3.83 million. Enquest is in 8th position with 1.53million tonnes. Nexen and Apache are both in the same game as Enquest – efficiently managing mature fields and I suppose the predominance of such experts in the North Sea is illustrative of the gradual overall decline in production (note Mr Salmond; a golden goose whose egg laying glory days are over). The CFO of Enquest, Jonathan Swinney, explained to me that although in the same sector Nexen and Apache were not direct competitors as they were much bigger companies and would be aiming for larger opportunities than they were.

Enquest’s assets may date back to the 1970s but the company itself is a recent creation. It came about as the result of the merger of the North Sea production assets of Petrofac an oil facilities provider and Lundin a Swedish exploration company. Holding mature production assets was not a natural long term fit for either company and it was thought merging them would achieve critical mass. Enquest had an IPO in July 2010 and by checking disclosure filings you can see that many of the major shareholders are Swedish as the shares were inherited from their being shareholders in Lundin. Enquest’s main assets and prospects are a) the Thistle/ Deveron, Heather/ Broom and Don fields  - all old fields where they are extending the producing lives by the application of new technologies b) the Alma and Galia fields which they are on the point of re- opening after they were mothballed in 1992, c) the Kraken heavy oil field which is a new field and finally d) they have made initial approaches to acquire assets in Malaysia but to date no significant capex has been spent there. It should be noted here that they do not solely take on existing fields which are operating but will also start production in fields that were too marginal (with old technology) to have been exploited in the past and also restart closed fields. They engage in a small amount of explorative digging within existing fields they control. However, I was told by Mr Swinney that they will only do so where they have a one in two or one in three chance of success – they are not going for broke like the standard exploration company.

If not careful I could now get carried away and begin discussing the “attic oil trapped along Southern bounding fault” in the Galia field or the success of subsea trenching operations. While perhaps allowing me to indulge in some Texan booted JR daydream I am not so sure it will advance our understanding of this bond. Rather than get too involved in the minutiae of the oil industry I think we should now approach the company from the point of view of a bond holder and try and identify where risks might lie.

·         Could they suffer a North Sea version of the Gulf of Mexico BP Macondo blowout? This is very unlikely. The BP platform, employing previously untried technology, was drilling at much greater depths. More importantly the BP field gushed whereas Enquest’s mature fields only ooze.

·         How vulnerable are they to a fall in the oil price? Not very; their operational cost per barrel is $31.6 per barrel. There is an additional capex cost of $10-15 for existing fields and $20-25 for new fields. However, capex costs are sunk expenditure. I cannot see oil prices getting anywhere near this breakeven level even if capex costs are included.

·         What about the costs associated with decommissioning – could they get out of control? The words “decommissioning costs” bring to mind the nightmare experience of the nuclear power industry. However, to compare the two would be a fallacy. The environmental risk is largely dealt with by sealing off the well which is a “simple” task. Then it is a question of disposing of the rig. Fixed rigs are expensive to decommission but with Thistle the decommissioning costs have entirely remained with BP and with Heather (Enquest has a 100% working interest) they are only liable for 37% of the costs. Elsewhere they have floating platforms. These are much cheaper to be disposed of as they can be towed away to a low cost destination for break up (away from the eagle eye of Greenpeace?).

·         How good is their cash flow? By the nature of their assets Enquest has excellent cash flow. In 2010 it was $267 million, in 2011 $656 million and $240 million in the first half of 2012. Typically these fields will provide declining streams of oil. Therefore cash from investments gets returned quickly. I give as an example the Alma Galia fields which are shortly to come on line. In 2014 26million bpd are expected and this declines rapidly to under 4bpd 9 years later, only a sixth or seventh of initial production.

·         What about capex expenditure, how controllable is it? Capex is flexible and largely at the discretion of the management. The amount spent, as appears on their balance sheet, is certainly volatile. In the first half of 2011 it was $108 million and this leapt by a magnitude of nearly five to $504 million in the first half of 2012. This leap can largely be explained, I believe, by the approach of:- have money at the bank, will spend/ invest. In 2012 the largest item by far of capex was investment in Alma/ Galia to bring it online in 2013 (cash flows back pretty quickly from this) and the third item was acquisitions.  Apart from that most capex is spent on improving platform facilities, replacing 1970s equipment/ technology etc. leading to improvements such as increasing oil produced from 70% to 95% watercut. (The watercut is the point at which the ratio of oil to water that comes out of a well pipeline ceases to be profitable. I.e. 5% oil can now be recovered profitably whereas it used to need to be 30%. It is always good to learn something new!).

·         How indebted are they? As of today, this might surprise you, they have no debt and their first debt will be this issue. They have a committed loan facility from the banks to the tune of $525 million which has a floating charge on the assets of the company. However, this facility is currently undrawn. Finally it should also be noted they have deferred tax liabilities of $638 million. Oil taxation is fiendishly complicated.  Corporation tax was increased last year to 62.5% from 50% in a last minute Osborne lunge for revenue (knocking the shares at the time). But since then, after howls of justifiable indignation, additional allowances to encourage further brown site and marginal production have been introduced. The effect of all this is that very little money, if any at all, currently passes to the exchequer (in the confusing jargon of Enquest they refer to paying no cash tax). So long as Enquest expands and takes on more capex taxes keep getting delayed. They can write off, for instance 100% of capex against tax. The deferred tax, which is not a precise sum as to what will eventually be paid, appears on the balance sheet as a provision. While an ever upwardly creeping number may of course look worrying you can take the view that as the tax that is deferred can be used as cheap financing for future development.

Given the lack of debt, good cash flow and seemingly good outlook for the oil industry where might the problems arise? Potentially problems could come from too fast expansion (interestingly since launching their bond road show Enquest have bought an £18.75 million stake in the Alba oil field – they are already spending their bond proceeds!). The company is in expansion mode and they do not pay a dividend on their shares for this reason. This is natural given their claim they are able to make returns of 20-30% on new investments. The current pristine debt picture cannot therefore be expected to last.

It is also important to remember that liabilities (deferred tax and decommissioning) stack up to be dealt with (paid) in the future. Transparently and sensibly accounted for this should not be a problem even if it means there is some implied non-financial “gearing”. Fears of an excessive and unwise increase in either financial debt or non-financial gearing can be tempered by the alignment of interest between the management and shareholders/ bond holders. The CEO Amjad Bseisu owns 10% of the company and he is unlikely to want to sink his investment.

Conclusion: I like the company and I like this issue. There has been a bit of a run up in the share price since this bond was announced and I expect the bond road shows may have caused some interest to spill over into the equity (a positive sign). The 5.5% coupon is slightly higher than I originally expected and looks good when compared to alternatives in the non-financial arena. I expected there to be some institutional demand for this bond and I am told followers of Enquest, who have been unable to buy because the stock does not pay a dividend, have shown a particular interest. Assuming you broadly agree with my outlook for the corporate bond market (see 10th January, Where to Guv?) and keep an eye on interest rates given the longish 9 year maturity, I recommend a buy. I shall be buying the issue and it is not unreasonable to expect a pretty decent capital gain in the weeks to come. 

Oliver Butt is a Partner in City and Continental LLP, a leading independent broker in fixed income. The author and or the LLP may hold a position in or trade in any of the securities mentioned above.

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