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Carnarvon Petroleum Limited (ASX:CVN) is an oil and gas company that over the last two years has made the successful transition from junior explorer to mid-tier producer.

Their main focus over this time has been their onshore Thailand tenements held in a joint venture with the Canadian listed Pan Orient Energy (CVN own 40% and Pan Orient are the operator). This joint venture has been highly successful.

In recent months, the company has indicated a desire to diversify and reduce their reliance on this joint venture. It has acquired interests in four blocks offshore in Western Australia and has farmed into a block in Indonesia. CVN also recently stated they are close to finalising several new ventures with new term activity.

The Thailand joint venture

The company’s Thailand operations are the heart of the company. It has ownership in five tenements in different areas of the country. Two of these tenements are in a joint venture with Pan Orient Energy whom holds a 60% interest in the joint venture and is the operator.

This leaves CVN with a 40% interest. To date, this joint venture has been a success with four producing oil fields and another three discoveries that the joint venture is looking to stgelop.

Production began in the third quarter of 2007 and was steadily ramped up to a peak of over 11,500 barrels of oil per day (over 4,600 bopd net to CVN) in the fourth quarter of 2008.

Figure 1 – Quarterly production of barrels of oil per day (BOPD) Net

Source: CVN “Good Oil” Presentation

Production fell in the first two quarters of 2009 as the joint venture switched its focus from production to exploration. For this reason the September quarter production will be low and the current company guidance is for between 5,500 to 6,200 bopd (2,200 to 2,500 net to CVN). Production will begin to be ramped up again in the December quarter with an estimated 8,000 to 10,000 bopd gross (3,200 to 4,000 net to CVN).

The oil is being produced at a very low cost of circa US$5 per barrel including trucking and transport. The cost of drilling a well is also very low and ranges from US$1-2 million.

As a consequence of the recent focus on exploration, CVN has been able to meaningfully increase its reserves. Drilling in FY09 increased Proven and Probable reserves net to CVN by over 40% to 16.6 million barrels of oil. In a recent announcement of two new potential oil fields, CVN flagged further contingent resources of 13.7 million barrels of oil. These resources are contingent on being awarded a production licence.

Political Risk

The major risk associated with the company apart from fluctuations in the oil price is the political risk arising from operating in Thailand. During their short production history the ongoing political instability has not affected their operations and the fiscal regime they operate in has not changed. The company works closely with the local community employing many locals; it is in the best interest of the Thailand government to ensure stability.

Fiscal Regime

The fiscal regime that CVN operates under varies from what we are used to in Australia. In order to fully understand it we need to break it into three steps:

1.    Corporate tax
2.    Royalties
3.    A special remuneratory benefit.

Firstly, the Thailand corporate tax rate is 50% and is paid twice yearly. There is a double taxation agreement with Australia ensuring no Australian corporate tax is payable in Australia on Thailand earnings. Exploration expenditure is immediately deductible for tax purposes. This means that for every exploration dollar that CVN spends, it effectively results in a tax break of 50 cents.

Second, Thailand government royalties are paid on a sliding scale and range from 5-15% of revenue. The royalties are applied separately for each tenement.

Finally, oil producers in Thailand are subject to a Special Remuneratory Benefit (SRB). This is a tax on profits designed to deliver increased revenue to the government in times of high profitability for a company. The SRB is charged on profit, which is defined as gross revenue less operating and capital expenditure, royalties and exploration expenditure. This is also charged on a sliding scale from 0 to 37.5%.

As a result of the above regime and the current expenditure base CVN estimate they generate net profit of around 30% of revenue.

Other Opportunities

CVN has stated its intention to diversify away from Thailand and its joint venture with Pan Orient. The map below shows the positioning of all of CVN’s current interests.

Figure 2 – CVN’s current interests

Source: CVN “Good Oil” Presentation

In addition to the two tenements held in the joint venture with Pan Orient, CVN has a 50% stake in one other tenement and also has two other tenements under application. CVN recently completed two-dimensional seismic imaging on the other tenement they currently own, which has thrown up a number of interesting prospects. They are looking to drill four low cost wells in 2010.

CVN recently announced, a farm-in to acquire a 25% stake in an onshore tenement in Indonesia. They will commence two-dimensional seismic imaging in 2010. Previous drilling in the block has confirmed an active petroleum system.

In Australia, CVN has a number of interests. In the Bedout Sub Basin they have recently acquired a 50% interest in four blocks, including a previous gas discovery. They also have a number of minority interests in blocks in the Carnarvon and Perth Basins.

Figure 3 – Valuation

The first thing we noticed from our StockVal valuation is that the Return on Equity has been spectacular over the last two years. The ROE in FY08 (their first year of profit) was 72.4%, and was followed with an ROE of 102.0% in FY09. This high level of profitability was achieved through drilling and producing highly successful low cost wells. The company has achieved great profitability from a low equity base.

The current level of profit appears sustainable, as the flow rates on their wells are showing no signs of declining. However, whilst the use of drill rigs for exploration has recently affected production, the increase reserves have provided some certainty for the next 10 years. CVN is currently retaining all of their profits as they look elsewhere to grow and diversify their production. We can therefore expect the ROE to decline over the next two to three years as the equity base increases. In other words, whilst profit is sustainable the profitability is likely to decline from the current very high levels.

With CVN currently retaining profits there is the risk that they will not have the same success as they have had in the past. The company is obviously aware of this and is diversifying their exploration interests.

The balance sheet is currently in good state with $31 million cash in the bank and no debt. Free cash flow continues to fund all exploration costs.

Conclusion

CVN has had a couple of spectacular years. It has taken itself from a loss making junior exploration company and into production. The Thailand joint venture with Pan Orient continues to perform well and is the backbone of the company. They are continuing to explore the prospects there and we believe there is further upside. The company is wary of the need to diversify its interests and is actively pursuing opportunities. CVN recently stated that they are close to finalising several new ventures with new term activity. We believe the company is a good value below $0.60.

Guy Carson uses StockVal. Exclusively for The Bull subscribers, StockVal is offering a free two-week test drive. Click here.  

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