DNO ASA (OTCPK:DTNOF, OTCPK:DTNOY), the Norwegian upstream oil company I have been covering since April 2019, has recently issued a press release that made a somber impression. After reading the statement written in a succinct manner, I have to conclude that the bullish investment thesis cannot be reanimated, at least for now, and DNO is a “Hold” at best. In a worst-case scenario, DNO is a “Sell” even despite its record-low valuation. The thesis that I called “stalled” in November is now shattered. Only Brent price recuperation can revive it, but I am among those skeptical investors who consider the prospects of $40 per barrel of the North Sea benchmark oil a distant future not to be easily achieved. Mr. Sechin, the CEO of Russia’s Rosneft (OTCPK:RNFTF), however, is bullish on the oil price and anticipates it to hit around $60 by year-end (I will touch upon it in the conclusion), as he sees the shale players will not be able to operate in the current price environment and will have to exit the market.
Executives across the global oil industry make tough decisions and scale their capital budgets, weighing if their companies could survive during the downturn. DNO is not an exception. It informed investors the 2020 budget would be cut by more than 30% or $300 million, the first-half 2020 dividend would be canceled. Apart from that, measures would be undertaken to lower opex and layoffs would be an inevitable step necessary to cut expenses. Among the issues that led to these tough decisions was not only the oil price war that put liquidity in jeopardy. As the company clarified,
DNO and contractor staff movements and rotations have been impacted by border closings, quarantines and other coronavirus travel restrictions.
As a short reminder, DNO has one of the lowest production costs in the overall industry due to the economics of the Tawke and Peshkabir oil fields in Iraqi Kurdistan (its 2019 lifting costs in the region stood at $3.3 per barrel); I highlighted this fact in my initial coverage of the stock when I was also impressed by its copious free cash flow and high FCF yield which pointed to dramatic undervaluation. In this sense, it is somewhat terrifying what is ahead for high-cost producers like the Canadian oil sands players if ultra-low-cost firms see their margins and cash flows plunging.
On a negative side, the oil price slump only confirmed the timing of the Faroe Petroleum takeover (and its impact on the debt profile of the company) was unfavorable. With the additions of the North Sea offshore oil-producing assets to the portfolio, DNO’s average lifting costs rose to $5.4 per barrel of oil equivalent (in the North Sea, it spent $17.7 per barrel of oil equivalent; see page 6 of the 2019 Interim results). Next, after the Faroe takeover, DNO’s end-2019 consolidated debt jumped to $1.06 billion from $594 million in 2018. The silver lining is that the company had been consistently buying FAPE01 bonds using its abundant cash flow, and by now, the leverage had been partly reduced. In the recent press release, the company did not mention if it suspends the bond buyback program or not.
Investors say goodbye to the recently reinstated dividend
Inspired by the regularity of the export payments from Kurdistan, DNO reintroduced its dividend in late 2018. Now, the dividend is something of the past, as export payments have become irregular again.
DNO’s ability to maintain its level of spending has also been strained by interruptions and delays to monthly payments for its oil exports from Kurdistan; the last payment received in January covered September 2019 exports.
For a broader context, its closest peer, the LSE-listed Genel Energy (OTCPK:GEGYF), has recently presented its 2019 results and said it had decided not to eliminate the dividend, but postponed the DPS increase. This is a courageous decision, and I hope the firm will not have to eliminate shareholder rewards urgently in the coming weeks.
The Baeshiqa license exploration campaign remains a top priority
In my previous articles, I have already discussed the light oil discovery made by DNO in the Baeshiqa license (the partners in the asset are energy heavyweight Exxon Mobil (XOM), Turkish Energy Company, and the KRG). In the press release, DNO said it would not scale spending related to the Baeshiqa-2 back, as it is essential to assess if the discovery is commercial or not. Apart from that, a $100-million Peshkabir-to-Tawke gas capture, transport and reinjection project also remains a priority. Here I can only conclude that DNO’s Board clearly understands that it must protect the company’s growth prospects (the Baeshiqa is at the crux of the medium-term growth) even when oil bears are raging.
DNO is not ill-prepared for the downturn
On a positive side, DNO is led by experienced executives who have already seen the worst. The company came through the geopolitical crisis in the Middle East amid ISIS expansion and was battered by the mid-2010s oil price slump. Mr. Mossavar-Rahmani, Executive Chairman, was at the helm during this challenging period and I believe the Board members under his leadership will do their best to ward off the cash crunch.
Mr. Wood, Chief Financial Officer of Tullow Oil (OTCPK:TUWOY), another embattled exploration & production company that I have covered recently, called the current market environment “a perfect storm.” I believe Mr. Wood’s phrase perfectly encapsulates what the overall oil industry is facing now.
It will not be an exaggeration to say the Norwegian E&P player is also in the middle of a perfect storm. DNO is grappling with a few headwinds: uncertainty regarding export payments from Kurdistan (again), the oil price downturn, and not perfect balance sheet, which was negatively impacted by the Faroe takeover in 2019. In the previous article, analyzing 2019 results of the company, I concluded the stock was no longer a “Buy,” as the critical staples of the bullish thesis like surfeit free cash flow were no longer relevant. DNO is testing a valuation nadir now. On the Oslo Stock Exchange, DNO trades at Enterprise Value/2019 EBITDA of 1.5x (assuming EV of $825 million and 2019 EBITDA of $549.4 million). Analysts anticipate its 2020 revenue to contract by more than 38%; so, the sales slump is likely priced in and it justifies the multiple.
For an energy investor, DNO’s warning on budget reductions is of high importance, not only because it reflects the sentiment in the onshore oil industry but also demonstrates what repercussions the COVID-19 and the increasing oil price confrontation (Nigeria has recently announced it is ready to sell crude at hefty discounts to benchmark prices) spawn for the oilfield services industry. Speaking in more detail, by end-March, DNO will reduce the number of active drilling rigs in Kurdistan to two from six. Lower rig count means lost revenue for drillers.
Oil players, shocked by simultaneous pressure from the price war and the debilitating effect of the coronavirus pandemic, even ponder previously barely imaginable options. Reportedly, Texas might begin to cooperate with the OPEC+ in order to coordinate production cuts to bolster the crude price. To rewind, the Texas Railroad Commission has not imposed output curbs since 1972. However, the market considers the prospects of cuts are highly uncertain.
To sum up, I reckon the $60 oil price Mr. Sechin anticipates by end-2020 is not going to materialize. Even if a few players go bust, it does not mean the loss of production will be enough to offset the debilitating effect of COVID-19 on the demand for crude. In this sense, I have a somber outlook on DNO’s short-term prospects and a neutral outlook on the medium-term stock price.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.