Continual Evolution

HNR: Is the recent price drop justified by deterioration in fundamentals

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I have previously posted about my rationale for a large position (in fact my largest holding) in Harvest Natural Resources (NYSE:HNR).

Lately, the stock has not done too well - in fact it is down about 25% in the last few weeks. So I have been doing some digging to see if anything changed regarding the fundamentals.

The main trigger for the decline seems to be an analyst downgrade (2 levels below previous). Rather strangely, the main reason he gave for the downgrade was the lack of stock price appreciation in response to a positive event (more on this later). I expect a better reason from a professional analyst: if there is no fundamental deterioration and the price is lower than before then I would expect the stock to be upgraded rather than downgraded.

The positive event the analyst referred to is the recent sale of a neighboring oil field asset by Anadarko (NYSE:APC), which established a comparable market value to HNR's relatively illiquid assets. Now the APC sale established a value of proven & probable ("2P") reserves of about $6 to $8 per barrel of oil equivalent. Using comparable metrics, the enterprise value of HNR implies that their oil & gas assets are being valued at $3 per barrel of oil equivalent, implying that the stock is selling at least 50% below what just the Venezuelan assets are worth. Note that the "Chavez" discount would be shared by both APC and HNR assets since they are neighboring fields. And there are more assets outside Venezuela that are not being valued in the stock price at all.

Today the company announced its Q1 results which indicate that the recovery towards normal oil production is still intact, albeit a bit slower than I would have liked. Production is up to 13.3Kbpd which is up slightly from last quarter. While I am a bit disappointed at the slow pace of progress, most of the disruption due to the two year hiatus seems to be finally over, and normal operation seems to have resumed. During the conference call, the CEO suggested that the peak production that is possible (based on pre-disruption 2004 performance) may be in "mid 40Ks" range, as more and more production drilling takes place. And since the fixed costs are high, every extra barrel of oil produced adds disproportionately into profits.

The CEO also hinted at more stock buybacks ahead - he suggested that the stock price is irrationally cheap but that the $18M pre-approved buybacks could not be done due to constraints of quite period following internal news about the quarter. Since the total EV is only about $200M, a buyback of about $18M can be significant. The CEO also said that the analyst downgrade made no sense to him.

HNR has been adding geographical diversity to their asset base with fields in Gabon, Indonesia and (recently) two small fields in US, further reducing risk and improving the chances of positive surprises.

But the main reason to invest in HNR is the huge leverage as production recovers from the current 13kbpd (where its a bit above break even due to large fixed costs) to a possible figure near 30 to 40Kbpd over the next few quarters. This will also add to the recovery factor assumed in pricing the assets under ground which also should add to the enterprise value of HNR.

I think that HNR is even more attractive at the current price and the weakness over the past month presents a great buying opportunity.

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