We refresh our view on Cairn Energy, focusing on key areas of interest for investors already familiar with the company. We examine a number of valuation approaches for SNE in Senegal, the potential for reserve upgrades and exploration value. We believe SNE is an outsized asset and assume Cairn seeks to farm-down. This will naturally affect long-term value upside, but would in our view drive a better balance of asset and financial risk. We also examine features of Catcher, Cairn’s cost of capital and look at the Indian tax dispute. After a long period of value stagnation (as cash was invested to develop Catcher/Kraken), coming years could be a time when investors see a path to this investment steadily bearing fruit. Our core contingent NAV is 225p/share and our RENAV is 255p/share.
The recent SNE-6 well test appeared to show strong connectivity between wells in the upper reservoirs, going some way to settle concerns that the pressure declines seen in past well testing would be major obstacles to recovery. If we assume that lower reservoirs have recovery of 30% (as hinted at by Cairn), this implies the current 473mmbbl 2C estimate has recovery factors in the upper reservoirs of between 9-14%, with FAR’s 641mmbbl estimate implying 19-22%. The interference test may well clear the way for higher recovery factors than 9-14% to be used by Cairn, but it may be more difficult to move much beyond 20% we suspect. Given the positive interference test and other appraisal results, we choose to use FAR’s estimate for the time being, awaiting an August update from Cairn.
The final hearing of the arbitration is due in early 2018 and judgement could be a few months after. We believe the market is largely pricing in very little value for the stake, and taking a very risked view on Cairn winning any of the $1.1bn damages.
We revisit our valuation, giving a contingent NAV of 225p/share. Within this, we (notionally) risk the Cairn India stake at 50% and assume Cairn will farm-down part of its stake in the Senegalese assets to reduce risk. We think exploration at SNE North and FAN South are unlikely to be more than incremental additions to value, but that the progression of SNE and the production cash flow from Catcher/Kraken could be the impetus to get Cairn’s shares to move higher in coming years. Druid/Drombeg is a high risk/value prospect; together with SNE exploration it contributes to a RENAV of 255p/share (based on a long-term oil price of $70/bbl).