Yesterday I woke up to the news of oil price dropping below zero and started wondering what kind of world we are living in now. Just 12 years ago, I was sitting in the conference hall of Goldman Sachs Hong Kong listening to their presentation on why oil price would keep going above US$150/barrel and now it’s worth less than a bottle of water. Naturally, I thought the share price of oil companies will get hit badly but then the big boys like BP, Shell, Exxon etc seem to be doing okay. Then I realised most investors probably expect them to ride out this temporary storm on the back of their large balance sheet while the real casualty falls on the US shale operators with much higher cost of production and unsustainable debt levels.

Closer to home, we have Hibiscus Petroleum (“HP”) which is purely involved in oil exploration and production (E&P) and to a large extent, its share price fluctuates according to the oil price. I think a lot of retail investors pay attention to this company as it’s the most convenient way for them to speculate on oil prices. Most of the comments I’ve heard always say that its share price of RM0.45 is very cheap compared to its peak of over RM2 and you can make a lot of money when the oil price recovers. You know that this is one of the most speculated stocks when the housewives start talking about it. I’ve decided to have a look at it just in case I miss this once-in-a-lifetime opportunity to get rich.

Oil and gas E&P is a very capital intensive business besides the enormous risks involved in drilling. HP basically joined the game by taking over mature brown field assets from bigger players and try to squeeze the last drops of oil from them. It’s similar to picking up cigarette butts on the cheap and try to enjoy the last puff. The difference is, they still need to spend a large amount on “Production Enhancement” effort before drawing the last puffs. Currently, HP only generates income from its North Sabah PSC and the Anasuria Cluster in the North Sea while the rest of its assets in Australia are still in the development and exploration stage.

Again, I always start by looking at things that make me not so comfortable and there are plenty.

The production of crude oil is a commodity business and HP has absolutely zero pricing power because its daily production of over 8 thousand barrels per day represents only 0.01% of the world’s output and its crude oil has no difference compared to the rest of the world. What it needs to do is basically invest in the right assets (at the right price), develop and operate them in the most cost effective manner. However, it’s forever susceptible to a single factor totally beyond its control – oil price. As a shareholder of HP, you practically cannot go to bed everyday without praying to the God of Oil.

I think the management of HP has done a great job in keeping its production cost relatively low at US$20/barrel(2019) while conventional oil production costs US$30-40/barrel around the world, except Saudi Arabia who claims to produce its oil at the cost of below US$10/barrel. Hence we see commendable net profit of RM230 million reported in 2019 when HP managed to sell most of its crude oil above US$60/barrel. With the current oil price, it is certainly making a loss unless it can further push down production cost. I don’t have the technical knowledge and the relevant data to assess whether this is possible but I think it’s highly unlikely, given that it’s already 33% lower than the norm.

I have no doubt the oil price will recover but I don’t know when. I think it’s absolutely stupid to guess (some prefer the word estimate because it sounds more intelligent) the timing of oil price recovery and whoever does it instantly makes himself/herself look like an idiot. There are just too many factors on the demand and supply side affecting the oil prices that trying to estimate the timing is like shooting ten moving targets with one bullet. The key question is whether HP can survive the low oil price and ride out the storm?

Some say HP will be fine because its management is very prudent – it has zero debt and lots of cash on its balance sheet. That is true, but I also find it hard to believe that it can generate enough internal funds to finance its enormous capital expenditure. It has zero debt because most banks have been reluctant to lend to the oil and gas industry in the past five years and the management has openly admitted that it has problem accessing the debt market since 2014. Therefore, HP has no choice but to tap the equity market even though it usually costs more than the typical 5-7% cost of debt. For example, it has undertaken private placement of 144 million shares from Aug 2017 to Jan 2018, bringing in RM91mil to finance its operation. Even though share placement is easier for management but existing shareholders face an immediate 10% dilution to their holdings. At the same time, HP has issued 317mil warrants which can increase its share base by up to 20%. Right now most of the warrants have not been exercised because the strike price of RM1.00 is way above the market price. In other words, you have a company which is forced to be conservative with no debt but at the expense of higher cost of capital.

Some people are salivating over the RM273mil cash balance shown in the FY19 balance sheet but they have overlooked the fact that it’s just a snapshot at a particular point in time. It’s rather meaningless if the company has high cash burn rate which usually relates to oil and gas company. In the case of HP, the same RM273mil has dwindled to RM90mil in the subsequent six months mainly due to the RM225mil capital expenditure incurred for both its Anasuria and North Sabah assets. Bear in mind there is still another RM22mil due in Mar 2020 for the last tranche of payment for the acquisition of the North Sabah assets.

With the current oil price, HP should be bleeding heavily and I won’t be surprise if it has to turn to issue more equity since the debt market is more of less shut. As its share is being traded at historical low, this is one of the worst time to issue share because it most likely has to issue at a discount to attract investors. Issuing share at a price way below intrinsic value is a sure way to destroy shareholder value. HP is essentially suffering from a double whammy.

The conclusion is, I don’t think I will pursue this at the moment due to the following:

1. It is inherently difficult to estimate the earning power of HP due to its erratic capital expenditure requirement and the volatility of oil price. Therefore whatever analysis and calculation of its intrinsic value is pretty much just a mental masturbation.

2. I foresee a lot of shareholding dilution going forward.

3. I am terrible in speculating oil price movements and I don’t intend to even start.

4. I can’t reliably estimate how it can ride out the current storm unscathed under some conservative assumptions. What if oil price recovers but stays at US$20/barrel for a considerably long period? Will it have enough cash to sustain its capital expenditure – in oil and gas, you cannot just postpone the spending until the sun starts shining.

5. I don’t like to invest in something that requires me to pray very hard everyday.

Having said all that, the share price of HP may go up after this because there is so much noise and speculation on this counter by all sorts of punters. At one point yesterday there was 11mil buy orders against 3 mil sell orders and don’t be surprised to get stock tips from your uncles or aunties regarding HP after this.