New Zealand Oil & Gas

by Jenny Ruth

Friday 16th May 2008

New Zealand Oil & Gas reported $58.2 million in sales for the three months ended March, taking revenue for the nine months ended March to $153.7 million, $141.8 of that coming from the Tui oil well in which it has a 12.5% stake. Tui began producing in July last year and has been significantly exceeding expectations. The company made a $41.4 million net profit for the six months ended December compared with an $0.5 million profit in the same period a year earlier. It also declared its first dividend in 10 years and only the second in the company's history - five cents a share.

Sharechat: Why do you think the Tui pre-production forecast was so far off the mark?

Managing director David Salisbury: It reflects the geological understanding and reservoir understanding that we have ahead of developing a field. We're dealing with what's happening under the earth's surface - in this case at a depth of around about 3,500 metres. When we're dealing with uncertainties in geology and resource performance at that depth, the best engineering tools we have available to us, and that's available to the industry worldwide - no one else would have better tools - you end up with quite a wide range of uncertainties. The point we're making is we're dealing with uncertainties in trying to understand the geology and how a reservoir will behave. The best technology we have gives us a range of outcomes. In this case, what we now know from the performance of the field is that it was an under-estimate. That's the sort of uncertainty the industry deals with on a daily basis.

SC: Is the operator, AWE, too conservative?

DS: I wouldn't say they're being too conservative, given that we have such a range of outcomes. People can be more or less aggressive in how they view things. In this case, we've under-estimated but there are a lot of different parameters taken into account, a lot of uncertainties. AWE do the best job they can, given those uncertainties. The industry has experience of some companies - this is just a generic statement - who will tent to emphasise the upside. AWE and the Tui partners aren't in that camp.

SC: Has Tui's daily production rate started declining yet?

DS: It came off a little bit through January to March. It dipped down from an average 47,000 barrels to about 42,000 barrels a day. It's been a little bit stronger through April. I haven't got the average figures with me - I'm waiting to get those. I don't think there's been a marked decline through April. We are seeing some decline but certainly not the decline that was expected. On the other side, what we have seen is increasing water rates. The constraining factor for Tui production becomes the water-handling capacity of the FPSO (Floating Production Storage and offloading vessel). Obviously, as we get more water, we get less oil. What you can tell from the oil production to date is we've seen more water and it's started to push the handling capacity of the FPSO but it hasn't backed out the oil production as much as expected.

NZ Oil & Gas public affairs manager Chris Roberts: Oil production is typically around 40,000 barrels a day and there's about 80,000 barrels of water that's being processed a day so we're now starting to reach the handling capacity of the FPSO.

SC: Are you expecting the Tui reserves estimate to be revised upwards? By how much?

DS: The way I'm going to answer that is when we have the completed work, we will make a public announcement. In advance of that, I don't think it's appropriate to give a direct answer to that question. The modelling work is on-going. We expect it to be completed fairly shortly so there can be an announcement to the market ahead of the end of June.

SC: Are your production forecasts for Tui through to 2017 likely to be upgraded? By how much?

DS: Again, I'm going to answer that in the same way. The modelling work is on-going and part of determining the resource is also to re-look at the production profile because they're related issues.

SC: Why have Tui's production costs been lower than forecast?

DS: The very large majority of Tui's production costs are fixed costs. They're to do with the cost of the lease of the FPSO and the operating costs of the FPSO, most of which are fixed. Because we've had a much larger volume of through-put than we anticipated, it's brought the average cost down quite markedly. When we were developing the field, we were anticipating nine million barrels for the year. We've already gone over 12 million and that's had a very significant effect in terms of lower unit operating costs. There are some variable costs to do with marketing, but, as a proportion of the overall costs, they've very small.

SC: Why have the Kupe capital costs been higher than expected?

DS: Predominantly, it reflects the industry pressure. The industry is going through a growth phase. There's enormous demand for personnel, parts and products. We're seeing a lot of cost price inflation. We're seeing very steep increases in salaries for people. We're seeing increases in the cost of steel and products manufactured from steel. We've seen vendors supplying everything from earthworks, equipment to more specific parts have such a full order book that they can charge a premium. On the other side, the Kupe capital costs - when they were announced to the market, they were announced in New Zealand dollars and costs in currencies other than New Zealand dollars had been converted to New Zealand dollars. We've benefited quite significantly from the fact that the New Zealand dollar has been a lot higher against the US dollar than had been anticipated. That's had quite a mitigating effect. This is one of the reasons why our expectation that our exposure to the Kupe capital costs has increased by about 10% from the number that was announced when we made the development decision. People have queried why isn't it higher. The cost increased that the industry has experienced have been in the order of 20% or more.

SC: How is the Toke permit mapping progressing?

DS: The siesmic work was shot around the middle of last year. The interpretation is ongoing at the moment. We would expect to have results shortly. It's a work in progress.

SC: Will New Zealand Oil & Gas be bidding for any of the 12 Taranaki blocks up for auction?

DS: The disappointing fact is, no, we will not be bidding for any of them. We've undertaken a very detailed review of all the blocks that were on offer. We've undertook the work as part of a consortium. The disappointing outcome for us is we see no potential in exploring a number of the blocks. Where we do see potential, typically they're very high risk and low return, low reward. So we're not going to bid. There were one or two blocks where we though we could see structures of interest but our assessment was they were likely to be very small. It doesn't make sense to drill at a cost of $US10 million on an exploration well that only has a one in five or a one in 10 potential for success when you can only recover one million barrels of oil, if that. It's a disappointing outcome for us. We would like to be acquiring new acreage but we have to only go after the opportunities we think are attractive.

SC: Your partners seem pretty optimistic that the Momoho well will be successful? It seems you had to make that statement this week because one of your joint venture partners let something slip?

DS: The background to that is Origin Energy released a number about the potential size of Momoho as part of a briefing of analysts in Australia, I would expect in the context of the BG offer for Origin - we weren't privy to it. There had previously been an agreement not to release any numbers. The joint-venture is bound by confidentiality agreements to each other. NZ Oil & Gas was inclined to release numbers but had been complying with the confidentiality restrictions. Obviously, once a number was put into the public domain, we felt it was appropriate we should advise our shareholders and stakeholders what our view of the prospect was. For people who look at the Origin Energy release, they will see there's some difference between the number we've put into the public domain and Origin's. They've put a number into the public domain of 100 BCF (billion cubic feet) of gas. We've put a number of 200 BCF gas equivalent, so we're more optimistic, one of the big differences being our internal assessment of Momoho is that it's highly unlikely this is just gas. It's far more likely than not that this has quite a lot of liquids associated with it. Our view of Kupe is that the value lies principally in the liquids. The oil and LPG extract from Kupe is likely to be a lot more valuable than the gas. We thought 100 BCF implied dry gas which we don't believe is likely to be the case. We would say any liquids are likely to be more valuable. We felt we should put our best view out into the public domain.

SC: What are your prospects of obtaining an exploration rig next year?

DS: There is a tight market for rigs. Having said that, we are working with our joint-venture partners and we fully expect that we will have a rig active in New Zealand in the latter part of next year. We're quite confident that will be the case and we have a need to bring a rig in for the drilling of a further Tui well. Given the time value of money, we would prefer to be producing more Tui oil sooner rather than later.

SC: How likely is it NZ Oil & Gas will invest elsewhere in New Zealand outside Taranaki? Are you looking at any such prospects at the moment?

DS: Yes, we are screening prospects outside of Taranaki at the moment. The likelihood of investing elsewhere depends on us finding what we think are attractive opportunities and being able to secure them. If you turn the question around, it's undoubtedly the case that Taranaki will not provide the scale of opportunities that we will need going forward. That's not to say there's not a lot of potential in Taranaki, but the key to the oil industry is to have a lot of opportunities you can screen so you can pick the best ones. Taranaki is relatively small. It has a limited set of opportunities coming available at any one time. To keep the momentum and to go for growth, it does drive us outside of Taranaki.

SC: What proportion of the options are you expecting to be exercised?

DS: Obviously, provided that the options continue to be in the money, we expect a high proportion of them to be exercised. Perhaps not 100%, just because you get some shareholders who may forget they have them, although we will be sending out reminder notices to people shortly. The worst outcome is people forget they're there and lose the opportunity. What proportion we will get very much depends on how the share price tracks over the next little while.

SC: Do you have any plans for spending the proceeds any time soon after the exercise date?

DS: We have ideas which we're actively pursuing at the moment. We don't expect people are investing in us so we can put the money into a bank account. We have some specific ideas which we're working on. We're pursuing those aggressively. We would like to invest the funds as soon as we can but, of course, in saying that, it has to be a prudent investment. I'm sure people exercising their options wouldn't want us to make rash investment decisions simply for the purpose of investing the funds. We are actively screening and looking for good opportunities.

SC: What are your expectations for coal and oil prices in the immediate future? Do you think $US75 a barrel is a realistic long-term oil price assumption or do you think that will prove too conservative?

DS: I always answer that question, at least initially, with a comment: if I knew where oil and coal prices were going, I would be a trader. The best we can do is to look at all the information sources, but to manage the business, primarily we're looking at the cashflow we need for our requirements. When we come to invest, we run scenarios so we cover a range of outcomes. The oil price has moved so much in the last year, in fact, in the last few years. It's very hard to predict and it's very volatile. We've seen the price changing analysts' views very frequently, not just $US1 or $US2 a barrel, but in the order of $US10, $US20 or $US30 a barrel. I look at the behaviour of OPEC. Several years ago it had a benchmark price of $US30 a barrel. It was believed the world economy would go into recession if oil moved significantly above that. Then oil moved over $US30 a barrel and the world didn't go into recession. Then OPEC settled on $US50 a barrel with a similar rationale. The oil price went through that and kept on going up through $US70 and $US80. Most recently OPEC has said it's comfortable with a floor price of $US80 a barrel. I think one of the dynamics at work is that world demand hasn't been significantly curtailed by the increasing price. Whether or not OPEC has the capacity to increase supply to bring the price down, it's certainly the case that its not inclined to do so. If I'm Saudi Arabia and producing 12 million barrels a day and I can get, say, $US100 a barrel, why would I produce 13 million barrels a day to get $US70 or $US80 a barrel? I suspect that dynamic is going on at the moment. World Oil is dominated not by Exxon or BP or Total or any of the companies the public tend to have in mind. It's dominated by the oil countries, Saudi Arabia, Kuwait, Venezuela, Russia. If demand is staying high while the price is rising, those countries and the people who control oil in those countries, are making enormous sums of money. You have to question, is this sustainable or will there be some increase in supply that will drive the price back down again. I think the concensus view is that the world has gone through a fundamental demand shift. This is driven by the factors people are well aware of, the economic growth in China, India, Brazil and Eastern Europe, with enormous demand for energy which is driving world wide demand to ever higher levels and driving supply into more costly sources. Whether it's under the Gulf of Mexico, Canadian oil sands, the Arctic Circle perafrost, the cost of energy supply is going up to meet that demand. I've heard numbers that the marginal cost of oil production is around $US60 a barrel. In that context, it's highly unlikely oil prices will go back to levels of $US50 a barrel. That would require an absolute collapse in demand that will force some supply out of the market. It's hard to see that degree of collapse. I think going forward, that oil prices getting up towards $US100 a barrel are far more likely than oil prices down at $US50 a barrel. I think $US30 a barrel is probably relegated to history.

SC: What about coal prices?

DS: We tend to read analysts' reports as well. The company and my expertise is primarily oil and gas. For coal prices, I look to analysts' reports and Pike (River Coal) statements. I don't think it would be enormously useful to express a view on coal prices.

SC: Are you expecting to pay a final dividend this year?

DS: When we announced the dividend, we did say that was a dividend for this financial year.

SC: Analysts are suggesting there will be no final dividend.

DS: That's exactly what we were intending to say. It's intended this is the dividend for financial year 2008.

SC: The company has said it will pay out "a reasonable percentage" of profits in dividends. What percentage is likely to be "reasonable"?

DS: Reasonable means that when we come to look at our cash position, our profitability and our exploration and capital expenditure needs, we will determine how much we can prudently pay to shareholders while maintaining and growing the business and meeting the expenditure commitments we have. That's why we deliberately used the term 'reasonable' rather than any fixed percentage. This is a capital intensive industry and expenditures tend to be lumpy by nature. To say we will pay out a percentage of profits doesn't allow for the lumpy capital spend.

Other questions answered in writing by Chris Roberts:

SC: What are the terms of the partly paid shares - what are the prices to be paid and the time frame in which they are to be paid?

CR: Employees are offered shares which they have to partly pay - one cent per share. The shares have a two year escrow period and can then be exercised for a 20 % premium over the share price when the employee started. So an employee starting this week would pay for some partly paid shares which they could turn into fully paid shares in 2 years time for $1.60 plus 20%.

SC: Tui - Which holes have been producing over which time span?

CR: There are four wells - Tui-2H, Tui-3H, Amokura-2H and Pateke-3H. All four wells have been producing but for most of the production period only three wells have been used at any one time, with the 'choked' well changing regularly, as the operator optimises the overall production. Currently all four wells are in use.

SC: Kupe - Details of the 3 productions holes - vertical or horizontal and what length do they penetrate the reservoir? Was the snorkal used for drill final sections, inturn details of how thick are the reservoirs in the drilled section?

CR: The total measured depth of the three wells is:

KS-6 3,385m

KS-7 3,503m

KS-8 3,834m

All three wells have a horizontal deviation at the bottom - the longest being KS-8. The vertical depth subsea is roughly the same for all three wells at around 3,300m.

Information from the development drilling regarding the reservoir is currently confidential to the joint venture and NZOG is not able to disclose it.

SC: Would a discovery at Momoho fall into the lower royalties for new exploration discoveries from July 2004 to December 2009?

CR: Yes. If a discovery is made between 30 June 2004 and 31 December 2009:

Ad Valorem Royalty (AVR) will be 1% for natural gas
Accounting Profits Royalty (APR) will be 15% on the first NZ$750 million cumulative gross (offshore) or 15% on the first NZ$250 million cumulative gross (onshore).

In calculating the accounting profit deductions are made and may include associated production costs, capital costs (exploration costs, development costs, permit acquisition costs and feasibility cost), indirect costs, abandonment costs, operating and capital overhead allowance, operating costs and capital costs carried forward and abandonment costs carried back.

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