Reeves-A-tax the North Sea: gives Serica a good SQZ - OB Idea #19

....But the numbers win out anyway

88% enough for you Chancellor?

Dear reader,

Compelling economics at Serica. And welcome to the first of two 6X loaded ideas.

So the Oak Bloke 25 ideas for 2025 is based on an imaginary £35k assumed portfolio with £1,000 invested in each idea (less dealing charge) - except for Serica and one other - where I’m placing £6,000 not £1,000 (less the usual £4 dealing charge).

Intrigued?

Could a 17.7% prospective annual yield have something to do with that choice?

Net income was £111.8m in FY23 the market cap is £485m so the P/E is trailing 4.34X.

But Serica have had bad luck in 2024. Four operational issues on their Triton hub (FPSO) in 2024…. bad luck comes in how many reader? Threes? Try fours.

First in May a compressor failure led to an unplanned shutdown. Second a planned shutdown in July lasted three weeks longer than expected. Third at the end of October a further shutdown due to a seal failure until the start of December. Fourth on the 5th December a further issue with the seals meant a 2-4 week repair. A permanent fix will be the introduction of redundancy to the compressor in 1Q25.

Is that why I can recommend SQZ at 129.6p? If we go back in history below 130p is about the same as it was in 2018 when revenue was about one twentieth of its revenue today. When operating profits were less than a sixth of what they are today. When Brent Crude was in the low $60s and UK Gas was 40p a therm. Today Oil is $73 and and UK Gas 100p a therm by comparison.

When I look at SQZ I was drawn to the compelling logic of this slide. The dotted line is the market cap as at 09/09/24. Today the dotted line is about $50m higher. The light blue bar is the forecast free cash generation over the next 36 months. At $75 oil and 80p gas. If Oil and Gas were 5p higher then that equates to $90m incremental. If they were LOWER then reduction in tax means it is not $90m lower.

These are SQZ’s assets:

Acquisition of Assets - Skerryvore and Fynn

50% of Skerryvore adds to SQZ’s 20% while 50% of Fynn is a new holding. At a cost of just $6.4m and $11.5m deferred ($17.9m) (plus earn outs of up to £30m and £90m respectively for actual production at a cost of just 80p a barrel).

Tax Losses of £197m for RCT (Ringfence Corporation Tax) and £193m for SCT (Supplemental Charge Tax) is a large benefit - extending tax relief by 18-24 months to 2028 and 2030 respectively.

Skerryvore has a prospective and contingent 110mm barrels while Fynn has 292mm barrels. Wait.

What were SQZ’s reserves before? 140mm barrels. So SQZ has just added 200 million barrels to its 140mm reserves and the share price did what? Nothing? Wow.

I’m not saying 200mm barrels are nailed on - of course they’re not - they’re contingent. But zero value? Zero value compared to 2018 despite now holding holdings like 30% of Buchan, bought in 1H24 and developing that field - the disparity is stark - and can’t be wholly explained by the unfortunate tax grab of recent years.

Certainly can’t be explained by the commodity prices and those I believe we’ll see in 2025, even if we see (and hope to see) a continued build out of renewables, there is still a need for UK Gas.

The oil within the Fynn reservoir is viscous and made up of long chain hydrocarbons, which means that when refined it contributes little to gasoline supplies, but is a good feedstock for lubricants, asphalt and anode grade petroleum coke (an essential component for fast charge EV batteries). The other partner in this is none other than the clever folks from Orcadian Energy. You’d like to think the NSTA and Ed “bacon chomp” Milli will approve the scheme since Orcadian have proposed renewable energy powered extraction, and are experts in polymer flood. We shall see.

Compared to importing oil (and gas) the north sea makes a lot of sense. If Ed Milli genuinely wants to “just stop oil” perhaps he should turn the “Just Stop Oil” protestors into a new British police force, reminiscent of the Sparrows of Game of Thrones. Hordes of peaceful protestors turned into thugs unleashed on motorists and home owners would certainly reduce the demand for oil and gas, and drive green ambitions, otherwise if we continue to allow people the freedom to consume oil and gas, then perhaps we should consider the impact of the source of said oil and gas?

The reality is UK produced gas is greener. Much greener. And Serica can be a large part of that story.

TAX.

A 78% headline tax is a scary number. Offputting one could say. Does that create hidden value? Probably. Where there’s muck there’s brass, and our government are certainly doing their best to muck up the north sea. That rate is from 1st November 2024 and the rate until then on 75% is still scary.

However it is interesting. Net income in 1H24 (to June 2024) was $82.5m compared with an operating profit post interest (EBT) of $188m. So a 56% tax rate, not 75%. Why? 35% of the 75% tax rate can be offset by losses. Given $1bn of accumulated losses, that offset applies for a good long while.

The 75%/78% is made up of three taxes and these apply for 5.5 years until 2030 we are told.

Business hates uncertainty and at least the budget promised a consistent approach to the North Sea for the life of the Parliament (to 2029). Retention of first year allowances was also a huge, er, relief.

There is incidentally a way in which the EPL can be removed. But it seems to me the chances of UK gas increasingly reliant on LNG falling below 57p a therm is low.

So let’s analyse Serica on the basis that 78% will apply and will apply beyond 2030.

Serica’s presentation makes analysis quite easy. A ~£150m free cash flow per year for three years. Current dividends of 23p a year (a mind boggling 17.8% yield) costs £86.5m. Leaving £63.5m a year for anything else. Plus a further ~£350m of “currently committed investments”. These being focused on the two main fields BKR and Triton.

Interesting the black dotted line is £1.15 which was the share price at 9th September. Today it is £1.29 so the 1H24 presentation clearly had some effect - and it was previously at £1.45-£1.50. Showing that 3 years of future free cash flow more than equals the market cap tends to have that effect!

Considering the balance sheet

There’s not really any concerns where Receivables + Cash + Inventory roughly equals Borrowings + Liabilities + Payables + Dividend.

The reserve based lending (RBL) is at SOFR + 3.9% which is about 9.1% and is a $525 facility so there is $300m headroom plus cash and FCF could stretch to an acquisition approaching up to $700m-$800m potentially. Equally paying down the RBL would remove interest costs of over $20m a year

The DEC test

I suppose the prism I must consider Serica is vs that of Diversified Energy (DEC). There are some parallels and some differences. DEC is what I consider incredibly cheap and good value. It is a 83% gas and 17% NGLs/Oil vs 60% gas/40% oil at SQZ.

Brent oil and British gas prices per therm are higher than DEC. But taxes are more onerous too. Debt is much smaller at SQZ and its dividend is higher.

So which will win out?

On a simple dividend + buy backs basis one can of course immediately point to SQZ being the better of the pair. If you further consider debt Serica wins too.

In fact Serica wins on most metrics.

There are three metrics I considered before to compare DEC with SQZ

The first was reserve life where DEC’s reserves exceed those of SQZ. Is that a permanent state of affairs? No, and SQZ have increased their reserves and the recent acquisitions have the potential to be transformative. The challenge now is for SQZ to turn those into PDP - proved and producing.

The second was political interference. Perhaps imagining “Sparrows” from a fantasy world earlier in this article is a little bit colourful but the point is a serious one. This share does get held back by the negative approach to our national resources. But given the low approval ratings of our PM I suspect my earlier predictions in my prior article of Labour ideology facing political reality is coming home to roost. I actually believe Starmer will be desperately seeking ways to actually achieve growth and “Bacon Chomp” Ed won’t be allowed to pursue his agenda in the North Sea.

Thirdly was where I considered strategy and I said DEC had a simple strategy of “hypermiling” and SQZ didn’t…. I now take that back. The emerging strategy is this. Shell are exiting the north sea. Dana are exiting the north sea. Everyone is exiting the north sea…… except Serica.

Could a strategy of hoovering up and developing north sea assets from bombed out juniors like Parkmead, despite the apparent reasons not to, actually be a genius move? Genius for a cash rich, and cash-generative politically savvy operator, who is able to withstand lean times, and who looks forward to a future when a future government in 5 years or maybe less is pro-North Sea?

Even under net zero we will need plastics, we will need lubricants, so we will still need the oil of the north sea. We will also need the north sea to store CO2, and this effort is underway.

Conclusion

Serica is mortal and can be harmed by bad luck, it was hit by bad luck four times in 2024. But despite that bad luck it shakes it off and keeps on keeping on, and fixes the issue.

Its priced at 1X its free cash for 3 years. That’s a bonkers valuation. SQZ is the first O&G holding which on a valuation basis made me pause and think I can’t out- “Top Trump” this compared to an O&G holding I have come to know very well - DEC.

Since DEC is a 2024 pick that I can’t repeat that pick so what’s the next best? Serica.

Regards

The Oak Bloke.

Disclaimers:

This is not advice

Micro cap and Nano cap holdings might have a higher risk and higher volatility than companies that are traditionally defined as "blue chip"