We upgrade NOGLN 22s and 25s to Hold. After the publication of FY 19 financial results and a conference call hosted by the new management team, we carefully examine everything we know about Nostrum to evaluate possible restructuring outcomes. Nostrum’s business in its current shape is weak and is not sustainable with oil prices below US$60/bbl. The good news is that management has given up efforts to turn around upstream and instead focused on monetising the recently completed gas processing facility GTU-3. Given the geological issues, several years of falling production, high operating breakeven oil price and extremely scarce financial resources, we welcome the change. Nostrum still has enough cash to take it to the end of 2020 if coupons are paid in Q3 20, or a bit longer if the company decides to default on interest payments. GTU-3 can process c2.5bcm of gas (Nostrum’s total capacity is 4.2bcm) and become the main source of cash flows in the future. However, there is only one processing contract signed with no gas delivered yet, which leaves GTU-3 seriously underutilised. In gas-rich North-West Kazakhstan, there is a good chance of contracting feedstock for GTU-3 or selling the company. According to our estimates, recovery on bonds could exceed the current bond prices. However, serious uncertainty about restructuring outcomes is likely to keep prices firmly below 30 for a long time.
No hope for the upstream. Rapidly declining production and low oil prices put Nostrum on the brink of operating breakeven in 2020 (Table 1 in full report). Last week, management reiterated full-year production guidance at 20,000boepd and sales at 19,000boepd, implying a c30% yoy decline. We estimate that with lower production, Nostrum’s FCF-breakeven oil price will be at cUS$60/bbl in 2020, a long way from the current US$32/bbl. The company will have to use dwindling cash reserves to cover the shortfall in operating cashflows to pay interest on the bonds and fund the substantially reduced capex. According to our estimates, if Brent remains at cUS$25-30/bbl and the next coupon payment is made, Nostrum will run out of cash by end 2020-early 2021. In such difficult circumstances, management faces equally difficult choices. Preserving cash instead of paying US$43mn to bondholders in Q3 20 could have its benefits from the company’s point of view. Nostrum has just hired financial and legal advisers and is likely to formally approach bondholders to start restructuring negotiations soon.
GTU-3 – the cornerstone of debt restructuring. With rapidly declining production and suspended drilling, a recovery in oil prices can no longer bring a quick turnaround. This makes GTU-3 the key valuable asset and the basis of any positive outcome for bondholders. Because of falling production, Nostrum does not have nearly enough feedstock to utilise 4.3bcm of nameplate annual capacity of the state-of-the art gas processing facility. A transformation from an upstream oil and gas producer to a midstream company relying on revenues from processing third-party gas, is, therefore, the only plausible scenario under which Nostrum can continue as a business. If Nostrum ceases to exist as a company, GTU-3 would potentially be the most valuable asset in liquidation.
Two approaches to GTU-3 valuation. For this purpose, we consider two scenarios: 1) Nostrum signs gas processing contracts and GTU-3, which was effectively funded with bondholders’ money, begins to generate returns, and 2) gas contracts are not signed, and the company’s assets are sold. Under scenario 1, Nostrum could potentially generate US$90-US$310mn EBITDA depending on GTU-3 capacity utilisation and other assumptions (Table 2 in full report). In a liquidation, the company could be worth US$285-570mn (Table 3 in full report).
Scenario 1: Transition to midstream on the basis of GTU-3. The starting point of the analysis is Nostrum’s estimates of free cash flow from the only gas processing contract signed so far. In March 2019, the previous management team shared selected details of its gas processing agreement with UOG, including expected free cash flows of US$50mn based on the annual volume of c0.5bcm. If all of Nostrum’s processing facilities operated at full capacity utilisation (4.2bcm), the company could generate US$310mn in EBITDA, potentially providing a strong basis for a value accretive restructuring. There are three important assumptions underlying this forecast: 1) the economic terms of the UAG contact are accurate, 2) other contracts can be signed on similar terms, 3) full capacity utilisation can be reached. A stress test of these assumptions (Table 1) shows that in a negative scenario, Nostrum’s EBITDA could be just over US$90mn. There is still a wide range of potential outcomes, but they no longer depend on the upstream. If the transition to gas processing is somewhat successful, NOGLN 22s and 25s are fairly valued or offer some upside.
Scenario 2: Liquidation. It is too early to seriously consider a liquidation scenario. Nostrum’s bonds have traded at distressed levels long enough for most of the high-yield investors to sell as the price was going down. Most likely the current holders are represented by distressed debt specialists who would be willing to engage in a prolonged negotiation if a recovery looks attractive. However, if GTU-3 was to be sold to a third party without any gas processing contracts, its value would probably be lower than under Scenario 1. In a simplistic recovery analysis based on GTU-3 valuation at cost (cUS$550mn) and net working capital, but ignoring reserves, cash, short-term debt, advances and accruals, we estimate the highest recovery at 51 cents (Table 2 in full report). The range of valuation depends on the discount applied to GTU-3 valuation at cost and time to liquidation. This scenario also suggests that current NOGLN prices are at least at their fail level.