We upgrade OILFLO 22s to Buy. OILFLO 22s resisted the sell-off in Kurdistan O&G bonds in March only to drop c23pts in April, after the issuer warned that bond amortisations could be at risk from low oil prices and that discussions would be held with bondholders to explore the possibility of certain amendments to the terms of the notes. We are not aware of the specific details of those discussions, but do we know that Glencore partially funded the April amortisation. Since oil prices bottomed out last month, we doubt the situation has improved and, unless Glencore has again stepped in to cover the shortfall, bondholders may have received a partial amortisation in May. Having evaluated four potential scenarios for OILFLO bonds, we believe their fair value is in the range of 76-86, which is above the indicative mid-price of 77. Based on our assessment, we upgrade OILFLO 22s to Buy.
OILFLO amortisations are funded from the KRG’s monthly oil cargoes. The US$500mn 12% bonds were issued in 2017 to finance Glencore’s prepayment for the future crude oil deliveries from the Kurdistan Regional Government (KRG). The monthly oil cargo volume was agreed at 3.5mmboe. In 2017-19, the bonds only paid monthly interest, for which Glencore is responsible, and, in February, the bonds started amortising at the rate of US$20.8mn a month. The role of Glencore is to market KRG’s oil and retain up to 100% of revenues to fund monthly amortisation of the bonds. Glencore is required to hold 10% of the outstanding principal of the bonds at all times, pay interest and transfer the interest and retained portion of the oil revenues to Oilflow SPV, the issuer, which passes them on to the bondholders.
Until March, oil cargoes fully covered monthly principal amortisations. According to the notice disclosed by Oilflow SPV citing Glencore, the total value of crude deliveries in March 2020 was expected to be lower than the amortisation amount (US$20.8mn) due in April as a result of the sharp fall in oil prices. On an exceptional basis, Glencore agreed to cover the shortfall. According to another notice, dated 31 March, Glencore was planning to reach out to certain bondholders to discuss potential amendments to the terms of the bonds. A rapid deterioration of oil prices reduced the value of the KRG’s oil cargo. Late March-early April was a particularly turbulent period in the crude oil market, and we do not really know at what discount Glencore sold the KRG cargo. For the March cargo not to cover the US$20.8mn amortisation, the average realised price on the sale of 3.5mmboe should have been less than US$6/b. Combining it with an estimated discount of KRG’s oil to Brent of cUS$12/b, we come to a benchmark price of US$18/b, close to where Brent bottomed out in April. What also could have happened is that the KRG delivered less oil than specified in the contract.
Cargo volumes are at risk, but the KRG’s willingness to pay is high. Following the recent decision of OPEC+ to cut production in response to the unprecedented decline in prices, Iraq agreed to reduce oil output by c1mn bopd. The KRG supported the federal government, at least verbally, declaring that the region was fully on board with the decision. According to S&P Global Platts, Kurdistan’s oil exports stood at 490,000bopd versus 3.4mn bopd exported by the Federal government. If Kurdistan were to join Iraq in production cuts on a proportionate basis, it could “cost” the region some 130,000boepd. Another factor to consider is that, last year, Baghdad and Erbil (Kurdistan) reached an agreement (again) about transfers from the federal budget to Kurdistan in exchange for 250,000boepd of oil. Kurdistan has not fulfilled its part of the deal in 2020 and Baghdad threatened to stop payments, which increased pressure on the region’s troubled finances after the oil price shock. Should Kurdistan fully comply with earlier agreements and production cuts, the region will be left with very little crude oil volumes to convert into budget revenues. This is clearly the ultimate negative scenario, and, for that reason precisely, we do not expect Kurdistan to part with half of its daily production or decisively reduce output. But, even if the region does not fully implement production cuts and oil handover requirements, the KRG will almost surely seek to revise the OILFLO-related contract. Such a revision could address the cargo volume or introduce a cap on the oil proceeds that can be taken from each monthly shipment to cover OILFLO amortisations. Having said that, we expect any such amendments to be negotiated in good faith and assess the KRG’s willingness to pay as high, even if its ability to pay is impaired in the current circumstances.
A probability-weighted valuation based on our four scenarios gives a 76-86 price range for OILFLO 22s. Our scenario analysis is based on a set of shared and individual assumptions, as explained in Table 1. A lower valuation is based on a combined 25% probability of two negative Scenarios, 1 and 2, under which we assume the bonds will get a serious haircut or even that there will be no principal amortisations from now on. We believe that both Scenarios 1 and 2 are rather unlikely given the KRG’s historical track record of restructuring its liabilities to the oil companies. Scenarios 2 and 3 both imply that the principal will be fully or almost fully paid, but at different rates. The interest and principal cash flows under all four Scenarios are shown in Table 3 and some of the original terms of OILFLO 22s are summarised in Table 4.