Reiterate Hold. ShaMaran, a small E&P company operating in the Kurdistan Region of Iraq (KRG), reported upbeat production results in Q3 19, having achieved the FY guidance ahead of schedule. Production, however, has yet to translate into cash flows. The company’s relatively small non-operating interest and high leverage make it highly sensitive to oil price volatility, production levels and capex requirements established by the field operator. Significant production growth already achieved in 2019 should unlock cost pool monetisation in 2020f and pave the way for deleveraging. Our Hold recommendation is based on the view that the SNMCN 23s, the highest-yielding bond in our Kurdistan E&P universe, already offers a significant premium and is unlikely to widen without unexpected credit-negative news.
Production growth in the spotlight. In Q3 19, ShaMaran’s WI production increased by 68% to 6.9kboepd on the back of the acquisition of an additional 7.5% WI in Atrush and successful implementation of expansionary capex. The company confirmed FY 19 average production on the field level at 30-35kboepd, which according to our calculations corresponds to 7.3-8.6kboepd on the company level. This rapid production growth has yet to find its way into ShaMaran’s financials, which we expect to start happening in 2020. Meanwhile, in 9M 19 revenue (US$46mn), EBITDA (US$22mn) and operating cash flows (US$13mn) declined yoy, because of the high base effect of 2018 when ShaMaran benefited from accelerated recovery of the early exploration costs.
Tight liquidity in 2019-20. High capex and acquisition costs have driven the company’s free cash flows in the red in 2019 and will continue to put pressure on liquidity in 2020f. According to our forecast, capex commitments and interest payments will be just about covered by operating cash flows in 2020. This leaves the company with very little financial flexibility if Brent falls below US$60/bbl. Other things being equal, production growth could unlock the pool of accumulated historical costs and help the company accumulate liquidity and reduce leverage.
Leverage has peaked in 2019. ShaMaran’s leverage reached the highest level (5.8x) since the company started commercial production in 2017. With the debt maturity profile clear of any repayments until 2023, refinancing risk is remote if the company can cover interest payments. EBITDA interest coverage ratio was at a low level of 1.1x in Q3 19, which makes a Lundin family trust guarantee covering c80% of the annual interest bill an important credit enhancement mechanism. According to our forecast, net leverage could start reducing in 2020, if production and price targets are met.
Risks to our recommendation stem from Brent price going below US$60/bbl in 2020, potential escalation in KRG-Iraq relationship and/or the security situation in Iraq and Kurdistan, as well as geological risk associated with further development of the Atrush Block.