Xcite Energy should prove a highly profitable investment in 2011

It has been several months since I have posted on the Contrarian Investor UK blog, partly due to new job commitments and lacklustre visitor numbers. However, I feel compelled to start afresh in 2011 and would appreciate readers comments on the blog. There is so much misinformation on the bulletin boards and private investors continue to be hungry for information.

To start 2011 I will make my first post on the North sea oil company, Xcite Energy (XEL), listed on UK AIM and the Canadian TSX (Toronto Stock Exchange). Xcite own a 100% working interest in the Bentley heavy oil field which it acquired in 2003, approximately 160km east of the Shetland Isles. In February 2009, RPS Energy published a Competent Persons Report (CPR) for block 9/3b, in which they assigned the highest category of Contingent Resources to the field with a probability of commercial success of 70% and Base Case resources of 122.5 MMbbls. Subsequent to the CPR, based on reprocessed 3D seismic, XER have shown the Bentley East feature to be part of the overall Bentley field and, therefore, now include a second drill centre to the south to access Bentley East and the southern areas of the field, thereby adding 40 MMbbls to the base case resources. The Bentley field, therefore, has most-likely (P50) resources of around 160 MMbbls, with a low to high range (broadly equivalent to P90 to P10) from 109 to 235 MMbbls, assuming conventional, cold flow recovery, utilising pumps to lift the oil. The big question for Xcite was, could they get the oil to flow out of the reservoir because it contains heavy, viscous oil. This oil attracts a price around 10% lower than standard Brent Crude and historically was difficult to extract. Bentley was previously owned by U.S. company Conoco Phillips, who drilled several times in the 1980's but failed to bring oil to surface.


Rather than adopt a traditional farm in model, Xcite has entered into a more innovative solution. A contractor based model called the "Bentley Alliance", whereby it works with several partners with particular experience. These partners are able to take a small equity stake to help fund development of the field. Estimates for production development are around $100 million which is likely to be 50% in the form of equity and 50% debt. The partners in the alliance are:

• BP - marketing of oil and $20m debt provider
• Transocean Drilling - rig provider for the 9/3b-R well and EPS
• ADTI - well management and drilling contractor alongside Transocean
• AMEC - engineering services for EPS & full field development
• Fugro – geotechnical services partner 

I came into the Xcite party fairly late in the day, so missed the big move from 60p+, but starting building a large position prior to the Bentley Field Block 9/3b flow test during November. Its been quite a ride, as the share price oscillated into the 325p+ range then collapsed as low as 230p during early December, as the flow test was postponed due to poor weather in the North Sea then a faulty pipe to the tanker. Rumours circulated on iii.co.uk and advfn bulletin boards that the delay was due to a flow test failure. The market makers saw their opportunity and swung the price down heavily to trigger private investors stop losses and "doom and gloom" pervaded most posts. I had to laugh as random Twitter and "bloke in a pub" rumours were seen as proof of issues. So what did I do, I bought more Xcite based not on the rumour mill but on the fundamentals of xcite which looked very exciting!

The RNS from 8th November 2010 confirmed the potential of the Bentley field, "The Company is pleased to announce that the 9/3b-6 well on the Bentley field is progressing on plan, on schedule and has reached target depth for the second part of the planned work programme, the horizontal section of the well, 9/3b-6z.The horizontal section has reached the planned total depth at 7085 ft measured depth in the well section and has successfully tracked the top of the reservoir. This provides over1800 ft of gross reservoir section since reservoir entry point of 5261 ft measured depth. The reservoir in the 9/3b-6z well bore section was encountered at an estimated 3618 ft true vertical depth subsea, some 18ft higher than the pre-well prognosis of 3636 ft true vertical depth and thus giving more oil column. Petrophysical analysis is being undertaken and is expected to confirm close to 100% net to gross oil pay. The completion and testing of this horizontal section is expected by the end of November."

Finally on the 21 December 2010, XEL issued the RNS I was waiting for. "The Company announces that the flow test of the 9/3b-6z horizontal well on the Bentley field has been successfully completed.The flow rates achieved demonstrate both the commerciality of the Bentley field and the reservoir properties to be above the upper end of modelled expectations. Key flow test results were: 1) Total flow test of 36 hours including clean-up of 9 hours, with cumulative production to tote tanks of over 2,000 barrels. 2) Multi-rate flow tests were conducted, culminating in a final stabilised flow rate of 2,900 stock tank barrels of oil per day. Richard Smith, Chief Executive Officer of Xcite Energy, commented: "This is an outstanding outcome for the Xcite team and for the industry contractors to deliver this successful well test on Bentley. This flow test fully demonstrates the commercial potential of the Bentley field and the long-held belief that Xcite has maintained in this major North Sea asset. We now move on to the first stage production planned for 2011 with an excellent platform.""

On board the Ocean Nomad rig, engineers had used tote tanks to measure the flow rather than plan A which would have been direct transfer to the Betty Knutsen, the tanker originally contracted to receive the oil. To allow the field to be commercially viable required a flow rate of at least 1200 barrels a day. 2900 barrels a day flow rate was an exceptionally positive result.

So on December 21st, Xcite not only had a heavy oil reservoir of 150 million barrels plus, but proof it could be extracted and with a good flow rate. A huge de-risking by any standard. So what happened next? You would think that the share price would have exploded upwards with all the uncertainty removed. Well on the release of the RNS, the share price moved sharply upward to reach 420p or so. Then as profit taking kicked in the price began to drift down, with some director selling on December 24th exacerbating the move down. With rumours of a seriously dilutive placing at below £3 the share price fell to a low of 330p i.e. back to where it was before the flow test! A great opportunity for a bit of pre-Christmas Xcite shopping and Contrarian Investor UK upped his stake big time at this bargain price. 


Xcite has benefitted from a Standby Equity Distribution Agreement ("SEDA") with YA Global Master SPV Ltd, which was increased by £20 million to £60 million in December, which should reduce the possibility of a placing. The SEDA allows Xcite to request money at a point of its own choosing, in return for the issue of shares at zero discount. These shares cannot be sold for 4 months after their issue.The "Bentley Alliance" structure and relatively low field set up costs also reduces the risk of any major shareholder dilution. In the unlikely event of a placing, like the recent one completed by Bowleven (BLVN), I do not believe that the discount will be large. I note the recent director's sale to an institution at £3.837, hardly at a knock down price! As for the director sales themselves, they still retain 85% of their holdings.

So what next from Xcite? Is it time to move on to another stock? Not on your nelly!! There's plenty of news flow to come. The key sentence from the RNS December 21st was "The flow rates achieved demonstrate both the commerciality of the Bentley field and the reservoir properties to be above the upper end of modelled expectations." So it would be expected that an independent CPR (Competent persons report) would be due during January to confirm the upside of the field. Once this is in the bag, watch the institutions pile into this share. Then we have the confirmation of the agreement to retain the N-Class "Rowan Norway", a harsh environment, deep water jack-up unit, designed and built for simultaneous drilling and production, which is currently under construction. Agreement has to be made by January 15th 2011 to avoid a $4 million termination fee. And don't forget that Xcite will start producing from the field during 2011 - it's not a 3 year wait for the oil to come to market.

Sure there was other AIM shares where the upside may be larger in 2011, but the key with Xcite is that we could see a share price of at least £5-6 in the next few months (up from its current £3.83) without the downside risk of a Bowleven or Range Resources. I read about Gulf Keystone etc. Would you rather buy into an asset in the North sea or Kurdistan, Iraq?! We know the oil is there and can be brought to the surface. I am somewhat over invested in Xcite and am nicely in profit but I am not selling one share until we see at least 500p, and I do not believe this is a pie in the sky target by any means. If we assume that the field is 200 million barrels and this is worth $10 a barrel after costs, then Xcite have a $2.0 billion asset. The current market capitalisation is £607 million or around $900 million, giving a 100% upside. Xcite would make a nice acquisition for a larger oil player. The company has announced a "poison pill" clause in the event of a takeover which allow existing investors to buy more shares at a discounted rate. Sit back and relax with Xcite, Contrarian Investor believes you won't be seeing a share price below £4 for too long. 


In summary:
Strengths
Low geo-political risk (North Sea)
Proven reserves (at least 150 mm barrels)
Proven high flow rate
Innovative Bentley Alliance field development structure
Production and exploration rig letter of intent signed (final completion due by January 15th)


Weaknesses
Currently AIM listed so high share price volatility
One asset company


Opportunities
Resource upgrade (strong possibility in January) following CPR
Further exploration upside
Will be 3rd largest independent oil producer in North Sea


Threats
Delays due to offshore drilling
Fund raising (low risk due to Bentley Alliance structure and SEDA)
Further director share sales


Happy New Year readers!