High oil prices are allowing Harbour Energy PLC (LSE:HBR, Financial) to generate healthy levels of free cash flow, but the largest oil and gas producer in the U.K.'s North Sea is not getting any love from equity market investors.
The company was created in 2014 by private equity group EIG. It was then acquired by privately owned Chrysaor three years later. That transaction set the foundation for much bigger things when the purchase of most of Shell's North Sea fields and the acquisition of ConocoPhillips' (COP, Financial) U.K. business suddenly created a North Sea oil and gas powerhouse. Harbour listed on the London Stock Exchange through a reverse takeover of the heavily indebted and loss-making Premier Oil last April. Premier’s historic losses created valuable tax credits through loss carry-forward accounting. Its private equity owners were subject to lock-up agreements, which depressed the stock initially but have since expired.
Currently, oil and gas stocks around the world are cheap, despite the Brent oil benchmark trading at $92 dollars per barrel at the time of writing. There are three potentially valid reasons for this. First, the futures curve is in steep backward motion: December 2025 Brent futures trade at $74 per barrel for instance, so that means oil market Brent prices will be about $20 per barrel lower three years from now. There in an academic argument that futures do not represent expectations, but the point is that is where buyers and sellers can hedge today for future delivery, so oil producers can lock in only $74 per barrel for Brent for December 2025 delivery.
The second point is that many institutional investors are trying to decarbonize their portfolios, so heavy carbon emitters like oil and gas companies get penalized through lower valuations (or higher returns) to incentivize investors to bear that carbon cost. The rise of ESG, all else being equal, is the fall of the oil and gas sector.
A third point troubling investors may be a U.K. North Sea windfall tax, which the government reluctantly introduced. But there are loopholes the oil producers are utilizing in that they can offset growth capital expenditres against the windfall tax to help the U.K. government claim it is focused on domestic energy security. This means the overall windfall taxes paid by U.K. producers are, in reality, quite small. The windfall tax will cost Harbour $300 million this year, which has not helped sentiment for the stock, but we should not extrapolate that forward.
Harbour Energy is one of three energy companies in the FTSE 100, the other two being BP PLC (BP, Financial) and Shell PLC (SHEL, Financial). Both companies have renewables businesses and, as a result, have a lower carbon intensity than Harbour Energy. Investors benchmarked to the FTSE 100 Index who need to reduce tracking error, but who also want to reduce the carbon footprint of their portfolio, would be better off being underweight Harbour.
So it seems to me that Harbour is artificially depressed. The market is giving it a lower valuation because it is demanding a higher required rate of return to compensate for the “inconvenience” of owning the stock. For more flexible, less constrained investors, this provides an opportunity. It is just this kind of taking advantage of market mechanics and institutional investor constraints that guru Joel Greenblatt (Trades, Portfolio) talks about in his book, "You Can Be A Stock Market Genius," which guides investors on how to make higher returns from special situations.
Harbour trades with an enterprise value/Ebitda ratio of just 1.62 and an enterprise value/forward Ebitda ratio of 1.4. In comparison, BP’s enterprise value-Ebitda ratio is 6.6, while Shell’s is 2.7. Harbour also trades lower than mid-cap producers like Energean (LSE:ENOG, Financial) and Tullow Oil (LSE:TLW, Financial), whose enterprise value-forward Ebitda ratios are 3.4 and 2.8. These low valuations do not reflect my outlook of generous cash returns in the medium term for oil producers.
Hedging
Commodity producer hedging has always been a bone of contention amongst investors. The argument in favor is that it locks in margins and provides stability in operations. The argument against is that investors can decide their own exposures, so shareholders will want commodity upside exposure. As a result, management teams will rarely call hedging decisions well, which is expensive as the investment bank usually facilitating the hedging is taking out big fees.
In this case, Harbour is so cheap as that I do not mind its hedging. Its hedging agreements that were struck at time of the Chrysaor Premier Oil transaction are staring to expire, which means the group can lock in higher prices that are available in the market now. Harbour’s average realized price for Brent crude was $58 per barrel in the first half of last year and rose to $82 per barrel during the first half of this year. Similarly, natural gas prices were locked in at 0.69 pounds per therm (89 cents) in the first half of this year against 0.38 pounds per therm for the same period last year. In hindsight, it is easy to say they should not have hedged.
In Harbour’s trading and operations update earlier this month, the company said it expects to generate free cash flow of between $2 billion and 2.2 billion, compared to previous guidance of $1.8 billion to $2 billion, with the roughtly $200 million increase driven by improved production levels, lower capital expenditure and higher commodity prices partially offset by the resulting higher U.K. cash tax payments. This assumes Brent oil and U.K. gas market prices average $90 per barrel and 2.20 pounds per therm for the fourth quarter, resulting in $102 per barrel and 2.12 pounds per therm for the full year. Net debt stood at $1.1 billion at the end of the third quater and Harbour continues to expect to be net debt free in 2023.
Harbour’s strategy is to look for attractive oil and gas fields to buy from distressed sellers in the North Sea. This will help it replace production from the natural decline rate in oil field production and from the fields that come to the end of their productive lives altogether. The company is not performing exploration. By acquiring mid-life fields already producing, Harbour can use debt finance to help fund the purchase. It recognises it operates in a volatile and cyclical business, so it aims for net debt to never exceed 1.5 times Ebitda.
Some of the near-term volatility is mitigated through Harbour’s part-hedging strategy. Mr. Market is too pessimistic about the risks facing the company, however. The company is still a relatively new entity (although management are very experienced oil and gas executives) in its current format for investors, so perhaps they are looking for a track record in free cash flow generation to build up confidence.
I say the high returns and focused strategy already on offer make the stock a real bargain.
