I became interested in Brazil's HRT Participacoes em Petroleo SA (HRTPY) when I noticed Southeastern Asset Management had a large position; currently over 14% of the shares outstanding. HRT is not a stock for everyone because there is a substantial chance of losing all of your money, but as I argue below, I believe that the risk is more than offset by the opportunity of making crazy multiples on your money. I believe that HRT is an ideal candidate for Nassim Nicholas Taleb's barbell strategy where you invest 90% of your portfolio in safe instruments and invest 10% of your portfolio in black swans. However, don't invest more in HRT than you are willing to lose.
HRT Participacoes is an oil and gas exploration company with no debt, but no production either. For purposes of keeping this article simple, I will assume that the three offshore wells being drilled this year in Namibia are the only prospects that matter. Independent third party reserve engineers, DeGoyler and MacNoughton (D&M), have made the following assessment of these prospects:
Wingat - Chance of Success = 27%; P50 = 778 mmbo; P10 = 2112 mmbo (mmbo = million barrels of oil)
Murombe - Chance of Success = 23%; P50 = 2877 mmbo
Moosehead - Chance of Success = 25%; P50 = 1512 mmbo
Before the DeGoyler and MacNoughton report was performed, HRT had estimated that the P10 values for Wingat, Murombe, and Moosehead were 4300 mmbo, 10700 mmbo, and 5500 mmbo, respectively. Notice that D&M's estimation of P10 for the Wingat prospect is approximately half of HRT's estimation. D&M's estimation of the P10 values for Murombe and Moosehead have not been disclosed, but for purposes of this article I will assume Murombe and Moosehead have P10 values of half of the HRT estimates. This assumption appears to be roughly right when compared to D&M's P50 values.
1) A natural gas find is worth zero. The nearby Kudu gas field was discovered in the 1970s and has yet to be produced.
2) If successful, the prospects have a 50% chance of finding oil and a 50% chance of finding gas. These are oil prospects so by definition the odds are greater than 50% that success means oil, but I don't know how much greater so I will assume 50%.
3) If a prospect is an oil success, there is a 50% chance of recovering at least the P50 value
4) If a prospect is an oil success, there is a 10% chance of recovering at least the P10 value
5) If a prospect is an oil success, the value of a barrel of oil in the ground is $7
Chance of Murombe P50 oil success = 0.23 x 0.5 x 0.5 = 5.75%
Chance of Murombe P10 oil success = 0.23 x 0.5 x 0.5 = 1.15%
Chance of Moosehead P50 oil success = 0.25 x 0.5 x 0.5 = 6.25%
Chance of Moosehead or Murombe P50 oil success = 1 - [(1 - 0.0575) x (1 - 0.0625)] = 11.6%
Chance of Moosehead or Murombe oil success = 1 - [(1 - 0.23 x 0.5) x (1 - 0.25 x 0.5)] = 21%
Murombe P50 oil success = 2877 mmbo x $7/bbl x 86% ownership / 645 million fully diluted shares = $26.82 per share
Murombe P10 oil success = 0.5 x 10700 mmbo x $7/bbl x 86% ownership / 645 million FD shares = $49.93 per share
Moosehead P50 oil success = 1512 mmbo x $7/bbl x 79% ownership / 645 million FD shares = $12.96 per share
What about Wingat? Murombe and Moosehead are over 600 kilometers apart and are in separate sedimentary basins, so I believe these two prospects are independent of each other. Wingat and Murombe are close enough to each other that I do not believe that they are completely independent of each other (particularly, source risk and oil versus gas risk). However, if one were to assume that Wingat and Murombe are completely independent of each other then the point on the above graph representing 21% chance of oil success would be moved over to 33% chance of oil success.
Using the assumptions in this article:
The chance of failure is substantially greater than the chance of oil success.
There is approximately an 11% chance of an intrinsic value of at least $13 per share before year end. The Kelly Criterion recommends wagering 4% of your bankroll based on this datapoint and the current share price of $0.92. But wait, there's more!
There is approximately a 6% chance of an intrinsic value of at least $26 per share before year end.
There is approximately a 1% chance of an intrinsic value of at least $50 per share before year end.
If HRT's P10 value of 10.7 billion barrels for Murombe were to be achieved, then the intrinsic value would be $100 per share before year end.
Don't bet more than you are willing to lose!