Harvest Natural Resources Will Probably Double in a Couple of Months

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May 22, 2012
I have been a shareholder in Harvest Natural Resources (HNR, Financial) since 2008 after I noticed that Mohnish Pabrai owned the stock. During that time I have listened to all of the conference calls and roadshow presentations. I have found the CEO, James Edmiston, to be very credible. I am also convinced that management is committed to preserving shareholder value, despite a couple of controversial decisions.

In the last two conference calls, Mr. Edmiston has made clear that the exclusive negotiations underway for HNR's 32% interest in Petrodelta, if successfully concluded, would result in a sale substantially above the current share price. He has stated and continues to say that there will be no fire sale, and he has also indicated that a sale at recent share prices would constitute a fire sale.

What is the expected timeframe that a sale, if successful, will be announced?

James Edmiston referenced the exclusive negotiations in his closing remarks in the first quarter 2012 Conference Call by saying "we will be able to give great clarity on this issue certainly within this quarter."

What is the likelihood of a sale being consummated?

I believe that the likelihood of the sale being consummated is better than 50/50. Why spend over two months engaged in exclusive negotiations if both parties didn't believe in a probable favorable outcome? The only parties expanding their presence in Venezuela are the Chinese, so it seems likely that the prospective buyer is CNOOC or Sinopec since this deal fits their modus operandi. Increasing the likelihood that the deal is consummated is the fact that the Chinese are not restricted by the Foreign Corrupt Practices Act (the Venezuelan government is part of the negotiations too).

What is the likely price for the proposed sale of HNR's 32% interest in Petrodelta?

From Slide 11 in the April 18, 2012 IPAA presentation the value of the reserves is as follows:

2P reserves = 103.8 mmboe = $1.053 billion after tax @ $96.2/BBL WTI net to Harvest Natural Resources

3P reserves = 210.5 mmboe = $1.918 billion after tax @ $96.2/BBL WTI net to Harvest Natural Resources

Theoretically, the 2P reserves (proved plus probables) is the most likely value to be ultimately recovered. In other words, it is equally likely that the amount of oil ultimately recovered will be either more than or less than the 2P number. However, as I show below, the third party reserve engineers, Ryder Scott, have used very conservative recovery factors for the new El Salto, Temblador and Isleno fields relative the the legacy Uracoa, Bombal and Tucupita fields despite the same geology, reservoirs and depths and utilizing the same drilling and production technology.

From the 2007 Annual Report:

“Since acquiring the rights to develop and operate the three SMU fields in 1992, Harvest increased estimated ultimate oil recoveries from an initial nine percent to 27 percent, adding 200 million barrels of recoverable oil. The proved, probable and possible reserves at December 2007 for the newly awarded fields imply an average 13 percent estimated recovery factor, providing Petrodelta with an opportunity to increase reserves by increasing oil recovery.”

From the Q4 2011 Harvest Natural Resources Conference Call:

James Edmiston: “...the reserve report continues to confirm our bullish, technical view of the volumes, although at a lower recovery factor than we have as our own internal view.”

Again from the April 18, 2012 IPAA presentation:

Slide 6 shows that the majority of the production is from the new fields which continue to ramp up while the SMU fields have leveled off. Slide 5 shows many prospects in the El Salto field which are bound to add meaningfully to future reserves. Slide 9 shows infrastructure plans to handle a massive increase in production at just the El Salto field.

The majority of the oil yet to be recovered is in the new fields. It is clear to me that the value of all of the oil yet to be recovered, net to Harvest, most likely greatly exceeds the 2P value of $1.05 billion. There is a very good chance that it will exceed the 3P value of $1.92 billion. I believe that a strategic buyer not anchored to the current share price would gladly pay at least $500 million (approximately $11 per share) for Harvest Natural Resources' 32% interest in Petrodelta. Based on my interpretation of Mr. Edmiston's comments, I judge that this is approximately the minimum valuation acceptable to Harvest.

What if the sale is not consummated?

I see the most likely worst case scenario as the nationalization of Harvest's 32% interest in Petrodelta. Yes, worse scenarios are possible, but very unlikely in my opinion. In the case of nationalization, Venezuelan law stipulates that the government pay book value for the assets. The book value of Harvest's 32% interest in Petrodelta is $232 million which is approximately where the stock is trading now. I believe that this is a situation of “heads I win and tails I probably don’t lose much” occurring in a short time frame.