Tullow Oil - Spend a dollar to make a dollar

All,

Please find our updated analysis here.

While the oil markets continue to gyrate, we maintain our focus on production levels, the main driver of Tullow’s financial health. We don’t dismiss the benefits of the current oil price to Tullow, but Tullow have a large hedge position, with 75% protection on the downside (at $55/bbl). Tullow are exposed to 40% on the upside due to naked puts purchased under the conditions of the now refinanced RBL facilities. This means that Tullow are only hedged on the upside for 60% of their planned FY22 production at $78/bbl.

- Tullow has increased its hedges since year-end, and will comply with the covenants of the bonds which state that 75% of Yr 1 and Yr 2 production is hedged.

- We have updated our model post the publication of FY21 numbers and adjusted our CAPEX and production numbers marginally from previous models.

Jubilee v TEN fields:

- As we have previously highlighted, production levels are the most important aspect concerning Tullow's financial health. The two main assets of Tullow are Jubilee and TEN and the differences between them highlight the issues Tullow is facing.

- The Jubilee field has benefitted from CAPEX spending over the prior years, which is reflected in the number of wells drilled in recent years. TEN hasn't, and this has caused a reduction in production, especially in the FY19-FY21 period.

- FY22 plans are not likely to impact the trends, with drilling at Jubilee to include two water injectors and one new producer. At TEN, the plans are for two development wells at the Ntomme River Base with the corresponding infrastructure spend, and an additional production well in Q4, all of which will have no impact on FY22 production levels, but increase production in FY23.

- The decay rate at TEN has been greater than expected, which has caused a reduction in the recovery assumptions on the existing segment of the field. This in turn is the reason Tullow and its JV partners have turned their focus to other parts of the field and are spending the CAPEX on two development wells. The risk at TEN has increased.

- Overall, it is imperative on Tullow to continue to spend the CAPEX budget on new wells, as this is the only way to stabilise and increase production figures. Jubilee highlights the benefits of the CAPEX spending and TEN’s decline reflects the lack of spending.

Stress Test:

- This is an extreme scenario but we wanted to explore the impact of no further drilling success at Jubilee and TEN fields in Ghana.

- Tullow expect to spend $700m at Jubilee and $550m at TEN in the next 4 years (FY22-FY25). We have grossed up these figures to c.$780m and $640m respectively to account for the additional stake acquired under the pre-emption rights. We have assumed Tullow will spend all of its CAPEX plans over the FY22-25 period, but none of the new wells in Ghana produces. Our oil price assumption is $100/bbl for FY22 and $90/bbl there after.

- Under this scenario, leverage would increase to 2.5x, just below levels of refinancing in FY21.

- We acknowledge that under such an extreme scenario, the value of existing reserves would drastically reduce. The flip side is that we would not expect Tullow to continue to drill and spend $1.4bn of CAPEX without any success, and if this scenario happened, CAPEX would be curtailed materially.

- I repeat we do not see this scenario as remotely possible, but it highlights the impact of current oil prices on deleveraging the balance sheet. Tullow expects to deleverage to 1.5x leverage by FY23 at $75/bbl oil price.

Ghanian Tax Liability:

- We mention this potential liability although there is no new information on it. This issue has been rumbling on for some time and was again highlighted in the accounts. Ghana has issued a demand for $471m for potential liability from operations in FY14-16. This has been disputed since 2018 but any negative resolution will have 0.5-0.6x impact on leverage. Management did not provide any update on the issue.

Kenya:

- Currently, Tullow and its partners are in discussion with the Government of Kenya and have submitted FDP (Final Development Plan) to the Ministry. Any completion of this process will no doubt be positive for the equity and to a lesser extent the bonds. Tullow intends that a strategic partner (farm-down) will be secured ahead of Final Investment Decision. Note: Even if Kenyan operations get approval, positive cashflow is unlikely to be until FY25/FY26, hence the impact is likely to be less for the bonds.

- We strongly believe that any sale/farm-down will not deleverage the business, as any cash received will be used to fund Tullow's share of the $3.4b gross CAPEX to cover the upstream and pipeline to First Oil. Tullow currently owns a 50% working interest in three of the four Kenyan fields (100% of the last field).

Positioning:

- We maintain our 3% position in the 2025 bonds (acquired at 70% in January 2021) and our long 4% equity position (52p in March 2021).

- Over recent weeks, the differential between sub and senior bonds and absolute trading levels have continued to widen despite the increase in oil prices. Our model, which is more conservative than Tullow's guidance, and based on a $100/bbl oil price for FY22, $90/bbl thereafter, shows the Company reaching below 1.0x leverage by December 2024, just before the refinancing of the structure.

- Downside protection is provided by the hedging position Tullow are obliged to undertake as part of the refinancing.

Happy to discuss.

Tomás

E: tmannion@sarria.co.uk
T: +44 20 3744 7009

M:+44 7786 705 806
www.sarria.co.uk