Interactive Investor

Should I buy shares in Greka Drilling?

21st January 2013 15:52

Darshini Shah from interactive investor

Greka Drilling stock has been quite a performer over the past month, almost doubling in value. Interactive Investor finds out what's behind this share price rise and whether there's further to go.

What Greka does

The rise commenced when the company, on 28 December, announced that it had signed a contract with China National Petroleum Corporation's (CNPC) Huabei Oilfield Company for its LiFaBriC (lined faulted brittle coals) drilling services.

The LiFaBriC methodology has been developed by Greka Drilling for the complex geology experienced in China - the country's coal bed methane resources are estimated to be the third largest by volume in the world after Russia and Canada. But China's coal is not as easy to access as deposits overseas - tt has low permeability, which means that China has not been able to capitalise on its methane assets.

Advantages of LiFaBriC

According to analysts at Edison Investment Research, the LiFaBriC drilling method has "key" advantages, revolving around greater contact with the coal seam, "which helps overcome the lack of permeability, the need for fewer wells and no potentially hazardous fracking requirements".

In fact, Greka estimates that one LiFaBriC in-seam well effectively saves about five verticals. "This not only reduces capital costs but also reduces the environmental footprint," say the Edison analysts, adding that the LiFaBriC method also has the advantages of "no fracking and fewer problems with blockages".

China is growing

Greka's business backdrop is exceptionally well underpinned by the Chinese government's ambitious plans for domestic unconventional gas development.

"Importantly, these plans are independent of any conceivable slowdown in China's economy in the near to medium term," stress the Edison team.

Underlying the bullish backdrop is the Chinese government's aim of increasing the role of gas in the energy mix, reflecting the desire to reduce the carbon intensity of the economy. Presently, gas represents about 4% of the mix, while the medium-term objective is to boost this to 8%. This is still a low percentage relative to the US or Europe, where the share of gas is 25% or more.

"Given that the government also wishes to lessen China's reliance on energy imports, achieving the former objective will necessitate much greater emphasis on developing domestic sources of gas than before," the analysts note. "Due to the relative paucity of conventional resources, this effectively implies developing China's sizeable unconventional gas resources in the form of coal bed methane (CBM) and shale."

China is estimated to hold the world's largest CBM resource base, with proven reserves of seven trillion cubic feet (tcf) and gas in place of over 500 tcf.

Until recently, the Chinese government's drive to exploit unconventional gas has largely focused on CBM. Development of the resource base has, however, been heavily constrained by a number of factors, the most significant of which is challenging geology.

Nevertheless, the Edison analysts point out that production has started to gather momentum, albeit from a low base. "Based on industry sources, China's CBM production was running at about 109 billion cubic feet (bcf) and 187 bcf in 2010 and 2011 respectively. The former represented 3.2% of total natural gas production and the latter around 5%.

"The government's objective for CBM is for China to be producing around 1.1 tcf by 2020. This is expected to be about 15% of total gas production."

Shale gas prospects

Attention is also now turning to shale gas, reflecting the resource base identified by both the Energy Information Agency (the statistics arm of the US Department of Energy) and the Chinese Ministry of Land Resources (MLR); and secondly, the tremendous success of the US gas industry in developing shale resources in the US over the past 10 years or so.

Shale gas exploration and development in China is at a very early stage. So far, only about 60 shale wells have been drilled, compared to over 13,000 in the Barnett Basin in Texas alone. Only five domestic companies are currently active in shale gas exploration and development in China.

Based on press reports, the Chinese government is targeting shale gas output of about 3.5 tcf by 2020. This is expected to be equivalent to roughly 25% of the total gas supply at that time. In comparison, US shale gas output is currently running at about four tcf.

To date, there have been five commercial shale gas discoveries in China, with Sinopec's Yuanba find in Sichuan province in the centre of the country probably the most significant.

"The number of companies involved in shale gas exploration and development in China is likely to increase sharply in the near term, given the MLR's pending second licensing round," notes Edison Investment Research. "Foreign companies with the necessary technical and financial credentials are expected to participate in the bidding, either in partnership with domestic concerns or possibly independently."

Demand for LiFaBriC on the up

According to the statement on 28 December, CNPC has announced plans to drill a total of between 1,500 and 2,000 wells in 2013.

If the initial trial with LiFaBric is deemed successful, it is expected that CNPC would formally implememt the use of LiFaBriC in the Qinshui Basin.

This announcement came just days after the company announced the signing of a contract with Petro-king Oilfield Technology, "the first in a series of expected third-party contracts from China-based exploration and production companies".

This is a far cry from October 2012, when Greka Drilling only had one customer - its former parent Green Dragon Gas. At the time, Greka had indicated that obtaining new third-party business both in and, in due course, outside China, was a key objective, in an attempt to keep the revenue flow from Green Dragon Gas at below 33% of total revenues, derisking the business model by decoupling Greka's fortunes from those of Green Dragon.

And more opportunities exist, given China's gas ambitions and the serious sums of money being committed by both home-grown oil giants like Sinopec and CNPC, and international companies. Royal Dutch Shell, for example, has earmarked $0.5 billion (£0.3 billion) for tight gas and shale projects in China.

First-mover advantage

Greka's competition in China comprises of a number of small non-specialised coal-mining and oilfield drilling contractors, plus the in-house drilling operations of the national oil company majors.

However, investors should remember that Greka Drilling has first-mover advantage in applying its innovative LiFaBriC drilling method.

Base-case scenario of 21p - analyst

Edison Investment Research believes that a base-case valuation of $137 million, or 21p per share, could be justified for Greka Drilling, using a five times enterprise value multiple of its forecast 2013 EBITDA.

"However, assuming an upward trend in drill activity, we believe a valuation of five times 2014 EBITDA of $41 million could be justified, implying 28p [per] share," the broker commented.

Shares tightly held

Investors should be cautioned that the free float is quite tight - chief executive Randeep Grewal holds more than 66% of the share capital.

Interactive Investor discussion board user 'ma ma hu hu' estimates another two thirds of the remaining share capital (c. 21%) is retained by long-term holders, leaving about 12% of outstanding shares for others to fight over.

"This could potentially lead to a significant uplift in the share price at some point as new investors try and join the party," he optimistically points out, but warns: "I do foresee something akin to this in the future when stock again gets squeezed.

"The trick is then knowing when to get out."

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.

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