(Public) New Stratus Energy: Ecuador Settlement Is The Catalyst Shareholders Need

By: Jon Costello

Introduction

We first covered New Stratus Energy back on May 31, 2024. Since then, there have been some important events that unfolded that we want to cover here.

First, New Stratus Energy, ( NSE:CA) reported disappointing third-quarter results. The company had pinned its hopes on its prospects in Venezuela. However, as things turned out, the venture failed only months after it began. NSE attributed the failure to deteriorating economic and social conditions in Venezuela. The company is now at risk of losing its entire C$9 million investment in the project.

The news surprised us. It negated our investment thesis, which revolved mainly around what we thought would be an “easy win," namely, restarting production in a highly prospective and once prolific Venezuelan oil field.

There was, however, always a caveat with the risk of investing in Venezuela. The geopolitical discount that will forever latch onto the name caused it to permanently trade at a discount, and the sanction risks associated with US personnels being involved with Venezuela presented another problem for NSE.

Thankfully, NSE’s investment thesis has not been completely invalidated.

There are still two main investment regions left for NSE: Mexico and Ecuador. As we will discuss in this article, we think both offer an attractive risk-adjusted return profile for investors, but the most alluring setup comes from the potential settlement with the Ecuador government, which we will discuss below.

Mexico Prospects Remain Intact

The first is NSE’s project in Mexico, called Soledad. The company acquired Soledad in May. The following slide provides an overview.

Source: New Stratus Energy May 2024 Corporate Presentation.

Soledad owns a 49% equity stake in OPS, a private Mexican E&P that operates under a contract with the Mexican state oil company Pemex. OPS and its Soledad block has produced oil since 2013. Current production stood at 1,029 boe/d on September 30, 2024. Soledad is expected to use retained cash flow to increase production. If successful, NSE can increase its stake in Soledad to 90% in 2026. Despite Mexico’s leftist government, it has a far more stable operating environment in Venezuela. A sudden rug pull of the project similar to what happened in Venezuela therefore isn’t likely.

Through September 30, NSE has invested C$34 million in OPS. Its share of income from its equity stake in the venture amounts to only $972,925, which it has earned since May 1. We expect its capital investments to bear fruit in the form of higher production and income over the coming quarters.

Nearing a Settlement in Ecuador

The more speculative—and, in our view, more interesting—part of our NSE thesis centers on the company’s ongoing dispute with the government of Ecuador. For the moment, it appears that NSE’s fate depends on the outcome of this dispute.

We believe the dispute will likely be resolved in NSE’s favor. However, potential outcomes vary widely, as we sourced all of our data from publicly available information. We draw extensively from NSE’s public securities filings, but we also rely on data from Ecuadorian media sources of unknown reputation. The figures used below are based on our peer group analysis and best guesses.

NSE’s activities in Ecuador began in October 2020, when the company announced that it would acquire Repsol’s ( REPYY) Ecuadorian subsidiary. This subsidiary held a 35% stake in service contracts in Ecuadorian Blocks 16 and 67 in the Amazon. Repsol’s divestiture was part of a larger program to focus its operations. NSE paid C$5 million for the assets.

The deal also required the approval of the Ecuadorian government and regulatory authorities, some of which were granted to NSE by November 21, 2021.

NSE changed the operating company's name from Repsol Ecuador to Petrolia Ecuador. The acquired assets produced approximately 15,800 boe/d of 15-degree API crude oil. The deal required the Ecuadorian government to pay NSE a fee per barrel of production, amounting to $38 per barrel for Block 17 and $29 per barrel for Block 67.

After its acquisition, NSE reached an agreement with the Ecuadorian government to change the type of contract for the Blocks from a provision of services contract to an economic participation contract with production sharing. In connection with the contract change, NSE’s Petrolia Ecuador subsidiary pledged to spend $200 million on developing the blocks in 2022 and 2023 to increase their output to 25,000 boe/d. NSE went so far as to sign a letter of intent with Baker Hughes ( BKR) for oilfield services work in connection with its investment.

After the deal, however, the Ecuadorian government failed to uphold its end of the contracts requiring the ownership transfer of the blocks to NSE. Consequently, the government had liabilities of $120 million by late 2021, and its debt to NSE continued to increase throughout 2022.

On December 5, 2022, the Ecuadorian government confiscated NSE’s assets. It then put the assets out to tender. Ecuador’s debt to NSE had increased to $290 million, and the government declared the debt void once the contracts underlying Blocks 16 and 67 expired at the end of 2022.

NSE filed a notice of international arbitration, accusing the Ecuadorian government of failing to uphold its contractual obligations. It also sued the Ecuadorian government for $260 million in damages due to the government’s refusal to renegotiate contracts as had been agreed for Blocks 16 and 67.

New Regime

In November 2023, Daniel Noboa was elected as the new Ecuadorian president. Noboa has pledged to clean up Ecuador’s endemic corruption, reduce its crime rate, and remedy its energy crisis.

With Noboa’s election, NSE’s prospects for winning back its Block 16 and 67 concessions improved.

Since NSE has upheld its contractual agreements, the odds are good that it will win in arbitration. The Noboa government is motivated to increase Ecuador’s tax revenues from oil production. Foreign entities will balk at making deals if the government is questionable about its contractual commitments. If Ecuador intends to clean the slate and attract investment, it will have to offer compensation to NSE if it wants to attract additional foreign capital.

NSE is optimistic about its prospects. Its latest public disclosures on Ecuador came in its second-quarter 2024 earnings press release on August 29. In it, it stated:

“Subsequent to the end of Q2, NSE was notified by the Government of Ecuador that it will be receiving a $6.8 million correction factor adjustment dating back to an application made in 2022, which payment is expected before the end of 2024.”

Then, in its third-quarter press release on November 29, NSE reiterated that negotiations with the Ecuadorian government remain underway and that management believes that a positive resolution is expected “ within the next month.” When the announcement was first released, we were surprised by the boldness of the language. Normally, general counsels will refuse such language be included in press releases unless the management team was certain a settlement was coming. In addition, to say that it was going to be announced within a month shows confidence.

It has been over a month now since the Q3 release and no settlement has been announced. However, we suspect that if negotiations were not ongoing, the company would be required to press release that no settlement was made.

Moreover, if a settlement involved a simple one-time cash payment as compensation, the payment would have been made by now. We think something bigger is at play, and based on the latest public news announcements (more details below), we think it will be positive for NSE shareholders.

Given the highly idiosyncratic risk profile, NSE is now a special situation that hinges on the outcome of a legal settlement. It will be important for shareholders to exercise patience and to endure the volatility that is likely, assuming negotiations are proceeding.

If the Ecuador situation works out favorably, NSE shareholders could see significant gains from the current share price. We’re holding onto our shares under the assumption that a settlement will be forthcoming.

Possible Settlement: Campo Sacha

Noboa is on record as publicly stating that oil concessions will be granted to private parties. Revenues to the state from such concessions are expected to alleviate Ecuador’s liquidity strains, which have required it to tap external sources for financing to meet its domestic spending requirements.

One possibility that could work out for NSE shareholders is a concession in an existing oilfield. Recent reports indicate that Amodaimi Oil, a subsidiary of Chinese oil major Sinopec, and NSE are to have formed a consortium for acquiring a working interest in Block 60 of Ecuador’s Sacha field.

The Campo Sacha field is Ecuador's largest producing oil field, at 77,000 boe/d. It has been operated by Petroecuador, the country’s national oil company. However, the Ecuadorian government is apparently in the process of ordering Petroecuador to return the field to the government so that the government can grant concessions.

The government expects new concessions to boost Ecuador’s oil production and government tax receipts. The Sacha field, in particular, would make an appropriate target for privatization given its current state. Despite being one of the best-producing fields in Ecuador, the field is producing far below its capacity. Existing infrastructure is at maximum capacity and is suffering from a lack of maintenance. The field flares significant volumes of natural gas, which could be captured and sold if the field was operated properly. Without sufficient investment, the field is expected to produce only 170 million barrels of oil over its remaining life, a small fraction of its potential, which stands at significantly more than one billion recoverable barrels. The field will require $1.5 billion of investment over the next 20 years.

Clearly, the Ecuadorian government is not up to the task of managing the field. A private operator will be capable of optimizing production and marketing the produced volumes.

The consortium is reported to have offered an upfront advance bonus of $1.5 billion, followed by $1.761 billion in investments over 20 years. It expects these investments to increase the Sacha field’s production from its current rate of approximately 75,000 boe/d to 100,000 boe/d over the next three years. The Ecuadorian government and the consortium would split the income from the production, with the Ecuadorian government receiving 80% of the total and the consortium receiving the remaining 20%.

While detailed financials aren’t available, the Sacha field is reported to generate approximately $1.5 billion in annual net income with Brent in the mid-$70s per barrel. The field requires $160 million of annual capex to maintain flat production, which leaves significant cash flow to invest in increasing production. If the field’s production can be increased to 100,000 boe/d, its income would grow to $2.0 billion, of which $1.6 billion would accrue to the Ecuadorian government. The remaining $400 million of net income would accrue to the consortium.

Valuation Scenarios

The wild card for NSE shareholders is the company’s percentage ownership interest in the consortium. If we assume that the company is able to obtain a percentage of production equivalent to the production generated from its original Blocks 16 and 67, its 15,000 boe/d would represent a 20% working interest in the Sacha field.

We use Parex’s ( PXT:CA) netbacks of C$38 at $75 per barrel Brent as a shorthand estimate for the Sacha field’s netbacks. We also assume NSE capitalizes the new venture with 75% debt and 25% equity.

At 20%, the Sacha working interest acquisition would increase NSE’s valuation to C$0.94 per share, representing 110% upside from its current price.

If we instead assume that NSE be granted a 35% working interest, equivalent to its working interest in owned in its original service contracts for Blocks 16 and 67, the Sacha working interest acquisition would increase NSE’s valuation to C$1.18 per share, representing 162% upside from its current price.

These scenarios assume the company can successfully raise the necessary equity and debt capital. Given the attractiveness of the deal, we don’t expect it to have difficulty doing so.

The company would have to reinvest its earnings from the concession to cover its share of operating and capital costs. How it intends to do so remains a mystery, and we know too little to reach reliable conclusions about specifics. However, we suspect management has the opportunity to reach a deal that delivers significant returns to NSE shareholders. Given the sums involved, we’d consider anything less than C$100 million of additional equity value a disappointment, particularly in light of the $260 million it is seeking in its lawsuit against the Ecuadorian government. But even that amount would cause more than a doubling in the market price of NSE shares.

We suspect that this concession would represent an “amicable settlement” of its outstanding arbitration claim against the Ecuadorian government and its ongoing lawsuit. The company hints at such an outcome in the footnotes of its third-quarter 2024 financial statements, as shown below.

Source: New Stratus Energy Q3 2024 Financial Statements. Highlight added by author.

If a settlement occurs along the lines of the scenarios sketched above, it could be very profitable for NSE shareholders.

Risks

The deal is not without critics, some of whom assert that Ecuador’s hydrocarbon law prohibits concessions of producing fields to private companies unless the field under consideration is “marginal” in nature and produces less than 4,000 boe/d. To their point, Sacha is clearly not marginal. It has some of the lowest production costs per barrel in Ecuador. Meanwhile, it is producing many times the 4,000 boe/d maximum.

The government claims in its defense that the concession would be lawful because it would occur between state companies—Petroecuador and Sinopec—not between Petroecuador and a private company. However, Sinopec can presumably do what it pleases once it is awarded the concession. At the very least, we suspect it would hire Ecuadorian oilfield service or other private consultancies in connection with its operation of the Sacha field.

Financially, the risks are that the NSE share price drifts lower, making equity financing more difficult to achieve on attractive terms.

Conclusion

NSE has become a speculative special situation, but one that we believe holds significant potential. Given management’s previous communications that it expected to reach a conclusion in late 2024, we wouldn’t be surprised if it reached a deal within the next month. We continue to hold the shares in expectation of a deal.

Analyst's Disclosure: I/we have a beneficial long position in the shares of NSE.V either through stock ownership, options, or other derivatives.