KR III: Alama Kubwa: The big score

The migration of the wildebeest on Africa’s Serengeti Plain is one of the most awesome sights in the natural world.

Being in the presence of thirty thousand animals on the hoof, all intent on a common purpose—that would be a unique experience even if you were bereft of eyes and ears. When the herd moves, you can feel them all through your body. It’s like an earthquake.

As luck would have it, I was fortunate enough to be in Kenya on an investment research trip right at the time of peak migration in the Maasai Mara.

So of course I had to go on safari.

Though I’m not much of a photographer, this picture I snapped with my phone will give you an idea of how close I was to the action. The wildebeest were literally right at my feet. And to really grasp the scale of the event, just remember to multiply what you see here by about 500.



As you can see, the mass of wildebeest were at a river they needed to cross to continue their journey. Though they are not particularly intelligent animals, they seem dimly aware that the river hosts hazards to their health. Which it does, in the form of hungry crocodiles and grumpy hippos. So they’re very wary. They mill around, presumably begging (in wildebeest-speak) for some hero to show the way by taking the first leap into the treacherous water.

Now, I hate to gamble in my financial decisions. I’m well known for being ultra-conservative when it comes to analyzing investments. But outside of that, I like to make small-scale bets, the sillier the better. Since my companions and I could see that there were several likely crossing points, my good friend Keith Hill (more on him later) and I made a friendly wager on which route the beasts would eventually choose.

It took a while, and the analysts and fund managers with us in our jeep had a riot watching as different wildebeests would go to the river’s edge at the point I selected, dip their toes in the water and take a little drink, only to quickly back away at some real or imagined fright. First, it was one wildebeest. Then 10 minutes later, three wildebeests came to my route and the whole process repeated. Then about 50 wildebeests came to the river’s edge.

After an hour of thousands of animals performing the “Hesitation Blues,” everyone was convinced that I had won the bet.

I was all set to collect as this large group massed themselves behind a leader who seemed ready to plunge in at “my” crossing. But then he paused, as he thought he saw something in the water. He quickly snapped back onto the river’s edge and his followers retreated with him.

Meanwhile, there was one further element involved in the tableau: zebras.

A much smaller herd of them, maybe a thousand, was standing completely engaged, watching intensely which route the wildebeests would choose.

I must say, I never paid much attention to the zebra’s on past safaris.

But zebras are pretty smart, as I soon learned.

After those endless back-and-forth wildebeest sallies, all of a sudden one of them went all in, jumping into the water and making for the opposite shore as if his life depended on it. (Which it probably did.)

Within a minute, the whole herd stormed down the route Keith Hill had chosen and crossed the river. He won the bet.

It was as if a football referee had just blown the whistle signaling kickoff. All the animals that had previously been standing around immediately sprang into action. The race was on. Thousands of wildebeest stampeded into the river, determined to make it to safety instead of winding up in a croc’s jaws.

It was a stunning spectacle. But what caught my eye at that moment wasn’t the wildebeest. It was the zebras.

I hadn’t known how clever they really were.

They hadn’t been just passing the time. They’d been patiently watching and waiting for the wildebeest to act first.

Now, as the wildebeest made their mad dash across the water, the zebras calmly infiltrated the herd, using it as a shield.

At that moment I realized that I was not only witnessing one of nature’s grand gestures.

If I’d wanted a better metaphor for the state of the natural resource sector, I couldn’t possibly have come up with one.

The whole migration crossing the river reminded me of the current state of the resource sector. Since resources peaked and started their decline in late 2011, the great wildebeest herd of investors has been gathered at the river’s edge, taking the occasional little sip but afraid to commit to anything more.

They await the leader or leaders who will announce that the market has bottomed and the next uptrend is underway. Once that idea takes hold, the herd will bolt ahead en masse.

However, it’s the zebras who represent the savvy investors. They will not make the plunge and be taken down too early.

They know the gifts bestowed upon patience, and are secure in the knowledge that one day the market will turn. As I wrote in my July newsletter: Fortune favors the bold; but the market rewards the wise.

Fortune favors the bold; but the market rewards the wise.

The bold wildebeest, the ones who initiate the rush, may or may not do well, depending on how they take the plunge and more importantly what is waiting for them, such as the silently-hunting crocodile.

But the zebras are my kind of guys. Having used the wildebeest to run interference for them, they will peel off and go about their business once they feel secure. Just so, the wise investor will use the herd’s next frantic buying spree to compound his profits, and will pull away before the market once again reaches unrealistic levels.

That’s the way to make a big score.

Which brings me to this month’s investment story. Long time readers of mine know about Africa Oil, and the profits it’s already handed us, but let me explain why I bought back into the company recently, taking a considerable position at an average price of C$1.55.

The stock has moved the last few days, and I believe AOI is easily worth $3 a share.

Alama Kubwa: The Big Score

On the road, I love meeting new people. One rule I have on site visits is that I am always the first one up. This one particular morning, I woke at 2:30 a.m., and was wide awake.

So, after reading and shaving (yes, I shaved in a tent on the safari), I made my way up to the central area at around 4 a.m. There was a security guard with a shot gun, and we started talking. He got me a pot of coffee and he asked me why I came there. I shared with him some reasons, ending with, “my investors expect me to find a big score.”

He smiled and replied in Swahili “Alama Kubwa.”

In 2007, I was heavily invested in a private company called Turkana Energy. I was involved in the initial first two rounds of capital-raising required for the acquisition and preliminary exploration on a 10BB oil block in Kenya. By the fall of 2008, the company needed to raise another $10 million. I, along with a few other key large shareholders, took the initiative to remove existing management and attempted to take the company public. Unfortunately, oil was below $40/bbl at the time, and the market appetite was essentially zero for any early stage international exploration companies.

That’s when I came up with the plan to pitch Lukas Lundin, whom most of my readers know as one of the giants in the industry.

But first, I knew I had to sell Keith Hill, one of Lukas’s key oil executives. Keith—the bettor on wildebeest—is smart and very trustworthy, and I called him up and explained my plan. Now, it’s no secret that Keith Hill is a close friend and mentor of mine (except at the poker table, where I mentor him). So Keith, being the good friend he is, made time to hear my pitch. I put together a whole report to walk Keith through the value of the 10BB block. Keith, though, being the shrewd oil man he is, wasn’t going to be sold on my first effort.

But I don’t lightly take no for an answer, so I kept pestering him, and that’s when he said, “Ok, let’s talk to Lukas”.

The resource markets were in an awful state in late 2008, even worse than the current down market. Lukas listened to my pitch, had a whole list of questions, and after hearing my price, he also said “No”.

My heart sank.

I took it personally; not only did I have a lot of my own money in the deal, I had my fund, my friends, family and loyal subscribers in there with me at the same price. I had to make this work.

After scraping the remnants of my ego off the floor, I tweaked my proposal, and met with Keith and Lukas again. Again, we went over the metrics, the geology, the potential, and after going through my whole deck, Lukas again said no.
I left with my tail between my legs. I was frustrated, pissed off and very worried. During the walk back to my office on that miserable rainy Friday afternoon, I knew I had to redo my pitch deck and give it one last shot. Perhaps it was my naïveté, or my lack of experience at the time, or my unshakeable belief in the project, but I didn’t give up. A month later, we did a third meeting, and at that point, after a very heated debate, we finally agreed on terms.

The Benefit of Time

After we settled on a deal, Lukas and Keith worked out a plan on the structure and capital that would be required to give the 10BB block—and the whole concept of the East African Rift that would make Africa Oil a world class company—a real shot at success. Boy, were Lukas and Keith ever spot on.

Within a few years of that initial private placement in early 2009, Africa Oil made the world’s largest onshore oil discovery in a decade. The Lundins were able to attract a deep pocket oil company to farm into the project, which reduced the risk and cost for Africa Oil shareholders.

Fast forward to 7 years later.

Billions of dollars have now been spent exploring via seismic, and drilling oil wells on the various blocks in Kenya that Africa Oil has direct ownership in.

In fact, in the last 12 months, Africa Oil has raised more money than all the other non-producing oil exploration companies listed on the Canadian stock exchange combined. That alone is a mind blowing fact.

I first recommended Africa Oil in late 2008. Unfortunately, I also sold too early. I closed the position in 2012 just before it had a massive run northward. I had a very large position in the stock, and to sell any I had to make sure I closed it out in the newsletter first. I was wrong, as just a few months later, the stock was $12 a share. I still made over 300% gains, which is great, but I didn’t have what I would consider an Alama Kubwa or, in English, a Big Score.

Here’s the story in chart form:



So, what next?

Why did I buy back into Africa Oil (AOI.TO)?

I spent a few days in Kenya with Lukas Lundin and Keith Hill, along with analysts from JP Morgan, Fidelity, Credit Suisse, TD Bank, Pareto, and a few other fund managers. These were some very smart people at the site visit; arguably, some of the smartest in the sector.

While I don’t always agree with them, they’re all folks worth reading and listening to, and I do.

Here is why I think AOI is such a good buy. My updated 2C resource report (a calculation on how much oil the blocks may have) is much lower than every single analyst who follows the story (this is a good thing, as it pays to be conservative; and even using my numbers AOI isincredibly cheap).

Now, most analysts are very smart nerds, and I say that as a compliment. Usually, the analysts do not have the personalities of the investment bankers (generally speaking, analysts are quite boring people. A good investment bankers are salesmen with charisma), but have twice the analytical abilities. Yet they make way less than most bankers.

I will let you in on an industry secret: The investment bankers are usually very good at sounding smart, but it’s the analysts that actually come up with the information for the investment bankers to express and communicate to the market. I’ve been in this game long enough to know which bankers are real and give the best analysts a run for their money, and which ones are merely pompous asses. I may catch some flak for this, but trust me when I say that I know which way the scales tip. Most bankers are pompous asses.

I’ve been fortunate in my career that I can talk both languages, banker talk and analyst talk. So after dinner on the second night, followed by a few too many Kenyan cocktails that went down like Kool-Aid, I found myself with the analysts talking Africa Oil’s 2C resources and what we each thought they would be.

The analysts generally are shy, not very talkative, but they got chattier as the evening wore on and we started talking about our models and valuations. In summary, their range for the updated resource numbers, using just the data that is public to date, is 780-880 Million barrels. My range, on the other hand, is a more cautionary 720-750M barrels.

Here are the differences between me and most analysts:

1. I play with my own money, not others’. Win or lose, it’s my personal net worth at risk. So I don’t get overly carried away with my analyses.
2. I was the first person to publish a research report on AOI in early 2009, and have been following the story from day one. Thus, I believe my perspective is unique.
That said, even given my more conservative numbers, I am highly bullish on AOI. Here, in point form, is why:

§ Updated Resource calculation and Field Development Program (FDP) are coming by late 2015/early 2016. These will attract major attention from larger oil companies. Including my own estimates, the range is expected to be anywhere from 720-890 Million barrels of 2C gross. But more importantly, this will be a much more detailed resource calculation than the first, and will significantly de-risk the project for a bigger oil company, and add the kicker of real potential for large upside in reserve growth. There are very few basins like this in the world and trust me, the majors will take notice. I believe it’s just a matter of time.
§ AOI’s Big Three shareholders are absolutely top shelf: 1. Lukas Lundin and the Lundin Family. ‘Nuff said. 2. Dr. Richard Norris, Upstream Advisor to Helios Investment Partners. Richard is VERY smart. I spent a lot of one-on-one time with him on a private plane; we have similar outlooks on the industry, senses of humor, interests—and I just like the guy. He knows his stuff. The only negative is that his mandate is restricted to Africa. So, though I’d love to see his analysis on non-African projects, I can’t! Still, I highly recommend that all subscribers who want exposure to African oil projects pay attention to what Richard and Helios IP are up to. IFC (International Finance Corp.)/World Bank Group. For IFC to be in, it really shows the social and political aspects are well-covered.
§ Pipeline development: it’s still years away, but the pipeline route has been chosen and the government is fully behind the project.
§ One of only maybe 100 basins of this size in the world. The East African Rift will ultimately prove to be a multi-billion barrel oil basin, but more importantly, it’s onshore, and will lie in the lowest quartile of production costs. This alone will attract major attention.
§ Takeover candidate or Joint Venture Partner: I don’t know which, but one of the two will happen. Either Africa oil will be bought out at somewhere between C$4-5 per share or a joint venture partner with deep pockets will buy half of AOI’s concessions for cash and carry AOI’s future costs. Either way, from the current price in the C$1.50 range, AOI has considerable upside.
To be clear: This is a high risk speculation, and should not be speculated on with money you cannot afford to lose. The company does not have production nor does it pay a dividend. AOI, fortunately, has no debt either. My fund’s cost base in AOI is around the C$1.55 range.
The main thing to remember is that there are very few parcels of untracked land left in the world with the size and potential of what AOI has accumulated. Underexplored areas mean huge potential for oil companies; high risk, high reward is the motto in Africa. While African production as a whole has fallen off due to capacity and infrastructure issues, which does not mean investment in the area is unwarranted. In 2013 alone, six of the top 10 global discoveries by size were made on the African continent.


Currently the majority of African oil comes from the OPEC members: Nigeria, Angola and Algeria. Production from these three countries generated 68% of the African total. War-torn Libya has seen its production crater by over 50% since the coup there, yet still produces 355,000 barrels per day.

Regardless of jurisdiction, exploration capex was the first thing to be slashed by every exploration company in the world as the price of oil plummeted below $50. African nations saw significant investments during the bull market but, as you might expect, in 2014 and 2015 exploration funding diminished quickly. With nearly all the bidding for exploration licenses already complete, companies this year focused mainly on analyzing seismic data or small drill programs.



The East Africa Investment Hypothesis
Key Points
§ World class onshore oil deposits. Vastly underexplored, high risk/high reward yields tremendous upside with the right management team in place.
§ Logistically makes sense, as shipping times are comparable to Iran and Saudi Arabia yet no supply blockage issues such as via Strait of Hormuz.
§ Infrastructure continues to be an issue, but the Uganda–Kenya pipeline decision has finally been made.
§ Low oil prices likely to impact interim exploration and funding from African E&Ps, new LNG projects likely put on hold at best.

Geographically, East Africa is more complex than Northern or Western Africa and as a result, it is perhaps the most underdeveloped and underexplored oil region left on earth. Comparatively speaking, North Africa has approximately 20,000 wells drilled, West Africa 5,000 and East Africa only 500.

Eastern Africa hosts what is known as the EAR or East African Rift. (A rift is a crack or split in the earth’s crust.) The EAR started forming about 25 million years ago, as Africa began to rip itself apart at a whopping speed of several millimeters per year. While millimeters may mean little to us, to geologic formations they are keys to the development of massive organic-rich basins of sediments. Today, the EAR is the largest continental rift system on Earth. From the Red Sea it extends some 3,500 kilometers southward, though Somalia, Kenya, Uganda, Rwanda, Burundi, Tanzania, and Mozambique. The island of Madagascar lies just to the other side of the rift.

The total potential areas for production are several magnitudes larger than all the North Sea (850mbbl/d), which supplies one-third of Europe’s oil and gas needs. The area has given rise to the phrase, “hunting for elephants”.



As recently as 2006, East Africa didn’t even make the list of oil producers. That began to change in 2007, when Heritage Oil (LSE.HOIL) and Tullow Oil (LSE.TLW) announced a 1-billion-barrel discovery in Lake Albert, Uganda. Oil and gas explorers have reported major discoveries each year in the region since then, most recently out of a Kenyan project of Africa Oil (T.AOI), spudded in January 2012.



Uganda and more recently Kenya have seen the whale’s share of recent development. The majority of exploration in Uganda has occurred in the Albertine Graben Basin, located on the western border of Uganda. But to illustrate how recent this has all been, Heritage Oil became the first company to explore the country since the 1930s when it entered Uganda in 1997.

The big guys—International oil companies (IOCs) and the national oil companies (NOCs)—have dominated exploration in East Africa for the past 60 years. Only the utmost experienced management teams of junior companies such as Africa Oil have dared to step into the lion’s den. That being said, the number of wells drilled in East Africa is paltry compared to somewhere like the United States. Even pre-shale revolution, thousands of wells were drilled in the continental US on a yearly basis.



Wells drilled and reserves go hand in hand, as it is impossible to develop a world-class resource without drilling hundreds of wells. Outside of the African OPEC nations, the proven and probable reserve base for the continent is very small. Countries such as Uganda and Kenya do not even make it in the BP or IEA statistical database despite Tullow’s breakthrough exploratory program in Kenya, which the company believes has delineated approximately 645 million barrels of oil. That barely moves the needle. To put it in perspective, Africa’s total un-extracted reserve base is estimated at 129 billion barrels. This initial delineation is less than 1% of Africa’s total oil.



Compelling Logistics

The world continues to be a dangerous place. Avoiding the world’s biggest oil chokepoint while having comparable shipping times to Asia is a huge advantage. China always thinks strategically, and that will influence future trading partnerships with Africa, where it has been very active. On a competitive basis, Eastern Africa enjoys a proximity advantage over Angola, while avoiding the Strait of Hormuz chokepoint that bedevils Saudi Arabia and Iran.



Less Money, More Problems

Clearly a major issue that is hindering full speed development within Africa is capital. Jurisdictional and taxation risks can be a concern. However the African governments are learning that they require both the fiscal and intellectual capital from IOCs and consequently, they must work with them. If we look at the Frontier Market Sentiment Index, which gauges the investment attractiveness of nations, we can see that African countries are way up in the group.



The sentiment index shows Nigeria holding the top spot. However, if one has paid attention to the EIA status reports, imports of Nigerian Bonny Light have been plummeting. Why? Because the API gravity associated with Bonny Light doesn’t blend well with the American light oil. Due to the rapid increase in supply of light crude from the Eagle Ford and Permian, US refineries no longer require imported light oil feedstock, and in turn have increased demand for heavy crude. Furthermore, it is worth mentioning the amount of pipeline theft that goes in Nigeria. Mart Resources has been battling the issue for years as there are hundreds of illegal refineries set up. Nigerian thieves literally drill holes in the pipeline, fill canoes with oil and float them to refineries. This sounds like a situation to avoid at all costs.

Down in the 5th spot on the chart is Kenya. Kenya is truly the frontier of oil exploration with serious potential for elephant-sized deposits. Any of you who have followed my work for years know I was first to the party in Kenya over five years ago and pounded the table for Africa Oil. Africa Oil and Tullow blew the door off the hinges, sending Africa Oil’s share price from $1 up to $11 in less than 24 months. Since those initial wells, Africa Oil and Tullow continue to prove up ground with an estimated 645 million barrels of potential and contingent reserves, with upside potential for more than a billion barrels just in their acreage block. Kenya is a rich man’s game with onshore well costs costing upwards of $25 million and offshore wells costing $100 million.



Unfortunately, while the delineation of oil reserves has been positive, there are some significant headwinds on the midstream and downstream infrastructure side. For example, Kenya’s major refinery—one that has capacity to produce 90,000 barrels per day of petroleum products—hasn’t turned out anything in over two years. The Mombasa refinery was a joint venture between Shell, BP and Chevron back in 1960. In 2009 the three IOCs sold their stake to Essar, which has been in the process of selling its stake back to the Kenyan Government. Since 2013 the refinery hasn’t produced a single barrel of refined product.

There’s no time like the present



A second issue, and one that is more pressing than the refining issue, is the dire need for takeaway capacity at the wellhead. If there was an African equivalent of Kinder Morgan or TransCanada it would be a phenomenal investment opportunity. Unfortunately there isn’t anything even remotely close to that. In fact, the pipeline situation is so poor that it is a major deterrent for E&Ps. It is basically impossible for them to move commercial amounts of crude oil from the basins to the coast.



While the above potential profile is just a best guess scenario, it clearly demonstrates the throughput that Kenya will need in order to achieve commercial production. If we look at the current pipeline scenario below, we’ll see they do not have the required infrastructure. This is just Kenyan production; if they were to move Lake Albert crude from Uganda or Sudanese crude the capacity is substantially shorter.





Finally, after much debate, a route has been chosen for the Uganda-Kenya pipeline. The northern route will be taken, which will move crude from Uganda’s Lake Albert region, west to Kenya’s Lokichar Basin and then south down to the port of Lamu. The pro-forma price tag is a hefty $4.5 billion and the commercial operation date is expected to be 2022.
According to the Port Authorities at Lamu, the docks and berths are 95% complete.

The two governments also agreed on building a reverse-flow pipeline that will carry imported petroleum products from Mombasa through Nairobi and Eldoret to Kampala. This is hopefully a sign that the government will relinquish its refinery and focus on the E&P side.

The Lapsset Pipeline is also a major topic of discussion as the South Sudanese are desperate to move their crude away from Sudan. In fact, recently it was reported that the Sudanese have dug trenches around their oil fields to keep the South Sudanese out. Logistically it makes sense that this pipeline be tied in at the north end of Block 12A.

Just like the title states, there is no time like the present. All companies that are operating in either the Lake Albert or Lokichar basin cheered the final decision, even though they know that this pipeline will be built at a snail’s pace.

Leave the Refining Process to the Experts


The Kenyans are severely hung up on the refinery business, a serious hurdle. They need to swallow their pride and realize that initially they cannot compete with the 400,000 barrels per day output of refineries north of the Sahara and in Asia. It is cheaper for Kenya to export its crude and import its refined products back.

In theory the Mombasa refinery could be in operation via the government but it’s not.

Furthermore, if the three IOCs and Essar have sold out, then this is a pretty good sign to the Kenyans to not go to battle with the biggest and best refiners in the world. Over 2.2 million barrels per day of new refining capacity is coming online in the Middle East, and those economies of scale are virtually impossible for Kenya to compete with.

Vertical integration is a final goal for eastern Africa, but it’s not one that needs to be dealt with immediately. The far more important first step for the region is to construct a world class pipeline system to match its world class oil assets.

Capital Investments in Africa

Even in a developed country the upfront costs associated with developing a world class oil play would easily be in the billions. While Africa has made great strides in moving forward, most countries are by no means close to a developed economy. This means that even more fiscal and intellectual capital is required for the oil field developments. The chances of African governments following through on schedule and budget are extremely remote. Since both IOCs and governments want to exploit the massive oil reserves, pairing up is the most efficient and profitable solution.

At the corporate level, comparing the finding and development (F&D) costs per barrel on a regional basis, Africa and the Middle East is the cheapest area in the world. But that includes the low cost OPEC regions. Omitting them, it’s probably safe to say that Africa is the most expensive area in the world, with well costs in Kenya estimated to be in the $10-25 million range.

China We Trust

The Chinese have become more and more involved with Africa every year. The best measure of their involvement is through their Foreign Direct Investments in Africa. Below we see that in 2004, investments were under $2.5 billion, while now they have grown that number more than 10 times over, up to $25 billion in just 10 years.



Unsurprisingly, the Chinese have focused their investments in the OPEC nations, along with South Africa, the DRC and Sudan. East Africa has received less attention. But that will slowly start to change because the heavy sweet oil which comes from the EAR blends better than the lighter Asian crudes. China is the largest importer of crude in the world and the vast untapped reserves in Uganda and Kenya are just what the country is looking for. And, concurrently, the producers are looking to China. Uganda is so desperate for Chinese help it has even backed its debt with future oil-related revenues.



China has invested $3.8 billion (USD) in a deal to construct a railroad from the Uganda-Kenya border down to Mombasa. This strategic build will allow the Chinese to transport product out of Uganda, where they already have a vested interest both in oil and otherwise. The railroad also will move through the high profile oil basins in Kenya down to the sea.

Location, Location, Location,

In the junior space, when it comes to acreage positions in Kenya, Africa Oil (AOI) truly dominates. Not only do they have the most acreage, but they have also secured a partnership with Tullow. The Lokichar Basin, in which Africa Oil holds a 50% working interest, is a world class location.



The Silver Lining for Africa Oil

As we’ve seen, the finding and development costs illustrate the difficulties of setting up a business in Africa. Once they are built, though, looking just at the production costs, the assets AOI owns will be cheap to operate. This means that Africa Oil has positioned itself correctly in the market. By year end, AOI will have de-risked 720-890 million barrels of oil with significant upside still open.

The big initial outlays also work in AOI’s favor. It makes more sense economically for a major to come in and purchase a company such as Africa Oil rather than go the through all the due diligence and exploration involved in finding a deposit. And AOI will be dealing from a position of strength here. Because the company is so cashed up and has a clean balance sheet (no debt), it is less likely to be a takeover target within the next 18 months. Its balance sheet strength will allow it to weather the depressed oil price environment for some time to come, which means it will be less vulnerable to a lowball takeover offer.

This is why I bought stock for myself and my fund. I believe a major IOC will realize within the next 18 months the value proposition AOI currently presents just with its existing 2C resources, even disregarding all the upside.

What can go wrong?

In a single word: Lots. If Goldman Sachs is right and the price of oil goes to the low $20s, AOI’s share price will go lower alongside the whole oil sector. That is the biggest risk. Do I see that happening? I find it hard to believe oil will go to $20/bbl. Accordingly, I’ve made my bet on this one, and I have a 18 month target of C$3.00 for AOI.

In mid-2014 the Kenyan government stated that they would be re-introducing the capital gains tax in the extractive sector. The tax rate stipulates a 30% capital gains tax on resident companies and 37.5% tax for non-residents. AOI is one of the few exploration companies significantly investing in Kenya. The government knows better than to change the fiscal terms. Which is why I believe the government risk is a lot lower at sub $75 oil than it was $100+ oil, as the government has seen less exploration during the period of low oil prices. In fact, I believe the changes to the tax will actually benefit AOI, as the government recognizes the difficulty in attracting significant investment dollars in the current environment.

Catalysts

AOI will continue to better define and increase resources using the best techniques available, including doing EWTs (Extended Well Tests) and drilling appraisal wells. These are key for the coming resource update, as AOI is employing much more advanced and defined methods than in their earlier resource updates. With new real time modelling, new data will be inputted into the models and updated as the progress is being made. Because of the better techniques, the resource will be much better defined and much better understood.

These deposits are very complex and AOI is doing all the right technical things to de-risk the project for a potential buyer or JV partner.

By mid-2017, AOI will have to define and submit an investment decision plan to the government and the clock would start ticking on developing the field for production. For this to happen, the pipeline to be built plays a big role in evaluating the option. A realistic option could be to start production with a smaller 20,000bopd facility, using trucks and rail to transport output. Then when the pipeline is complete, production could be increased to 100,000bopd. In reality, it is way too early to model any of these situations as the price of oil and timing of the pipeline are too far out to create any realistic financial model. But they are items to think about moving forward.

Government capital gains tax is still an issue because if AOI sells its assets, there would be a large tax bill that would be required to be paid before AOI gets the cash. That said, I do not believe that any changes or modifications to the capital gains tax will happen until 2017, which should line up with the investment decision plan for AOI.

The size of the project is truly stunning. To put it in perspective, it is equivalent to all of the oil in the North Sea. AOI owns 50% across all of the key blocks. This is net to AOI of over 300M bbls today, and this is just the early days of the development of this oil basin. There is more found oil in Kenya with the drilling to date then what was found in the North Sea during its first seven years with an equal numbers of wells. The land acreage is compelling, and this will become a world class field. All along its 1,040 km in length, additional rift basin deposits will continue to be found for years to come.

AOI has been able to drill 38 wells in the last three years. There is no other junior in the world that has equaled such a blistering pace. As noted earlier, AOI has raised over a $1B in equity (while running up no debt) since inception, and has raised more money in the last 12 months than all of the other exploration (non-producing CDN peer groups) combined. This is an incredible achievement, but it’s just suggestive of the world class potential of the project.

Within the Lokichar Basin, there have been eight oil fields discovered since 2012. The low hanging fruit in the near term will be plucked as the northern end of the basin opens up with the current wells planned later this year. If Etom-2 hits, this alone could be a game changer and add 100-300 million barrels to the resource. I looked at the seismic, and thought Etom-3 would be a better target for drilling, but management explained their thought process and I understand why they did so. Basically, it comes down to drilling risk. Etom-2 is lower risk in drilling, but Etom-3 has much bigger size potential. If for whatever reason Etom-2 is a failure, that’s not the end of the game. It does not mean the northern end of the basin is closed, because the prospects of Etom-3 still warrant drilling. However, if Etom-2 does hit, the story will gain a lot of traction, as the company will now have a string of nine pearls (pearl being an analogy for an oil deposit) and the 2C resource could rise above one billion barrels of oil.

Moreover, the market is assigning ZERO value to the unconventional tight reservoirs that are yet to be evaluated but are economic and exist in the new models. From the data I have seen, I believe the majors will be modelling this horizon into their long term production models. These horizons are not economic on their own at current prices, but with the existing conventional fields, these horizons represent considerable free cash flow, or “bonus” pools of oil. For example, these wells unstimulated would run about 300bopd. But if horizontally fracked these tight “bonus” pools can easily add 500-1000bopd, which considerably ramps up cash flow.

The main reservoir is about 800 meters thick. The quality of the Lokichar basin is very high. I believe even if you only model the top formation of the total 800M reservoir, a major will want this project in its production portfolio.

When I started my first investment in the 10BB block back in early 2007, I had no idea how long and expensive the ultimate journey would be. To get a better understanding of the geology, consider that AOI spent, along with Tullow, US$60M in 3D Seismic in 2014 to better define and understand the development area of interest within the Lokichar basin. That’s just 3D seismic, not including the previous seismic (2D) and other non-drilling costs. But all of these costs are necessary to better understand the geology and save on future drilling. For example, pronounced anticlinal form at depth, better imaging of crestal faults, better mapping and definition of pools and deviate to better rock during drilling and helps in pod like structures—all are better “seen” from the 3D seismic to better optimize the drilling budget.

All of these elements will help to maximize the drilling results and bring in information to maximize the resource update (size) while de-risking the quality of reservoir (by increasing understanding and info of its quality).

From the existing wells that have been tested, oil has been produced from the source rock at a depth of 900m which was extremely rich and lower temperature.

This is very unique to the Lokichar basin. It produces oil at 900m where, globally, deposits of this size don’t start producing above 3000-6000m of depth. Thus, earlier on, the conventional wisdom was that this would be a problem and AOI wouldn’t be able to produce oil from the rich, low temperature formations. Not only has AOI proved this incorrect, it has shown that its wells can produce oil without any stimulation. This is extremely important, as without this testing, most of the technical people of the major oil companies in the AOI data room would discount the oil in the basin significantly. It’s no longer an issue.

In 2012, as part of my due diligence, I had one of the most respected oil geologists in the world do a complete analysis of AOI deposits for me using all the data known at the time. I wanted to know his answers to the questions I mentioned above back then, and I was not encouraged. I shared my results with management at the time, and it was one of the major reasons I sold the stock under $3 in 2012, just before the big run to $12. Apparently, I was not alone. Many of the majors who were in that data room before the flow results arrived came to the same conclusion.

Now we know better.

The results are in and my consultant was wrong, I was wrong and the majors were wrong.

Because of the shallow reservoir, it was generally assumed—as most basins of this size are anywhere between 3-6x the depth—that the oil in the Lokichar basin would not flow. Not only did it flow, but the results surprised almost everyone. The oil flowed to surface, without any stimulation or pumps.

No heating of tubulars, therefore there was no disruption to the flow of oil.

The clean-up rates were impressive, as 5600-6000bopd was produced over five zones

The clays in the logs really confuse things using conventional log analysis. Hence why my consultant and many of the majors got it wrong. The clay affects the logs analysis. Thus, AOI wisely spent time focusing on the specific data points and recalibrated the logs to better predict the permeability.

In an oil basin like this, most conventional technical people will focus on two aspects, the volume and the energy of the reservoir. The volume was never a question in the Lokichar basin. The energy (will the oil move to surface?) was the big question.

EWT (Extended Well Test) clean up data from AOI’s Amosing project proves lateral connectivity between wells in multiple reservoir pools. This is another big bonus that was unknown only one year ago. What this does mean however, at least in my opinion, is that with better modelling and definition, certain oil deposits will get smaller with better definition. As you get more definition, you create stricter controls, from my experience, which will improve the certainty of the pools (make them better defined and smaller). At the same time, you prove they are laterally connected (very important for future flow rates). EWT results will include water injection tests—which are critical to improve the certainty of the reservoir characteristics. It is important that the oil moves through the column and gets to the surface and these EWT will increase the certainty, something the majors will look for.

Again, the lateral connectivity of the wells in the Lokichar basin significantly de-risks the project for the majors.

As more wells were drilled, the bigger the basin got, such that most of the big oil companies in the world had to take notice and those companies contacted AOI. The oil consultant I used is one of the world’s top geologists, and an advisor to the board members of some of the world’s largest oil companies. But what everyone missed was that because the lateral connectivity within and between the oil pools exists, it’s the water aquifer that supports the pressure of the reservoir.

There just wasn’t enough data back then to put the puzzle together. Thus, there was no way until now to connect the dots. The logs were not clear because of the clay, there were questions back then on the lateral connectivity, and it was unknown that the water aquifer was the pressure source for the oil reservoir. Over $1 Billion worth of exploration has answered those questions.

All the subsequent testing applied has significantly improved the quality metrics of the Lokichar basin, such as:

1. The water saturation was lower than expected (that is very good, as you want to produce oil, not water from your wells). The results thus far are showing water saturation anywhere between 25-50%, with the average being 38%.
2. Permeability and porosity were both higher than expected (meaning the oil was moving to surface much better than expected) and this was all done without any stimulation or pumps.
3. There is very strong reservoir support and it appears that fewer water injectors will be needed when pumps are installed, because of the pressure of the reservoir. There is still much testing to be done regarding the injectivity of water tests back into the system to stimulate the well (all wells are stimulated later to fight the declines with water injection—very standard. But a question that will still need to be answered is, will the oil move?). Thus far, since the natural flow tests (meaning no stimulation or pumps) have been much higher than expected, there is a very high probability that the injection tests will also be positive.
4. Porosity is just the amount of “room” or “space” within the rock where the oil is held, and it measures the ability of the rock is to hold oil. For example, to use the Swiss cheese analogy, the holes are where the oil would be, and the cheese is the rock. The porosity is calculated as a percentage %, where the “room of oil within the rock or open space in the rock” is divided by the total rock volume. So a decent sandstone will have 10% porosity, which means 10% of the rock is open space that “holds” the oil, and 90% is solid rock. For comparison, Ngamia well results indicate 20-30% porosity.
5. A high permeability is critical because this is the ability of the oil to move through the rock and up to the surface during production. This was a big question on the Lokichar basin. Up until these recent EWTs, it was expected that the permeability of the Lokichar basin would be somewhere between 50-100mD from the log results. But the actual tests completed to date have shown that the permeability is actually 350-500mD.

This was a major de-risk event, and a huge part of me is feeling much more comfortable that the data points the majors used as reasons not to buy the project are being completely answered with absolute tests that all majors will accept.

6. Something AOI has been working on is to provide enough focused data points for the auditor to feel comfortable with the final recovery factor. A higher recovery factor means more oil that can be included in the updated reservoir and resource report.

These are some of the reasons why production costs at Lokichar are going to be so much lower than many of the basins of similar size globally that have been discovered in the last two decades. That’s an important aspect to consider, especially for someone like me who is bearish oil prices over the next 12 months.


This has been a long Katusa Report. I wrote it up on a recent plane ride. I thought I would go without sleep for a day to type this up for you all, and I hope you enjoyed it.

More importantly, I hope we all make Alama Kubwa—A Big Score on this one.

Till next time,

MK