Dana Gas: Comments on KRG Settlement

Unless you’ve been asleep you’ve already read about the settlement between the Kurdistan Regional Government and Pearl Petroleum announced on 30 August by Dana Gas. 

Most of the headlines focused on the USD 1 billion payment by the KRG to Pearl Petroleum and did not discuss other aspects of the transaction.  The market reacted with characteristic irrational exuberance. Hence this post.

To start a side comment. In a rather bizarre but not uncharacteristic move, DG did not confirm PPL’s receipt of the payment until 5 September after receiving “numerous market enquiries”.  Apparently, neither DG’s crack investor relations staff nor its management thought that there were parties who would be interested in knowing for certain that the KRG actually made the payment.

Not a particularly “brilliant” move to sit on such critical and positive news but sadly par for the course at DG.  Or as AA’s brother no doubt would have it, “shelled another dolly.” 

Here’s an extract from the joint KRG/PPL press release published by Dana Gas.

The agreed settlement highlights are as follows:

1. The KRG will immediately pay Pearl (PPL) a sum of US$600 million.
2. The KRG will also immediately pay Pearl a further US$400 million to be dedicated for investment exclusively for the aforesaid further development to substantially increase production.
3. Pearl will increase gas production at Khor Mor by 500 MMscf/day, a 160% increase on the current level of production (the "Additional Gas"). The Additional Gas, together with significant additional amounts of condensate, is expected to begin production in approximately two years.
4. The balance of sums awarded by the Tribunal ($1,239 million) is no longer a debt owed by the KRG and will be reclassified as outstanding cost recoverable by Pearl from future revenues generated from the HoA areas.  The profit share allocated to Pearl from future revenues generated from the HoA areas are adjusted upwards to a level similar to the overall profit levels normally offered to IOCs under the KRG's Production Sharing Contracts. This adjustment reflects the larger investment risks and costs involved in the development of natural gas resources compared to oil developments. After the recovery of costs and a return on investment by the Consortium, 78% of revenues generated from the HoA areas will be for the account of the KRG, and 22% for the account of Pearl.  
5. The Parties have clarified the Khor Mor block boundary coordinates and the KRG has awarded the Consortium investment opportunities in the adjacent blocks 19 and 20, and added these to the HoA areas, with commitments by the Consortium to make appraisal investments on these blocks, and developments if commercial oil and gas resources are found.  The KRG will purchase 50% of the Additional Gas on agreed terms to boost the gas supply to power generation plants in the Kurdistan Region.  The other 50% of the Additional Gas (250 mmscf/d) will be marketed and sold by Pearl to customers within Iraq or by export, or can be sold to the KRG as well to further boost power generation within Iraq.
6. Pearl will also expand its local training and employment programs towards achieving maximum localization and content, as well as supporting local communities through its active Corporate Social Responsibility (CSR) programmes.
7. The Parties have exchanged mutual releases, waivers, and discharges in relation to all claims in relation to the Arbitration and related court proceedings. The Parties have also amended and clarified the HoA language and terms, including extension of the term of the contract until 2049. 

Now for a closer look. 

1. DG is a 35% shareholder in PPL so at a first cut, DG’s share of the USD 1 billion payment is USD 350 million.  Sounds good, but there are at least a few wrinkles.
2. That money is at Pearl not DG, though DG will show the USD 350 million in its September financials, just as it shows its 35% share of PPL’s aggregate trade receivables.  If and until PPL transfers funds to DG, DG will not have use of the funds.
3. Also note the money in two tranches.  One of USD 210 million and one of USD 140 million.
4. Let's start with the second amount the USD 140 million. That amount will not be available for DG to use as it wishes because the USD  400 million tranche is required to be spent in the KRG to expand production, assuming of course that PPL honors its commitment to the KRG. 
5. As regards the first amount DG's USD 210 million share of the USD 600 million, how much of this DG will ultimately obtain unrestricted use of depends on Pearl's cash needs, particularly if PPL will require more than USD 400 million to fund the promised increase in production.   If the amount exceeds USD 400 million, then any funds ultimately transferred to DG and its partners for their own use will be lower than the USD 600 million discussed above. 
6. PPL has agreed to release the KRG from its obligation to pay the remaining USD 1.239 billion of the arbitral award.  However, this amount is not completely forgiven or “lost”.  It’s been transformed into a “recoverable cost”.  Under concession agreements, the operator is entitled to recover its invested costs plus a certain return (not specified here and I could not locate it in DG’s financials or other information it publishes) before the profit sharing mechanism becomes operative. 
7. What this means is that PPL and thus DG and its partners will recover this amount over time, if the Kurdistan fields produce.   PPL is thus highly incentivized to ramp up and maintain production as soon as possible.  That’s the good news. 
8. The bad news is that this is an installment payment which is estimated to begin some two years hence.  On a present value basis then PPL will recover less than the USD 1.239 nominal sum.  Depending on the timing of production, the amount may be much less. 
9. The KRG has increased DG’s share under the profit sharing agreement to 22% and has extended the concession period to 2049.  That gives PPL the opportunity for additional earnings and will counteract to some extent the present value loss on the USD 1.239 billion.  Just how much is not clear as again it will depend on the timing of cashflows. 
10. Dana will also be able to sell 50% of the Additional Gas for export neatly side stepping further exposure to the KRG's creditworthiness.
11. PL and the KRG have issued mutual releases on arbitral claims.  You will recall that earlier this year PPL was reported to be pursuing some USD 26.5 billion in claims against the KRF for alleged damages. On a positive note, the settlement of all claims may lead to an increase in KRG payments of outstanding be-whiskered trade receivables which would help DG’s cash flow but not its profit.   The stale receivables have already reduced DG’s realized profit from that reported by the operation of present value.  Nonetheless, more cash in hand would provide DG additional flexibility in conducting its operations.  Were it so inclined—an assumption for which there is scant evidence so far—the cash could be used to repay the sukuk.  This claim has been dropped as language from the preface to the press release indicate. 

The Parties have mutually agreed to fully and finally settle all their differences amicably by terminating the Arbitration and related court proceedings, and releasing all remaining claims between them, including the substantial damages asserted by the Consortium against the KRG.

While there is both some good and some not so good news for DG in the PPL settlement, on balance it probably is a net positive.  AA suspects that those who have read the news of the settlement and are expecting a cash bonanza at DG will be like the bankers who are anticipating "rich investment banking fees" in Saudi Arabia.

But Is this good news positive enough for AA to change his recommendation against investing in DG equity or debt? 

A resounding no. 

The first rule of investing is not to invest with issuers who have demonstrated that they cannot be trusted to honor obligations.