Arrow Energy Limited 10 Mar 10

Hedge funds provide an opportune time to lock in profit

Investors are pondering the offer from Royal Dutch Shell and PetroChina to buy the company for $A4.45 plus one share in a new company that would house Arrow’s international assets. In terms of dollars offered per 3P GJ, it might be said that the offer is a low ball one and that there is scope for Shell and PetroChina to increase the offer.

Since the heady prices paid for CSG resources the oil price has softened and the LNG price is under pressure, at least in the short-term. On a risk reward ratio $A5.00 is a great price – time to lock profits in.

No specific details of the Shell/PetroChina deal have been released other than to say the bid is conditional. One thing for sure is that the proposed takeover is conditional on FIRB giving its approval for the transaction, and this might prove a stumbling block.

If the transaction is not approved by FIRB, Arrow’s share price will fall heavily, just as fast as it soared.

There is another potential and major stumbling block in as much that New Hope Corporation owns 17% of the company. New Hope in turn is owned 60% by Washington H Soul Pattinson. The bid can’t possibly succeed unless New Hope tenders its shareholding.

Arrow’s market capitalisation has soared nearly 50% to $A3.7Bn. This has had a profound impact on consensus earnings estimates. At the current price of $A5.11, the stock is very over valued until 2014 when Fisherman’s Landing is producing LNG.

Based on 2014 metrics the company is not overly expensive on a PER of 23X. The cash flow multiple for 2010 is 10X which also seems reasonable. However, these metrics need to be risked adjusted.

There are significant technical risks and the company has not had previous experience in converting coal seam gas to LNG. Not only that but there is a risk that FIRB will not approve the corporate action.

If a risk factor of 80% is applied for FIRB approval, and another 80% for technical risk, the adjustment factor is 0.64. On this basis buying the stock on a 2014 PER of 14X might make good sense, but not on a multiple of 23X that is not risk adjusted.

The biggest risk for Members is that the hedge funds that have allegedly put a rocket under the share price will be very quick to exit if it appears that the bid is facing a strong headwind and destined to fail.

The Fat Prophets Mining Portfolio is going to take advantage of the current situation and is cashing in to lock in a very healthy profit.



SHARE PRICE CHARTS AND COMMENTS:

Fat Prophets initially recommended buying Arrow Energy at 75 cents in November 2005 (Fat Mining 2). Our last review of this stock was during February (Fat Mining 213).







Turning to the charts, Arrow Energy rose sharply on the back of fundamental news reaching a high of $5.15 on March 8. This represents a gain of $4.40 (+586.67%) since our initial recommendation at 75 cents. The strong gap in price saw prices trade from $3.49 to $4.79, a staggering $1.30 gap. Generally, gaps need to be filled over time. We would expect Arrow Energy to track sideways and progressively lower.
 






SATE OF PLAY

Major hurdles lay ahead for Arrow, not in the least of which was funding the $A2Bn capital expenditure required to build the Fisherman’s Landing LNG facility, and develop the upstream infrastructure.

It would have been amazing if Shell was not a party to a bid for Arrow. After all, Shell already owns 30% of the company’s tenements and 10% of the international assets. It would have been very difficult for another party to extract the benefits that Shell can.

Moreover, the introduction of PetroChina into the equation provides a cornerstone customer. Another major advantage for the bidders is that the Fisherman’s Landing LNG project has all the necessary approvals in place.

In valuing Arrow, the international assets have to be considered separately. There is no guidance from the company as to the value of these assets but the range seems to be between $0.55 and $0.80. Taking the current market at face value, a price of $A0.75 is being placed on these assets, which is roughly in accord with valuations.

Arrow and Shell operate through a 90:10 JV vehicle to manage the offshore assets. The international assets are coal seam gas projects in India, China, Indonesia and Vietnam. What is interesting is that both Indonesia and China have vast reserves of coal seam gas.

China’s vast reserves are said to exceed those of the North West Shelf by ten-fold. In a regional sense if Shell and PetroChina are successful in their bid, Shell will not get the drop on its rival BP that is readying for the first delivery of coal seam gas into its existing LNG facility in Indonesia.

Woodside Petroleum has highlighted a projected shortfall in contracted gas versus a flattish supply of LNG. However, there seems no shortage of coal gas and it is worth pondering how the market might be affected if vast reserves of gas are tapped from coal seams in India, China, Indonesia and Vietnam. By tyranny of distance, Gladstone is not well placed to compete in the developing Asian LNG markets.

The dilemma for Members comes down to risk versus reward. From a share price of over $A5.00 we see the risks for small shareholders greater than the rewards. We do not expect to see tension developing from a bid from a third party although a higher offer might be needed to dislodge New Hope Corporation.

At this point in time we see no reason for Shell and PetroChina to increase their offer and we see little chance of a better offer from a third party.

Accordingly, we are going to take advantage of a spike in Arrow’s share price and we are changing our recommendation from HOLD to SELL ALL for all Members.

We are also recommending Members consider a switch into Woodside Petroleum so as to maintain exposure to the growing energy sector.

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