Harvest Natural Resources

Harvest natural Resources is an oil and gas company headquatered in Houston, Texas. It's business activities lies mainly in oil rich Russia and Venezuela. Currently, it's prime asset is the right to drill for oil and gas in the fields of Venezuela and they have been operating under an OSA(operating service agreement) in Venezuela under which it would produce oil and deliver it to PDVSA(Petroleos de Venezuela)

The main risk investing in Harvest Natural Resources is that of a political one. This is due to the company being subjected to continuing expropriation through renegotiated contracts or broken contracts with the Venezuelan Government where the venezuelan Government acts to modify the property rights of the company under its sovereignity. During the last quater of 2004, the Venezuelan government witheld drilling permits and since then production levels were cut with large back taxes charged to these companies operating in Venezuela. Operating Service agreements were deemed illegal by the state government and companies which were operating in Venezuela had to be reorganised as mixed companies with majority stakes being controlled by the state. As an example, the Venezuelan Government recently converted 32 privately run oil field contracts into 21 state dominated joint ventures last year and this is exactly what is taking place in the backyard of Harvest Natural Resources. As i write this HNR is trading at a price of $12.55.


With regards to Harvest Natural Resources, the net effect is that Harvest Natural Resources now owns 40% of Petrodelta and PDVSA owns 60% of Petrodelta. PDVSA also owns 69% of Lagopetrol, Hocol owns 26% of lagopetrol, encopek petroleo owns 3.1% of lagopetrol and Carte De Inversiones Petrobras owns 1.6% of Lagopetrol. In case, you do not understand what i am talking about above, PDVAS(venezuela) now owns 69% of Lagopetrol and also owns 60% of petrodelta. Petrodelta and Lagopetrol which is an approved joint venture can then go on to set up a sales contracts with the PDVSA.(Get the picture?)Essentially, Chavez is doing this to generate addtional revenue for a poverty stricken country. Under the new changes, Harvest natural Resources can also operate in Venezuela till 2026 rather than 2012 under the operating service agreement. HNR has to pay taxes @ 50% and is also subjected to a 33% rolyalty. Subsequestly , HNR operating as Petrodelta will then invoice PDVSA from April 1st 2006 till 30th June 2007 and this will prove to be an estimated 275 million. After forking out its back taxes and operating expenditures and much needed working capital, Petrodelta will be expected to distribute the rest of the funds back to HNR. This has been revealed by Form 8K which was filed on the 18th of September.

Valuation(according to Q2)

Shares outstanding: 37.74 million shares

Market Capitalization: 473.6 million

Net cash(cash less debt): $1.71 per share

Enterprise Value per share : $10.84

Proved Barrels: 45 million

Probable Barrels: 31 million

Possible Barrels: 74 million barrels

Enterprise value per Barrel(proven, possible, possible): $2.72

Enterprise value per proven barrel : $9.09

Enterprise value per proven barrel is $9.09 while large integrated oil and gas companies frequently trade at an enterprise value of $15 - $18 per proven barrel. While using enterprise value may be subjective as there can be many unknown variables and it is too simplistic an approach.

Using Discounted cashflow with the following assumptions as per Ryder Scott Report:

1) 10% discount rate
2) 50% tax rate
3)Value of proven reserves:$616 million before tax rate
4)Value of Probable reserves:$317 million before tax rate
5)Value of possible reserves:$792 million before tax rate

Intrinsic value of reserves after 50% tax = approximately $24
Current price: $12.55

(The Ryder Scott group is actually an independent group of petroleum consultants that specializes in certifying and valuing reserves and they have been in business since 1937.)

In addition to the valuation metrics above, one can also spot a few catalysts:

1)Net of royalty income, Petrodelta will receive $275 million according to management. After costs incurred for the period of approximately 46 million, a 40% interest in petrodelta and 50% tax rate , HNR will obtain 45.8 million which is equal to $1.21 per HNR share. Any dividends distributed to HNR will be a catalyst to stock price moves to the upside.

2) Now that the mixed company has been reorganised, a huge part of the political risk has been removed. HNR can continue to operate in Venezuela. In the 3rd quater of 2006, despite having reported a negative number for earnings(-1.36 yield to date), HNR did in fact earn approximately $0.25 per share in Venezuela although it suspended drilling. Continued drilling in Venezuela would make a positive inpact to its income statement in the future, the extent of which cannot be estimated as yet.

3) 25 June 07 - HNR's board approves a $50 million buyback. This would enrich existing shareholders
Quote" Having achieved Venezuelan National Assembly approval for the formation of Petrodelta, we have eliminated much of the uncertainty that has negatively affected the value of our share price and hindered our plans for further development in Venezuela and elsewhere," Unquote

4)Removal of political uncertainty and future of harvest natural resources

5) Pabrai Investment funds have invested a substantial portion of their net worth into HNR. Activism may take place and we believe that as a substantial shareholder, Pabrai will be able to advise the management on what can be done to increase intrinsic value. This will help to narrow the gap between intrinsic value and current trading price.

Our opinions about the downside:
Now that the mixed company has been reorganised, it removes much of the uncertainty of operating in Venezuela. The downside is the complete seizure of assets by the Chavez Goverment in the future. But will that happen? As it is HNR has been operating in Venezuela for the last 15 years and has had a good track record of 'milking' the oil fields. Instead of doing it themselves, Venezuela which is a country lacking in technology and money would have to make use of HNR to pay for drilling of oil fields which can be rather capital intensive. In other words, i think they would prefer HNR around instead of themselves or some unknown and unproven company to do the oil drilling. This will bring in additional revenue streams for the Venezuela goverment.

What me and manpreet did:

We sold in the money current month put options @ strike 12.5 with the premium of each contract being $0.7. If the trading prices lifts above $12.5, we get to keep the premium. If it does not, our buy in price would have been $12.5-$0.7= $11.8 Buying in at $11.80 ensures that i have an approximate 50% margin of safety.