Middle Africa Insight Series Energy 14 July Key dynamics in Kenya s emerging upstream oil industry. Highlights

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1 Middle Africa Insight Series Energy 14 July 2014 Key dynamics in Kenya s emerging upstream oil industry Highlights Kenya is expected to start oil production in 2017 with production of around 100,000 bpd from Tullow Oil. Oil companies in Kenya are likely to drill almost 20 wells over the next 18 months and are likely to make more discoveries. We estimate the funding requirement of the Kenyan upstream oil segment at US$16 bn over the threeyear period, covering the cost of over 30 new wells, the Ngamia oil field development, the crude oil pipeline from North Turkana and completion of Lamu Port Inability to source necessary funding is however likely to result in oil companies having to relinquish some portion of their oil blocks due to inability to meet seismic and drilling commitments. More importantly, it could delay the start-up of oil production by another 1 or 2 years. The Sunbird-1 discovery in June by UK s BG Group has confirmed the presence of offshore oil reserves. This discovery provides further optimism regarding Kenya s oil potential as both an onshore and offshore oil play. Kenya is likely to play a key role in the emerging East Africa oil and gas industry with a a new export terminal at Lamu and a crude oil pipeline enabling oil exports to Asia. Tullow Oil risks being over-extended on borrowings if it takes on additional debt to develop its Kenya oilfields. However, it is likely to attract valuations as high as US$452 mn for a planned farm-out of a % stake in its Lokichar basin blocks. Kenya is likely to pass a revised petroleum law in October 2014, which is expected to provide the framework for oil revenue management and possibly increase the government s take from oil operations and enforce more local content initiatives. Communities in the oil discovery areas have intensified demand for involvement in the industry, which is likely to provoke inclusion of community development levies in the new bill. Rising insecurity is also a major cause for concern in Kenya. Recent attacks by Al-Shabaab could dampen investor interest. Offshore exploration could also be affected by an existing maritime border dispute between Kenya and Somalia. These dynamics make the next 18 months critical in the development of the Kenyan upstream sector. Kenya to become oil producer by 2017 Kenya is expected to join the league of oil producing countries in Sub Saharan Africa by 2017, going by the efforts of UK-listed Tullow Oil and partner, Australia s Africa Oil Corporation to submit a field development plan (FDP) by Although the first oil discovery in Kenya was only made 2 years ago by the two oil companies in the North-west of Kenya; a region called Turkana County, the oil explorers believe production can be started within the next three years. They estimate that their blocks possess between 600 million and 1 billion barrels of oil and could produce between 100,000 and 120,000 barrels per day of crude oil starting 2017 if the government approves their FDP by Q Preliminary studies show that the crude oil is light sweet and waxy (25 35 o API) with some of the wells drilled flowing between 3,000 5,000 barrels per day. The crude oil is to be exported through an export pipeline linking their fields in the North-Wastern part of the country to the proposed Lamu port on Kenya s coast. Tullow Oil plans to spud at least 12 more wells as it looks to assess the size of Kenya s oil reserves before deciding on potentially selling some of its Kenyan stake to bring in a new partner. Other firms such as US Independent Anadarko Petroleum Corporation, Canadian explorer Rift Energy and UK Independent Tower Resources are among several other oil companies also looking to acquire new seismic data and drill exploration wells in Kenya. About 20 new wells could be drilled within the next 18 months as oil companies look to open up the Kenyan oil sector. SEE ANALYST(S) CERTIFICATION(S) AND IMPORTANT DISCLAIMERS & DISCLOSURES ON LAST PAGE Ecobank Research ecobankresearch@ecobank.com

2 Table 1 Kenya oil discoveries since 2012 Date Discovery Name Block Basin Operator Net Pay (ft) 24-Jun-14 Sala-1 Block 9 East Africa Rift Africa Oil Corp Jun-14 Sunbird-1 L10A Lamu Basin BG Group Jan-14 Amosing-1 Block 10BB East Africa Rift Tullow Oil Jan-14 Ewoi-1 Block 10BB East Africa Rift Tullow Oil Nov-13 Agete-1 Block 13T East Africa Rift Tullow Oil Sep-13 Ekales 1 Block 13T East Africa Rift Tullow Oil 3-Jul-13 Etuko 1 Block 10BB East Africa Rift Tullow Oil Apr-13 Kubwa Block L7 Lamu Basin Anadarko Petroleum Corporation 1-Mar-13 Paipai 1 Block 10A East Africa Rift Tullow Oil 26-Nov-12 Twiga South 1 Block 13T East Africa Rift Tullow Oil Sep-12 Mbawa 1 Block L8 Lamu Basin Apache Corporation Mar-12 Ngamia 1 Block 10BB East Africa Rift Tullow Oil 797 Source: Global Data A recent oil discovery offshore Kenya is also likely to encourage oil explorers looking to explore Kenya s offshore oil potential. The Sunbird-1 discovery by UK s BG Group and Australia Independent Pancontinental Oil & Gas is the first oil column to be discovered offshore East Africa. The well intersected two hydrocarbon-bearing zones; the first hydrocarbon-bearing zone was a gross 29.6-metre gas column partly covering a second zone with a 14-metre oil column. This discovery provides investors with an alternative oil play to the East Africa Rift System, which is the major focus for several oil explorers. BG Group and Pancontinental are now likely to consider drilling a second well targeting the larger Crombec prospect, which straddles both block L10A and L10B. Further discoveries would considerably de-risk the shallow water oil play offshore Kenya, boosting offshore exploration interests from other oil companies. This could potentially force other explorers such as Tullow Oil and Anadarko Petroleum Corporation, who, despite their considerable offshore expertise in West Africa, are focused almost entirely onshore in East Africa, to have a strategic re-think about offshore East Africa. However, more discoveries are required to justify the expenditure that will be incurred to open up the offshore area. Map 1 Kenya oil blocks and location of discoveries Ecobank Research ecobankresearch@ecobank.com 2

3 Table 2 Kenya seismic and drilling programs (18 months) Period Company Plan Q Tullow Oil 2/3 wells for Amosing appraisal Tullow Oil Drill Ngamia-2 (Block 10BB) Tullow Oil Drill Lukwa (Block 10BB) Tullow Oil Drill Etom (Block 13T) Tullow Oil Drill Kodos (Block 10BB) Taipan Resources Gather 100 kilometres of high fold 2D seismic data Afren Airborne gravity and Magnetic survey Q Tullow Oil Ekales Appraisal well Drill Engomo (formerly Kiboko) (Block 10BA) Epir well (Block 10BB) Taipan Resources Drill Badada-1 well Anadarko Sala Appraisal BG Group new well on L10B National Oil 3D seismic on Block 14T 2015 Afren 2 wells on L17 & L18 Anadarko 2 wells on L7 & L11B Tullow Oil 9 wells on 10BB, 13T, 10BA Source: National Oil Corporation of Kenya (NOCK), Ecobank Research Kenya s regional aspirations are a major attraction Asides its oil reserves potential, Kenya is likely to play a pivotal role in the emerging upstream oil industry in East Africa. Kenya s Mombasa port, which is the major trade port in the East Africa region, would make it relatively easy to bring in equipment and to ship crude once development begins. Mombasa is the focal trade port for trade routes into Uganda, Rwanda, Burundi, the Democratic Republic of Congo (DRC) and South Sudan. Oil field development in Uganda, Ethiopia and even South Sudan are also likely to rely considerably on ease of getting men, materials and equipment through Kenya s borders. The $25 billion Lamu Port South Sudan and Ethiopia (LAPSSET) pipeline, which is expected to provide South Sudan with an alternative export route besides Sudan, is also based on the completion of the Lamu port on Kenya s coast. Kenya s trade relation with East Africa s countries is significantly strengthened by its ownership of almost 60% of regional storage capacity. Kenya s 1.7 million cubic metres of crude oil and petroleum product storage enables supply to the remaining East Africa countries, through a series of pipeline and road networks. The government intends to add another 740,000 cubic metres of storage at the Mombasa ports as it looks to become the major trading hub for the upstream oil industry. Map 2 Kenya s regional pipeline plans Juba South Sudan Ethiopia DR Congo Kinshasa Lake Albert Malabo Jinja Kampala Kigali Moyale Turkana County Eldoret Isiolo Nakuru Kisumu Nairobi Kenya Somalia Lamu Tanzania Source: Ecobank Research, NOCK Ecobank Research ecobankresearch@ecobank.com 3

4 Chart 1 Share of EAC oil storage, by country Table 2 Components of the LAPSSET Project 37% 1% 3% 2% 57% Kenya Tanzania Uganda Rwanda Burundi Lamu port at Manda Bay Oil Pipeline - 1,300km Refined Product Pipeline - 800km Railway Line - 1,720km Highway from Lamu to Isiolo to Juba and Ethiopia Airports at Lamu, Isiolo and Turkana (Lokichiogo) Oil Refinery at Lamu/Isiolo - 120,000 bpd Resort Cities at Lamu, Isiolo and Lake Turkana Source: Ecobank Research, CITAC From the oilfield servicing side of things, Kenya is also likely to drive the development of skilled workforce in the oil and gas industry. Although other countries such as Uganda and Tanzania are also looking to develop the requisite manpower, they are likely to adopt the approach of supporting their citizens looking to study at foreign universities. Kenya has adopted more home-grown strategies such as enforcing the training of locals by oil companies operating in the country and establishing energy-sector courses at its domestic universities. The Petroleum Institute of East Africa (in Kenya) has also been certified by the global energy industry association, Energy Institute, as an approved training provider. Kenya is also looking to establish the region s first seismic data processing centre. Kenya s National Oil Corporation (NOCK) is looking to complete the centre by July The centre would reduce the time taken to access and process seismic data on the region and could support regional exploration efforts. Funding issues to pre-empt equity offerings and government take-over However, all these plans by both the government of Kenya and the oil explorers looking at the country s oil potential require large amounts of capital. The average cost of a well onshore Kenya is $25 million. Thus, the 15 or more wells planned for the next 18 months are likely to require between $375 and $400 million. Between 2014 and 2017, explorers are likely to spend about $750 million on drilling wells. Offshore wells cost a lot higher as semisubmersible rigs attract as high as $600,000 per day offshore East Africa. Oil companies are also likely to an estimated $185 million on seismic data gathering and processing within the same period. The Lamu port portion of the LAPSSET project, which is the first phase of the project, is expected to cost about $5.5 billion. The second phase is the pipeline linking Kenya s oil fields in the Northern part of the country to the Lamu port, which is likely to cost about $4 billion according to Tullow s estimates. Due to the waxy nature of the crude oil discovered in both Kenya and Uganda, the pipeline is likely to either be a heated crude oil line or have built-in flow improvers. Tullow and partners are also likely to attract some additional expenses to deploy the proper gathering infrastructure to connect multiple wells in the two blocks, 10BB and 13T. Although Tullow Oil has revenue from crude oil production in other regions and could support its field development program with its robust borrowing base of $3.5 billion following a 7-year loan syndication concluded in 2013, the firm s capacity to take on additional debt is likely to reduce going forward. Net debt as at 31 December 2013 had risen 113% to $1.8 billion, resulting in a net gearing ratio of 33%. Based on additional borrowings likely to be taken to fund the $4.9 billion development plan for the TEN fields in Ghana, among other development programs in Gabon, Equatorial Guinea and the Republic of Congo, Tullow s gearing ratio could potentially be in excess of 60% by Thus, the independent could have little room for additional borrowing to fund exploration and development programs in Uganda and Kenya. Table 4 Kenya s funding need , US$m Table 5 FY2013 Net Debt and CashFlow from Drilling of wells 750 Geophysical studies and data analysis 185 Lamu Port project 5,500 Oil field development - Tullow & BG Group 3,000 Crude oil pipeline 4,000 New Refinery at Isiolo 3,000 Expansion of Mombasa port terminal 315 Kenya investment in Uganda refinery 74 Total Funding need (Govt. & Oil Companies) 16, Anadarko Petroleum Marathon Oil Tullow Oil Afren (EAX) FY13 Net Debt FY13 CFO Ecobank Research ecobankresearch@ecobank.com 4

5 Table 5 Oil and Gas deals in Kenya in 2013 and 2014 Date Deal Deal Value Deal Status Apr-14 Tower Resources acquires 15% stake in Block 2B from Lion Petroleum $35.72m Completed Mar-14 CEPSA (Spain) acquires 25% stake in Block 12B from Swala Energy $17.70m Completed Feb-14 Milio Energy to acquire 60% interest in Block L6 from Flow Energy, $27m Announced Pancontinental and Afrex Jan-14 Simba Energy to sell 40% stake in Block 2A to undisclosed company $8.6m Planned Nov-13 CEPSA (Spain) acquires 55% of Block 11A from EHRC Kenya $38.9m* Completed Oct-13 Premier Oil completes acquisition of 55% interest in Block 2B from $30.5m Completed Lion Petroleum Sep-13 FAR Oil to acquire 30% of Block L9 from Ophir Energy $11.0m Announced *Ecobank Research estimate Source: Ecobank Research, Global Data, Newswires Tullow s financing situation is considerably better than several other smaller firms looking to also explore Kenya s oil potential. With the exception a few firms such as Marathon Oil, Anadarko Petroleum, Afren and BG Group, most of the other firms exploring onshore in Kenya are smaller firms with no production elsewhere to support their exploration efforts. This considerably constrains the scope of exploration spend they can afford. Consequently, there have been several farm-outs as these firms look to reduce their share of exploration costs and bring in other partners to provide additional funding support for exploration plans. However these deals are unlikely to bring the level of funding required to open up Kenya s upstream oil sector as they involve very little cash; instead they include pledge of shares in the acquirer or of cash towards future seismic or drilling expenditure subject to a cap. In our estimation, the upstream segment in Kenya requires no less than $16 billion over the next 3 to 5 years. While operators like Tullow oil with proven oil reserves are likely to find it easier to attract higher valuations for farm-out of stakes in their blocks, other smaller operators could potentially have to raise more equity or relinquish their oil blocks to the government. In March, the government of Kenya decided against renewing the licence of Canadian explorer Vanoil Energy after the license expired in December (after four extension periods). Similar fate could potentially be awaiting more blocks where very little has actually been done due to lack of funding. Regulation and rising insecurity remain key worries However, equity investors are likely to weigh several other issues around Kenya, besides its prospects. New regulations expected in October are likely to focus on petroleum revenue management, especially following increased demands by communities in some of the regions where discoveries have been made for a share of potential oil revenues. The Kenyan government could potentially include some form of revenue sharing formula that awards a stake to the central government, the communities and then the operators. Furthermore, the new draft is likely to raise the threshold crude oil price to be used in the calculation of government take from the current $50 per barrel, as oil prices have stayed above $100 per barrel since The new regulation is also expected to include fiscal terms for gas following the multiple gas discoveries in Kenya and the government s plan to include natural gas in its power generation base. Some other things are likely to be retained. Exploration contracts are currently awarded through competitive bid rounds, though preference is likely to be given to the companies that bid highest and that also offer the most attractive terms for the Kenyan government. Oil-and-gas levies are usually expected to be paid to the state prior to the finalization of PSCs. Foreign investors are treated equally with local companies in terms of their ability to repatriate royalties and profits. The potential changes in the new regulation are likely to increase Kenya s share of revenues from the oil industry and also look to improve local content. They could also reduce oil company take compared to current terms. Therefore, a number of companies are actually looking to delay drilling and new exploration efforts till the revised petroleum bill is passed in October. Ecobank Research ecobankresearch@ecobank.com 5

6 Table 4 Fiscal terms and Tax schedule under the Petroleum Act Cost Recovery Limit Surface Fee Rentals (per sq km) Company Income Tax 65% (negotiable) Maxium of $100/sq km (negotiable) 30% (residents), 37.5% (non-residents) Government Take Relinquishment policy Royalty Dividends VAT Import duties Negotiation, based on production volumes 25% after 3 years, 25 % after next 3 years (original area) 10% (contractor) 10% (contractor) 16% (applied on supplies to oil companies) EAC Common External Tariff (CET)* Source: Ecobank Research, NOCK Rising insecurity in Kenya could also potentially dampen some investor interest in Kenya as continued attack by the Al Shabaab terror group from Somalia remain a key challenge to security of lives and property. A recent attack on the cities of Arusha and Lamu is likely to have damaging impact on the country s tourism sector as the two towns are key tourist attractions to Kenya. Construction works at the new export terminal at Lamu could be affected as well if adequate security is not provided by the government. The Al Shabaab militants hope to use the attacks to force Kenyan government to withdraw its troops from Somalia. Also onshore, communities in some of the discovery areas have also become more aggressive in their demands to be involved in the development of hydrocarbons found in their region. Access to jobs has already proved to be an early source of contention. In October 2013 for instance, Tullow Oil and partner Africa Oil Corp. temporarily halted exploration activities on two blocks in Kenya Blocks 13T and 10BB. This followed security concerns after repeated protests by locals over the perceived lack of local content. However, Kenyan nationals (from the Turkana region where Tullow s blocks are located) reportedly constitute about 57% of the company s workforce in its Kenyan operations. These protests over local content clearly highlight the early-stage challenges of oil sector management in prospective producing countries. The government of Kenya could consider including a community development levy in the petroleum fiscal terms in the new regulation as a palliative measure. The levy will likely support education in oil and gas-related courses at Kenyan universities and potentially fund development of infrastructure in these communities. Exploration activity offshore could be affected by an existing maritime border dispute between Kenya and Somalia. Although the two countries are working to resolve the issue, Kenya will not be able to license deep-water blocks in the disputed region, which is believed to have high prospects. Next 18 months are very important In our opinion, this makes the next wave of exploration efforts in Kenya very crucial. Success with these wells could persuade investors to provide the equity funding needed by the explorers, despite the challenges; especially those explorers with blocks where there have been discoveries or which lie in close proximity to the discoveries. Tullow Oil and Africa Oil are likely to bring in new partners to join them on their blocks without major difficulties. The prospects of the East Africa Rift System (EARS) have been proved by their discoveries. If planned drilling further derisks the 1 billion barrels estimated to lie in the two blocks 10BB and 13T, the value of a 10% stake in the blocks could be worth well over $450 million. Another top prospect could be Afren s subsidiary, East Africa Exploration (EAX), which holds a 100% stake in the two blocks (L17 and L18) next to BG Group s block L10A, where the Sunbird-1 discovery was made. Afren is likely to drill two wells in 2015 targeting prospective resources of about 1 billion barrels of oil equivalent. Block 2B, which hosts UK juniors Premier Oil, Tower Resources and Vancouverbased Taipan Resources, is another interesting prospect. Following gas shows in a previous well drilled in the block and gas discoveries in the neighbouring Block 9, Block 2B could potentially be an onshore gas play. Africa Oil s discovery of over 1 trillion cubic feet of gas in the adjacent block 9 while drilling the Sala-1 well has been supported by additional 3D seismic data gathered by the block 2B partners. A well is expected to be spud in Q4 2014/Q targeting the Pearl prospect, which is believed to be the primary prospect on the block. Ecobank Research ecobankresearch@ecobank.com 6

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