Kosmos Energy: The Underwater Underdog Rising

When you think of oil stocks, big names like Exxon Mobil (XOM) or Chevron (CVX) probably pop into your head. They're everywhere with their global energy assets. And then there are giants like ConocoPhillips (COP) with their wide range of onshore and offshore assets, or even the relatively smaller exploration and production companies like Diamondback Energy (FANG) digging up oil right from the US onshore shale plays. But you would rarely hear about a company that gets its oil and gas primarily from deep underwater. That's Kosmos Energy (NYSE:KOS). They've been kind of the underdog, watching from the sidelines while others captured the limelight. But guess what? Things are changing, and Kosmos seems all set to make waves with expected increases in earnings and free cash flow, thanks to rising production, higher oil prices, and major projects being placed into service. I believe this stock certainly deserves attention.

An Offshore Oil Company With A Caveat

Kosmos Energy is an independent E&P that predominantly extracts oil and gas from offshore territories, notably the Atlantic Margins. Founded in 2003 with a keen vision to explore the largely untapped deep-water pockets of West Africa, the company quickly made a significant discovery by identifying the Jubilee field off the coast of Ghana in 2007. This discovery marked one of the most significant and promising oil finds of its time. In 2015, the company made another notable discovery - the Greater Tortue Ahmeyim field located in the deep sea around Mauritania and Senegal.

In addition to these, Kosmos holds stakes in multiple endeavors in the US Gulf of Mexico and a pair of offshore projects in Equatorial Guinea. As of now, approximately 60% of its output stems from Ghana, with the US Gulf of Mexico accounting for just above a quarter (27% as of Q2-2023), and the remainder flowing from Equatorial Guinea.

It's evident, as seen in the chart provided, that like its counterparts, Kosmos Energy's financial performance has swayed with the ebbs and flows of oil prices. The company grappled with losses, most markedly in 2020, when oil prices took a nosedive, triggered by the unprecedented impacts of the COVID-19 pandemic. Yet, with the resurgence of oil prices in 2021, marking Brent's ascent past the $60 per barrel threshold, Kosmos Energy's earnings displayed a commendable recovery.

However, Kosmos Energy's financial footing still leaves room for improvement. The company remains saddled with a substantial debt load. While efforts have been initiated to pare down its overall debt, I believe there's a considerable journey ahead for the company to align itself with its industry peers.

As the second quarter concluded, Kosmos Energy reported a debt of $2.41 billion against its cash reserves of $89.1 million. This puts the net debt at approximately $2.32 billion, a slight decrease from its recent peak at $2.50 billion as of the end of 2021. However, this is still quite high for a company valued at $3.3 billion and results in a notably high debt-to-equity ratio of 266%.

In contrast, other stalwarts in the oil domain, such as Exxon Mobil, Chevron, ConocoPhillips, and EOG Resources (EOG), have adeptly leveraged the oil price surge to notably cut their debt burdens over the past couple of years. These companies, benefiting from robust profits and bountiful free cash flows, strategically channeled their excess cash to pare down debt. Currently, their debt-to-equity ratios, which are some of the lowest within the sector, range between a modest 15% to 35%.

On closer inspection of Kosmos Energy's cash flow dynamics, the underlying issue becomes more evident. The company's track record in consistently amassing healthy free cash flows has been somewhat lackluster. For instance, during the first half of this year, the company witnessed an outflow (negative FCF) of $195 million as cash generated from operations fell short of covering total capital expenditures. Although 2022 saw a positive swing with free cash flows amounting to $343 million, the prior year (2021) logged a negative FCF of $98 million. Such periodic inconsistencies, in my view, have contributed significantly to keeping the company's debt levels elevated.

Turnaround Potential: Higher Production

It's crucial to recognize that Kosmos Energy's focus is on offshore projects. Historically, deepwater ventures are notably costlier to develop compared to their onshore equivalents. However, the upside is that once operational, these projects can yield consistent returns over extended periods without the need for significant additional capital investments.

A notable observation is Kosmos Energy's hefty investments in offshore projects in Ghana, Equatorial Guinea, the Gulf of Mexico, Mauritania, and Senegal. This investment strategy primarily explains their subdued free cash flows. Yet, in my view, the silver lining is that these projects are nearing their operational phase, and the timing couldn't be better.

In Ghana, Kosmos has been channeling efforts into the Jubilee and TEN fields, which significantly contribute to its total oil and gas production. The company has a 38.6% stake in Jubilee and a 20.4% interest in TEN, with Tullow Oil (OTCPK:TUWLF) presiding as the chief operator in both areas. Significant capital has been infused into these regions by Kosmos and its partners to activate new oil wells and enhance production levels. The field reported a gross production of 82,700 bopd in Q2-2023. The commencement of Q3-2023 witnessed two new wells from the Jubilee South East development springing into action, which escalated gross production figures to 100,000 bopd in July. In the current quarter, one new producer well and two injector wells will also be placed into service, which should further augment production numbers.

Kosmos projects a Q3 production range of 67,000 to 70,000 boe per day, indicating an 18% uptick from Q2 figures, primarily steered by the new Jubilee wells. However, as the newly operational wells in Q3 progressively reach their full production potential in Q4, I believe there's potential for volume to climb even further. It's plausible to predict levels exceeding 80,000 boe per day and potentially nearing 90,000 boe per day. Note that Kosmos Energy's projection for FY-2023 stands at an average of 67,000 boe per day. Based on this guidance, one could infer a Q4 production rate hovering around 83,000 boe per day.

Consequently, I anticipate Kosmos Energy's Q4 oil and gas production to outpace Q1 figures by approximately 40%. This surge will invariably bolster the company's earnings and cash flows, and the positive trajectory could be further accentuated with prevailing robust oil prices.

Turnaround Potential: Higher Prices

Oil prices have witnessed a notable surge recently, with both WTI and Brent futures soaring nearly 30% over the past three months, settling at $90.13 and $93.27, respectively at the time of this writing. This significant uptick stems from a blend of factors: supply curtailments from OPEC+, restrained output from US shale oil players, and a resilient demand primarily from Asia, among other pivotal regions.

A pivotal announcement this month came from oil giants Saudi Arabia and Russia, two predominant OPEC+ producers. Both countries disclosed their joint decision to roll over their collective production cuts of 1.3 million bpd until the close of 2023. Concurrently, Russia implemented a provisional embargo on diesel and gasoline exports, a move that may further constrict global supply. In contrast, the US has shown a more conservative growth trajectory in oil production. The shale oil producers have been emphasizing robust cash flow generation and healthy shareholder returns over aggressive production growth. Data sourced from the US EIA pinpoints US field crude oil production averaging 12.8 million bpd in June, a marginal rise from January's 12.6 million bpd.

Oil demand has remained resilient, even with the broader economic apprehensions. Post-COVID reopening from China, a foremost crude oil consumer, was anticipated to champion a potent economic resurgence. The economic momentum, however, fell short of expectations, prompting the nation towards stimulus interventions. Paradoxically, oil demand in China has held its ground. This resilience is evident in the robust crude oil import metrics and refinery throughput figures. China's crude oil imports in the previous month rose to 52.8 million metric tons, marking an upswing of nearly 21% from July and a significant 31% YoY growth. Concurrently, refinery throughput increased to an all-time high of 64.69 million metric tons, reflecting domestic refining industries' endeavors to cater to healthy local and international demand.

In my view, the supply cuts from OPEC+, as well as lackluster growth from the US, might create a substantial supply shortage in the fourth quarter, which is in line with the estimates from the IEA and OPEC. With the onset of winter, the northern hemisphere is poised for a seasonal spike in oil consumption. Given this backdrop of tightening supply juxtaposed with surging demand, oil prices seem primed to sustain their elevated levels. This prevailing market climate augurs well for Kosmos Energy.

Earnings & Cash Flow Growth

I believe Kosmos Energy's finances will likely strengthen in the forthcoming months, and this optimism is founded on several tangible factors. Note that Kosmos Energy realized oil prices of $75.32 per barrel in the second quarter, but prices have since climbed to $90s a barrel range. With higher prices, coupled with burgeoning production rates, the company looks well-positioned to register significant growth in its earnings and cash flows.

One crucial element to consider is the company's capital expenditure trajectory. Given the development stages and the completion timelines of its projects, particularly the crucial Jubilee project, the latter half of 2023 will likely witness a decrease in CapEx relative to the initial six months. A projection can be made, based on the timelines and management's comments, that Kosmos Energy's capital spending for Q3 will be approximately on par with the $170 million reported in Q2, potentially escalating to about $179 million in Q4. This sequential increase in Q4 is can be attributed to intensified activities in the Gulf of Mexico and the Tortue Subsea project in Mauritania and Senegal. The entire second half of 2023 might witness a capital outlay of around $349 million, down from the $376 million in H1-2023.

The upshot here is that reduced capital expenses are colliding with a phase of ramp up in cash inflows, a combination that is likely to pivot Kosmos Energy to positive free cash flows in H2-2023, signaling a pivotal financial turnaround. But the horizon for Kosmos Energy looks even more promising.

Kosmos Energy recently started drilling on the Tiberius prospect and seeks to begin drilling work on Winterfell project in the ongoing quarter, which also explains the above-mentioned increase in activity at the Gulf of Mexico. The Tiberius play could hold 135 million barrels of oil equivalent reserves. We'll likely hear more on this when the company releases its third quarter results. As for Winterfell, it is supposed to be a 100 million barrels of oil equivalent resource, but with substantial upside potential. Production from Winterfell is on track to begin form the first quarter of next year. In the same period, the Tortue Ahmeyim LNG project is also expected to achieve first gas. The company and its partners have been doing work on subsea installation while development and completion of the FLNG is underway. Although Tortue has seen some delays, it currently appears to be on time for Q1-2024 startup.

The startup of new projects is going to do two things. First, the company's production is expected to surge in 2024, surpassing the anticipated 80,000 boe per day production of Q4-2023. This rise should bolster both its earnings and cash flows. Second, as more projects commence, the capital expenditures will likely diminish substantially. The scenario ahead paints a picture where Kosmos Energy will see growing cash inflows and reduced capital-related outflows. This aligns the company for a strong free cash flow stance.

Recall, as discussed, one of Kosmos Energy's challenges has been its inconsistency in generating substantial free cash flows, which in part has contributed to its significant debt. But it seems the company is nearing a pivotal moment. The projects that have been in the pipeline for years are set to be operational, and combined with favorable oil prices, could significantly elevate Kosmos Energy's earnings and free cash flows. In my view, the company will likely channel this surplus cash towards reducing its debt. While the company's current debt metrics are on the higher side, indications are that its leverage situation could start improving as early as this year. In my opinion, such a shift is bound to positively influence the company's valuation.

Takeaway & Risks

Kosmos Energy is on the verge of a transformation. The company, which has grappled with negative free cash flows and considerable debt, now appears poised to rectify its financial situation. There is a confluence of positive factors at play - the ramp-up in production, favorable oil market conditions, and the tapering of CapEx due to the completion of major projects. This trio is set to amplify both profits and free cash flows, which I expect the company to utilize predominantly for deleveraging the balance sheet. The future looks promising and I maintain a bullish stance on the stock.

From a valuation standpoint, the stock trades at 10.6x forward earnings, marginally above the sectoral average of 10.5x, as per Seeking Alpha data. With a valuation grade of 'C' on Seeking Alpha, the stock might not seem enticing at first glance, suggesting that investors keen on value may want to anticipate a potential pullback before buying.

However, investing in Kosmos Energy is not without its perils. Like its industry counterparts, the company's stock price remains tethered to the vicissitudes of oil prices. But what differentiates Kosmos is its relatively high debt load, which I think makes it inherently more vulnerable. A downturn in oil prices might exert a generalized downward pressure on all oil stocks, but the fall might be more pronounced for Kosmos due to its leverage profile. While the upside potential for Kosmos Energy is undeniable, potential investors must tread with caution. Its risk profile, accentuated by its debt position, makes it a choice that's not suitable for every investor, particularly those with a conservative risk appetite.