Published on the Value Lab 30/5/22
Here we offer the highest conviction opportunity since Dassault Aviation (OTCPK:DUAVF), where the company is valued at zero despite being at the confluence of myriad factors that are quintessential of the current economic environment and direction. Despite being well positioned against inflation and other economic woes, Japan Petroleum Exploration Co., Ltd. (OTC:JPTXF) nonetheless trades with its operating assets at almost negative values. They are positively exposed to gas prices, expanding their fields, but mostly to crude oil prices both through their E&P business. They also generate power and function as a utility company, and operate the infrastructure to move and store the gas and oil they produce. Their markets are primarily in Japan, which turns out to be a good thing on FX effects, and liberalization of the utilities market is a limited headwind in the resilient utility business.
With substantial fundamental already seen in the FY 2022, this year’s results will be even better as end-of-year prices for the period are half of current spot prices. These improvements in the wake of the invasion of Ukraine are not at all reflected yet in prices, which are at pre-invasion levels. With geopolitical factors and dislocation a durable levitator of prices, JAPEX is likely to be printing cash from its zero-value assets for a while. A thematically appropriate play and being valued at zero puts JAPEX at the top of our buy list.
Commodity Environment Plain To See
The commodity environment is that of serious supply side constraints, primarily bottlenecked by logistics, causing inflation that in many key geographies appears to be accelerating thanks to pernicious mechanisms around hoarding, speculation, and expectations of inflation perpetuating it through the wage-price mechanism. Hoarding and more conservative inventory management practices that are reducing the turnover and availability of goods is now even happening at the country level, where mercantilism is rearing its ugly head and protectionist measures are exacerbating cost pressures.
Finally, specific issues with the Ukraine-Russia conflict are furthering constraints on energy, but also other key resources like Titanium and Palladium, as Russian supply becomes blocked from entering circulation in western trade. There is no sign that this conflict is close to ending. In other words, inflation is here to stay, and consequently so are the prices of commodities with geopolitics putting energy, specifically gas and oil, squarely in the spotlight.
JAPEX, despite trading at basically a zero EV, is at least resilient and often positively exposed to the full theatre of issues that are stymieing the rest of markets through their E&P as well as their infrastructure and utility business.
The E&P business are the full set of upstream oil activities from exploration, a full suite of engineering capabilities, and finally the operation of rigs and production of oil and gas from their assets.
They are exposed to both crude oil and gas prices, with the current revenue breakdown between the two being the following:
Diluted bitumen (“Dilbit”) is bitumen that is diluted with other hydrocarbons like naphtha primarily for the purpose of being able to move it through pipelines. However, this business has been totally sold off as of now, where it used to be part of the Japan and Canada Oil Sands subsidiary. With the reversal in the infrastructure and construction boom entirely possible, it was not the worst timing for this, but the losses on these sales from book value are the only reason why net income is in negative territory.
In any case, the revenue breakdown will on a go-forward basis be between Gas and Crude at about a 1:35 split as far as the E&P business goes, meaning that the vast majority of the exposure is to oil prices.
The delta in this segment amount to the nearing completion of a couple of developments, as well as scope to expand oil and gas field capacity for a couple of their already established assets. They have assets in Iraq that are being quite meaningfully expanded from about 80k barrels per day to 230k. They continue to drill in Hokkaido and Niigata to explore for more reserves, and they are developing assets in the UK North Sea (The Seagull Project).
The overall volumes of oil should increase at least 12% on a normalized basis just based on the Iraq growth, but with the addition of the UK project it could be meaningfully more on top of Japan expansions. The opportunities for development have also grown as a consequence of the increasing strategic importance of energy while geopolitical concerns are mounting. Onshoring, especially a concern for Japan which is part of the frontier against China in the Pacific, is a major force for encouraging more developments, and we are seeing an uptick in interest in offshore engineering across the board.
It’s important to manually scrutinize volume projections, because JAPEX is exposed to a pretty major development in Russia off of Sakhalin Island which is of course under heavy fire since income might not be retrievable from this asset, and certainly realized prices on its oil will be a lot lower because of sanctions. Indeed, Exxon Mobil (XOM) has abandoned this project for obvious reasons, and the JAPEX stake’s value is of course in question.
Nonetheless, writing it off completely lets us see that meaningful volume growth for the rest of the exposures at much higher realized prices is entirely reasonable. The Sakhalin volumes attributable to JAPEX will be similar to what we’re getting in Iraq currently, except the Iraqi exposure is about to grow 3x to the loss of 1x Sakhalin in a write-off scenario, so offsetting it 3 times over. Also, our valuation later uses operating profit, where the consortium that is invested in Sakhalin is accounted for on an equity accounting basis, so not included in operating profit that we use for valuation. Also, Sakhalin sales wouldn’t be included in overall sales and volume figures reported in the annual report, but the income growth from Iraq should still more than offset any write-offs of Sakhalin that would affect the comprehensive income. UK and Japan expansions would just be icing on the cake for more volume based comprehensive profit growth.
If JAPEX continues to buy oil from Sakhalin however, not incurring the ire of political onlookers, they will be able to acquire oil at highly discounted prices. JAPEX acquires a lot of oil from Sakhalin as disclosed in related-party transactions. Japan is being as slow in phasing out Russian oil imports so this might be good for JAPEX as these discounted purchases could be a surprising benefit to the bottom line going forward. However, Japan isn’t extremely dependent on Russian oil, so we are not betting on this effect at all as imports from Russia are already falling. We’ll continue to ignore the Sakhalin contribution to income from historicals.
We think a 30-40% increase in revenue and a higher increase in operating profits in the next two years is entirely achievable given current prices, perhaps more if oil is purchased at discounts from the Russians. Note that JAPEX is guiding on assumption prices much lower than spot prices ($70 per barrel). With higher oil prices very likely in the medium-term future, especially as reopening puts aviation fuel back on the map in terms of end-markets, the business conditions have markedly improved for JAPEX in E&P.
Without Sakhalin, the reserves are at around 200 million barrels of oil equivalent on about 10 million barrels of oil equivalent produced annually, so more than 20 years of run rate production to consume reserves.
Infrastructure & Utility
Gas Supply Infrastructure
Japan is a very gas-intensive country, much like Italy, where stoves, boilers and heating are often gas powered. The gas transmission network is important, and many of its gas pipelines are operated by JAPEX to distribute the gas throughout Hokkaido (a cold region of Japan) and central Japan. They also operate 2 terminals for the storage of gas.
The pipelines transport both their own gas and imported gas from through the Pacific Ocean, probably substantially from Australia. As a toll road for gas, this is an excellent infrastructure exposure as part of the JAPEX portfolio. LNG is a transition energy source as far as the renewable push goes, with its properties being less polluting than oil and its prevalence as well as adapted infrastructure making it a great way to support energy systems while renewable gains a more robust footing. Moreover, the profits from this business, as well as that of their LNG terminals, are highly profitable and consistently profitable too. The business was a pillar of resilience in the COVID-19 racked year of 2020, continuing to produce a 12% operating margin. In most respects, it is a similar exposure to our other holding Rubis (OTCPK:RBSFY) both in assets and resilience.
Volumes through this network should improve from last year as tourism resumes and volumes of gas grow from JAPEX fields. While the sales from gas sales from the fields are relatively low due to the lower price of gas compared to oil per barrel of oil equivalent, the volumes produced by JAPEX alone are significant at almost 20% of the oil volumes. Moreover, with the electricity generation business being run by JAPEX we are about to mention also ramping up, pipeline utilization and demand should only improve.
JAPEX generates electricity primarily from natural gas as an input, but also through other more renewable sources. The provision is vertically integrated which is good while gas prices are high, and this segment which operates off PPA agreements with retailers is resilient to economic hardship, shown by the resilience of all generation-focused businesses during the pandemic.
The only real headwind in this business is that the Japanese market is behind the curve in terms of having lowered switching costs for consumers and allowing for a range of consumer options. Liberalization of the market has meant there are more retailers who are all looking to cut costs with their off-taking of power. it has made selling power more competitive, but the volumes are going to be resilient and prices aren’t going to come down that much or that quickly, as the Japanese have been slow to take advantage of the range of options and change.
Finally there is the Green business. Because of the links between carbon capture science and exploration, JAPEX is exploring CCS opportunities where CCS should account for 14% of the world’s carbon offsetting by 2050. Currently, this is not really a commercial segment, but it creates a new avenue for business down the line.
The valuation considers only the operating income without any positive effects from Sakhalin discount purchases, which are probably not going to continue for long, and from income from Sakhalin which is accounted for in the equity-based investments on the income statement. We have taken into account minority interests as well, which just about inches the EV to positive territory. But without the minority interest, a 4.8% stake in Inpex (OTCPK:IPXHY) and massive cash reserves with little debt to speak of result is a major net cash position that actually eclipses the market cap. We’ve even accounted for all possible tax effects of selling the Inpex shares. The valuation is the following on the latest LTM EBITDA figures.
Too Good To be True? Considering Everything
How could this possibly be justified? Perhaps a shrinking population and economic languishing of Japan is a concern. But surely a commodity business like this can sell their commodities elsewhere, especially from E&P. The infrastructure and utility business may suffer secularly on account of limited population growth, but the declines aren’t so rapid in Japanese population growth to warrant a dramatically different outlook from similar infrastructure assets in the west. With the biggest delta coming from E&P as it is commodity exposed, while the infrastructure business is commodity price agnostic, this issue of demographics is further limited.
The economy is even faring better than Western counterparts. Inflation is actually stalling rather than accelerating there, and the Bank of Japan is maintaining a quite dovish stance. This might be because of Japan’s long lasting spending glut, with less inflation transmission, and more isolated food market. In fact, the Yen is weaker than it’s been in years, and despite this imported inflation is not too evident, signaling a systematically different inflation exposure. Still, the commodities JAPEX are producing are picking up prices, even if the rest of the Japanese basket isn’t as much, so all the better for us.
Perhaps the Russian exposure is keeping investors away. Possibly, but many companies are involved with Sakhalin, and we analyzed here that the Sakhalin delta, even if written off, is offset almost 3 times over in terms of their volume-comprehensive income effect by the increases in capacity happening in Iraq. In any case, our valuation does not incorporate the value of Sakhalin in the non-operating assets, nor does it utilize the income in the EBITDA figure, so we’ve already ignored it to get this tiny valuation.
The reason this opportunity exists is that the markets are not that thoroughly parsed, because whereas in the US people put their savings into stocks quite a lot, the Japanese save overwhelmingly by investing in bonds. For a country that is self-inflicting economic woe by being so anti-spending, the rates at which they are putting money is almost zero-yield bonds for years is remarkable. The stock market is seen as gambling by most, and they’d rather just do Pachinko then.
We have witnessed similar unbelievable mispricing in the past. Sumitomo Chemicals (OTCPK:SOMMY) was one such investment, where the company issued incorrect data on one of its main subsidiaries, Dainippon Pharmaceutical (OTC:SMDPY), writing that it’s income would be half of what it was selling anti-psychotic medication. Moreover, the value of its other exposures, including nutrition and petrochemical, were at zero at some point in 2020. So, this has happened before, and the returns have been magnificent.
JAPEX is positively positioned towards crude prices and the rest of its non-commodity income is from extremely stable infrastructure income. Even when Russia invaded Ukraine, rallying commodity markets like oil and gas, the price of JAPEX barely reacted, and hasn’t made a net upwards movement since then.
Despite oil prices being higher than 2014 prices, the last time oil was doing great, the stock is still trading at almost half those levels.
The non-operating assets basically equal the market cap, meaning the operating assets have almost a zero value. There is no problem with liquidity, this is quite a major company, yet it still trades at a massive discount. We’ve accounted for the tax effects. With both the direction of the company being good, and the absolute situation of the company being good too, with resilient infrastructure exposures and an obviously rock-bottom valuation.
We can only conclude that JAPEX is an extremely strong buy. Moreover, with the Yen being at low levels as well, the USD income is converting into more Yen than historically, at higher volumes and rates. As these funds get added to the massive cash balance, when the Yen recovers, there are even great FX effects that will take hold in the non-operating assets.
The Yen is only cheap because the BoJ can afford to be dovish too, so the local markets are doing relatively well which should be seen as a positive. With the Yen perhaps gaining credit for that, as well as the fact that the Yen is typically a safe haven currency, some FX bonus can be hoped for. But even without the FX effects, this business can easily be valued at a blended multiple between a company like Aker BP (OTCPK:DETNF), which is an E&P company with quite broad geographic exposures, and Rubis. Doing about a 60:40 split, which is the long-term rate guided for by the company for E&P: non-E&P revenue, you’d have a multiple of 4.5x on EBITDA, where high EBITDAs right now from E&P companies are showing top of the cycle multiples.
We might not even agree with a top-of-the-cycle multiple as the situation for oil and gas are quite durable, brought on by conflict that will not be easily resolved between lots of stakeholders, including Saudi Arabia and the U.S., where a bit of a spat is going on right now over loosening the taps. Moreover, logistical issues causing broad-based inflation, as well as expectation effects and hoarding may not resolve easily and could perpetuate inflation beyond what the supply side situation might justify on a fundamental level.
So, the company is firing on all cylinders, with major capacity increases coming in Iraq for commodities that are at much higher prices than are reflected in LTM data. The Russia exposure is limited, and Japanese exposures are resilient with gas being a key resource for Japanese households and JAPEX operating the infrastructure to provide it to them. They even have a renewable angle with CCS and generation of electricity that is renewable, or at least not the most polluting with LNG. The dividend next year is also being guided to be yielding about 4% at current share price levels too, so there’s also an income proposition. Overall, overwhelming buy.