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Gulf Keystone Petroleum - Revelations: The Final Judgement

By Graham Neary | Monday 30 May 2016

Disclosure: The author has a short position in one or more of the shares mentioned. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from ShareProphets). I have no business relationship with any company whose stock is mentioned in this article.

And God shall wipe away all tears from their eyes; and there shall be no more death, neither sorrow, nor crying, neither shall there be any more pain: for the former things are passed away.

It is with no small sense of humility that I disclose a token short position in Gulf Keystone Petroleum.

After all, it is already very late.

It is one year and eleven months since Todd Kozel left the company to work on his complicated personal affairs.

It is one year and one month since the weakening Gulf balance sheet resulted in a security interest over the Kurdistan assets being granted to the bondholders.

It is ten months since Jon Ferrier told the Telegraph that the company faced a “perfect storm.”

We are some 175p lower than when Tom Winnifrith originally identified this as a sell. Others, notably including Lucian Miers, have analysed this stock superbly over the period.

The amazing thing about the stock market (and in my view, the greatest thing about it) is the assuredness, within reason, of liquidity on every single business day.

For long-only investors, like Terry Smith, this means buying the shares of proven success stories many years after they have already won the competition to dominate their particular industry. To quote the great man:

"We do not seek to pick winners in the sense that most punters do, which is studying form, viewing the horses in the ring and then betting.

We wait until we know who has won and then wait for the bookmakers to offer us odds against them winning. In our case there are not bookmakers in the sense of a racecourse, we are talking about the market mispricing shares." (Bold is mine.)

This has proven to be an excellent approach to stock market investment. You can wait for a company to have an unassailable competitive position, buy shares in them even if they are vastly more expensive than they used to be, and still make a lot of money.

I suspect that it also works well in reverse.

In other words, I suspect that the strategy of waiting for utterly hopeless situations to emerge and then shorting them, even if the share price has already collapsed by more than 99%, is a worthwhile strategy.

Why this might be the case is less important than whether it is true or not. However, one simple explanation would be the counter-productive yet all-too-common instinct to trade counter-trend. On the way up, investors tell themselves “nobody ever went broke taking a profit”, so they sell shares in successful companies which would have happily continued generating wealth for them for perhaps decades to come. On the way down, they tell themselves that shares in a busted business are “cheap” when the unfortunate truth is that they are worthless.

I know, because I’ve made these errors in each direction.

Gulf is a biblical tale of ruin which includes executive greed, the stench of corruption in the Middle East, the spectre of terrorism, war, a refugee crisis and liabilities which cannot be met.

The end is nigh as the company’s Standstill Agreement with those bondholders who agreed to it is set to expire on Tuesday.

What makes this such a compellingly worthless equity position is not just the $575 million due next year which cannot be repaid.

The amazing thing about this situation is that even if the bondholders were to charitably decide not to pursue their interests, the company would remain on the financial brink. Net capex of $45 million is required just to maintain production.

But Gulf’s cash dipped as low as $44 million at December 2015.

Fortunately, it appears as though the Kurdistan Regional Government is at least paying Gulf some monies owed. On Friday, Gulf announced that it had received less than half of the invoiced invoiced amount for May of circa $15 million. But on Twitter, the Kurd Ministry of Natural Resources insisted that international oil companies would receive their full payments by the end of May.

While encouraging that arrears are no longer increasing – and these arrears amount to some $180 million – the current payment cycle looks woefully inadequate to save Gulf’s current equity holders.

Including the October payments, Gulf needs to find some $53 million of interest coupons and $45 million to maintain production. The company has acknowledged that there will be other ancillary cash requirements this year of circa $32 million.

The Shaikan oil field is an important asset and it appears likely that oil will continue to flow from it, assuming the continued support of the KRG, but there is no reason to believe that current equity holders will benefit from it. The company needs a cash injection and the forgiveness of its bondholders, and therefore some combination of new equity investors and the bondholders are likely to end up with close to 100% of the restructured equity.

For anyone who was thinking about joining the short side as long as it remains possible to do so, I’d like to highlight that this is a very small position size for me. Strange things can happen and shares can double or quintuple for no good reason at all. Shorting is not a sleep-sound strategy. Making money on the long side is both easier and safer.

In the case of Gulf, I think the current market cap of £52 million is approximately £50 million too high and therefore am happy to risk a small position on the view that the bondholders are not charitable fools, and that in any case new funds will need to be raised.

There may be weeping and gnashing of teeth from current equity holders, but hopefully the outcome will be for the good of the company and its employees.

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