Pacific Rubiales

Energy Corp.
Julian Castillo- April 2014

Stock Data
Price C$ 18.1
52- Week Range C$ 14.8 -23.43
Price US$ 16.5
Target Price US$ 26.77
NAV per share US$ 24.77
Shares Outstanding MM 325.3
Market Cap US$ MM 5,367.45
Total debt US$ 4,372
Total debt to Cap (Dec 2013) 51.2%
Summary & Recommendations:

Pacific Rubiales has an incredible potential to continue growing by increasing its

production and revenue levels in the medium term. The current stock price of $16.5 is
not reflecting this potential which creates a good investment opportunity. I recommend a
long position on Pacific, its valuation is very low compared to its peers and the target
price of $26.7 derived from the DCF analysis implies an upside potential of almost 62%
from the current market price. Additionally the NAV valuation analysis yields a per share
price of $22.47 supporting the view of the company being undervalued by the markets.

Company Overview:

Pacific Rubiales Energy Corp. (TSX:PRE ; BVC:PREC) is a Canadian based

petroleum exploration and production company in the business of heavy crude oil and
natural gas. It is the largest independent oil company in Latin America with a portfolio of
94 E&P blocks diversified across six countries in the region, and 1 block in Papua New
Guinea. The main operations are in Colombia, where it currently holds 74 blocks and 16
producing fields, as well as in Peru with 9 blocks and one offshore producing field.
Approximately 85% of its current production is in two fields, the Rubiales/Pirri and the
Quifa heavy oil fields, with the remainder being from other light and medium oil and gas
fields.

Investment Thesis:

Pacific Rubiales has an extremely experienced management team with extensive

international exploration success and know-how of more than 30 years in the industry –
most senior management came out of the senior ranks of the Venezuela national oil
company PDVSA. This team has leaded the company to remarkable reserves and
production growth patterns since its birth, making it the largest independent oil E&P
company in Latin America. Pacific’s strong and diversified block base together with its
low production costs relative to other companies puts it in an unique position to continue
increasing its reserves and production levels in the medium and long run. Additionally,
the company is developing proprietary technology to continue supporting its long term
growth opportunities.

Despite its proven track record and promising upside potential, the company is currently
being undervalued by the markets. In my opinion, the markets are over reacting to short
term production limitations which shouldn’t affect the company’s performance and
potential in the long run. The recent drop of more than 17% in the stock price came
after the company released its Q1 2014 results, which were affected by lower than
expected output levels at the Rubiales field and higher production costs. However,
these shortcomings are explained by two conjunctural issues:

 There’s a heavy drought that has lowered water levels in a river near the
Rubiales field. In consequence local authorities are preventing Pacific from
 disposing the water residues in the river, leaving no other option than to reduce
the output levels.
 The guerillas bombed the Bicentenario oil pipeline earlier in the year forcing the
company to use alternative methods for transportation, which translated in higher
than expected production costs.

These two issues should get resolved in the near term and thus their effect would be
minimal in the upcoming quarters. Additionally, the overall reserve trends and daily
production levels keep increasing. The company should be able maintain strong cash
flow levels past 2016 when the Rubiales field license expires taking advantage of these
characteristics:

Growing Capex Investments Fully Funded by

Internally Generated Cash Flow:

The company is expecting to spend $2.5 billion in

Capex in 2014. This represents a 25% increase from
2013. This trend is likely to continue over the next
four five years, since they are expected to spend
between $1.7 to $2.4 billion per year on E&D. This
spending will be provided entirely by internally
generated cash flow in price environment of $80 -
$90 WTI oil price; and also generate substantial free
cash flow

Early Replacement Plan of the Rubiales Field by 2016:

The Company has already started replacing the production from the Rubiales field and
plan in no counting on it after 2016 when the agreement with Ecopetrol expires. The
early planning and replacement of this field will allow the company to maintain its strong
production and revenue levels beyond 2016. As seen in the charts below, a
disagreement on a new contract to continue developing the Rubiales field shouldn’t hurt
the company’s income statement.
Innovation Led Growth:

 Enhanced oil recovery- STAR: The company has confirmed that this
technology does work and they have been granted with two exclusive patents for
it. In addition the pilot program has been certified by independent auditors,
confirming it has at least doubled the oil recovery/extraction rate and reduced by
30 percent water residues. This technology gives the company the opportunity to
unlock a very large additional resource base and lower the production costs.
There’s a new contract being discussed with Ecopetrol for the Rubiales field
based on this technology. A positive outcome would translate in greater
production levels in the short term.

 Floating LNG facility: Pacific’s innovative LNG export project in Colombia is

expected to be the world’s first operational floating NG facility when it is
commissioned at end of 2014. The Company recently signed a five year 0.5
million ton per year (full facility throughput) heads of agreement with Gazprom
Marketing & Trading Company. Pricing will be linked to international oil prices
(Brent), FOB at the facility and is expected to result in a significant premium to
the current domestic pricing.

Opportunities in Mexico:

The recent energy reforms in Mexico create a big opportunity for increasing production.
The company has already started negotiating with PeMex for the creation of joint
ventures in onshore and heavy oil fields. They have identified 5 possible production
sites to start operating in 2015 if an agreement is reached with PeMex. This would
make Pacific one of the first independent companies operating in Mexico and would
allow for a rapid increase in production levels.
Valuation:

Comparable companies:

Pacific Rubiales valuation is very low relative to its peers with similar production and
reserves levels. It has lower EV/EBITDAX and EV/EBITDA than the comparable
companies, and it’s also at the low end of the EV/proved reserves and EV/ daily
production values.

Comparable Companies Valuation Statistics Capitalization Proved Daily R/P Enterprise Value /
Equity Enterprise Reserves Production Ratio EBITDAX EBITDA Proved Daily
Company Name Value Value (BBoe) (MMboe) (Years) Reserves Production
Ecopetrol $ 82,235 $ 72,762 1.9 0.6 8.1 6.5 x 6.7 x $ 39,080 $ 115,496
Talisman Energy $ 11,021 $ 15,825 1.0 0.4 7.0 16.3 x 22.2 x $ 16,222 $ 41,755
Nobel Energy Inc. $ 26,797 $ 31,608 1.4 0.3 13.1 8.7 x 9.8 x $ 22,480 $ 107,875
Hess Corporation $ 28,379 $ 33,605 1.4 0.3 11.1 4.9 x 5.8 x $ 24,673 $ 100,014

Maximum $ 82,235 $ 72,762 1.9 0.6 13.1 16.3 x 22.2 x $ 39,080 $ 115,496
75th Percentile $ 41,843 $ 43,394 1.5 0.4 11.6 10.6 x 12.9 x $ 28,275 $ 109,781
Median $ 27,588 $ 32,606 1.4 0.4 9.6 7.6 x 8.2 x $ 23,577 $ 103,945
25th Percentile $ 22,853 $ 27,662 1.3 0.3 7.8 6.1 x 6.5 x $ 20,916 $ 85,449
Minimum $ 11,021 $ 15,825 1.0 0.3 7.0 4.9 x 5.8 x $ 16,222 $ 41,755

Pacific Rubiales Energy $ 5,367 $ 8,755 0.6 0.1 12.5 3.0 x 3.4 x $ 14,286 $ 65,089

DCF Analysis

The DCF analysis suggests a per share price of $26.7 or 61.8% higher than the current
stock price of $16.5. This price is derived from a base case price scenario which
assumes $95 oil and $5 gas realization prices and conservative assumptions for FCF
projections. The valuation uses a WACC of 11.7% and a terminal value derived using
an EBITDAX multiple of 5x.

DCF Valuation Cost of debt: 8%

(in US$ million) Income Tax: 35.5%
PV of Terminal Value: 11,044 Risk Free Rate: 3.2%
Sum of PV of Free Cash Flows: 1,028 Risk Premium: 8.2%
Enterprise Value: $ 12,072 Beta: 1.1
Balance Sheet Adjustments: (3,387) Cost of Equity: 12.2%
Implied Equity Value: $ 8,684 Debt: 62%
Equity: 38%
Shares Outstanding: (mm) 325.3 WACC: 11.7%
Implied per Share Price: $ 26.70 EBITDAX Multiple: 5.0x
 Unlevered Free Cash Flow Projections
(in US$ million except daily production figures) 2014 2015 2016 2017 2018
Daily Production (MMboe): 154.13 168.93 177.38 186.24 195.56

Revenue: 5,048.75 5,547.30 5,840.62 6,115.89 6,421.69

EBITDAX: 3,368.42 3,672.34 3,745.31 3,792.62 3,840.76
Operating Income (EBIT): 1,765.46 1,955.79 1,900.15 1,814.41 1,712.17
Less: Taxes (626.74) (694.31) (674.55) (644.12) (607.82)
NOPLAT 1,138.72 1,261.49 1,225.60 1,170.30 1,104.35
Plus: DD&A 1,115.46 1,222.60 1,343.91 1,469.40 1,611.24
Plus: Asset Retirement Accretion 67.16 73.61 80.91 88.47 97.01
Plus: Stock-Based Compensation 44.60 44.60 44.60 44.60 44.60
Plus: Non-Cash Derivative Losses 20.74 20.74 20.74 20.74 20.74
Gross Cash Flow 2,386.68 2,623.04 2,715.76 2,793.51 2,877.94
Working Capital (Increase) / Decrease: 15 14 74 83 95
Less: Capital Expenditures: (2,585) (2,286) (2,344) (2,405) (2,473)
Unlevered Free Cash Flow $ (183) $ 351 $ 446 $ 472 $ 500
Present Value of Free Cash Flow $ (164) $ 281 $ 320 $ 303 $ 288

DCF Analysis Sensitivity

Per Share Price Sensitivity Price scenarios

Discount Rate Price in US$
9.0% 10.0% 11.7% 13.0% 14.0% Gas Oil
scenarios Downside 4.50 85.50
scenario

Downside 20.66 19.23 16.96 15.37 14.21

Price
Price

Base 31.43 29.60 26.75 24.65 23.17 Base 5.00 95.00

Upside 42.20 39.97 36.13 33.93 32.12 Upside 5.50 104.50

The DCF derived per share price was analyzed using three different oil and gas price
realization scenarios. The downside case assumes a $4.5 gas and $85.5 oil realization
prices, the base case assumes a $5 gas and $95 oil realization prices, and the upside
case $5.5 gas and $104.5 oil realization prices. The above chart shows that the DCF
valuation would yield a $42.2 per share price under de upside price scenario and the
lowest WACC, and a $14.21 per share price under the downside price scenario and the
highest WACC. The current market price would be achieved under the downside price
scenario and a WACC value higher than 12%.

Net Asset Value (NAV)

The NAV analysis yields a per share price of $24.77 or 50% above the current market
price of $16.50. This approach estimates the present value of the proven reserves, with
the base case price scenario. It assumes that the company never increases its existing
reserves, so there is no additional CapEx in future years beyond what is required to
develop existing reserves. Additionally, this model includes the proceeds from the
probable spinoff of two non-production business segments: Pacific Infrastructure,
valued at $1,000 million, where the company has a 41.4% working interest and Pacific
Midstream, valued at $1,200 million. The Company is expecting a spinoff of these
Midstream and infrastructure assets in the short term, maintaining the strategic value
through take or pay contracts, and realize additional value for its shareholders.

Net Asset Value as of Dec-13

(in US$ million)
PV of Cash Flows from Proved Reserves: $9,534.40
Other Business Segments:
Pcific Infrastructure 414
Pacific Midstream $1,200
Value of other bussines segments: $1,614
Enterprise Value for Entire Company: $11,138
Plus: Cash & Cash-Equivalents: 633
Plus: Equity Investments: 659
Less: Debt: 4,170
Less: Asset Retirement Obligation: 202
Net Asset Value: $8,057

Shares Outstanding: 325.3

Implied NAV Share Price: $24.77

Risks:

 Negative outcome of the Rubiales field negotiations with Ecopetrol: Even

though the outcome of these negotiations and the future of the STAR technology
shouldn’t have a negative impact on Pacific’s financial and operational
performance the stock has been sensitive to these projects. Pacific can afford to
lose the Rubiales field but the market doesn’t seem to understand this, so failing
to renew this contract could push the stock price down. However, this risk should
dissipate as the company demonstrates it is successfully replacing the
production from the Rubiales field.

 Decline in Oil and Gas prices: Pacific valuation is dependent on oil and gas
prices. Any sudden drop in these prices would compromise the revenue and
future cash flows of the company. This risk can be hedged by tacking a short
position in the USO or any other oil & gas based ETF.