This is for the investor trying to form an opinion on the outlook for Forte Oil as the company continues its growth from a downstream one into a diversified energy company. Having the troubled transition of Oando Plc from a purely downstream business into an integrated energy company at the back of the mind, one should be better prepared to position for Forte Oil performance over the next three years.

Downstream

In the past four years, Forte Oil has made significant strides in its downstream operations; ventured into the Power sector and competed on divestment of upstream assets, albeit unsuccessfully. The Company’s share price has set records on the level of capital appreciation returned in 2013 & 2014; FO was officially included in Morgan Stanley’s MSCI Emerging Market index (alongside ETI) in 2014 and was celebrated as one of the top 100 companies in Nigeria.

However despite these, the company’s main business remains the downstream business, which generates over 85% of revenues. Although sales volumes are up and the Forte Oil has regained lost market share in the PMS sub-segment, sale of other fuels seems to be crawling along while delayed payment of subsidies and bridging claims continue to constrain profit margins and cash flow. The Company has declared forex translation losses consistently over the past three years due to its downstream business – imports in foreign currency and sells in naira. Sounds similar to another oil and gas company you know?

Becoming an Integrated Energy Company

The move towards becoming an energy company, i.e. diversifying into power and the upstream segment among other things, is primarily targeted at boosting profits by adding high margin businesses into its portfolio. This is well reflected in the company’s FY14 gross margins per segment – Power (52%) Lubricants and greases (37%), Chemicals (26%) Fuels (7%). The power business profit margin is supported by the pioneer status granted the firm in 2014.

Power Segment

The positive outlook for the power segment is also supported by the low capacity utilization of the plant currently. Geregu has operated at less than 40% of installed capacity since 2013 due to the major overhaul required and gas supply problems. Forte Oil requires capital to complete the overhaul and boost power generation, which would in turn boost revenues and profits.

Chemical Business

I’m concerned about the contribution of the chemicals business, i.e. sale of drilling chemicals mostly to the IOCs; it is likely to decline in the second half of 2015 due to the downturn in E&P activities in the country as oil prices fall. Although revenues grew in H1 2015, gross margins thinned as business retention became challenging. Going forward the segment is likely to face major headwinds as drilling activities decline on low oil prices, non-passage of the PIB etc.

The company is looking to boost this business by offering other services and acquiring drilling equipment. Except they intend to acquire other drilling equipment used for logging, encasing wells etc, this could imply an intention to acquire rigs. The type of drilling rigs that would make any acquisition sense now are semi-submersible rigs. These are very expensive but there is a huge demand for them offshore West Africa. The company would require massive investment to acquire one of these but on the flip side, this would guarantee demand for their drilling chemicals while earning good rates for drilling.

Upstream Segment

The other upstream segment, FB Energy Development Company (FBEDC) is unlikely to contribute to the company’s profitability before 2017 going by their current status and lead time for closing upstream transactions in Nigeria. The company has bidded relatively well on divested assets, but has not been able to close deals for any oil producing assets. However, a rich pipeline of oil producing assets remain on the market, with more expected before the end of 2015; FBEDC is well positioned to bid on these but funding is likely to be a challenge. With current oil prices and continued challenges with militancy and oil theft in the Niger Delta, an acquisition asset must yield really high NPVs to attract funding.


More on Downstream

Downstream, the company has increased its market share in the PMS segment on the back of their investment in mega retail outlets, rebranding and good supply arrangements. However, that performance doesn’t seem to be replicated across other fuels and segments. The Company’s share of sales of diesel has actually dropped relatively to previous years due to tighter competition in the space. Forte oil is no major player in the Aviation fuel space dominated by Total and Conoil. Efforts to regain lost grounds in the lubricant space seem to be crawling at best.

Expanding its downstream Portfolio

The company also intends to add LPG, LPFO and Bitumen supply into its business portfolio. These are also high margin businesses in the fuel retailing category. However, it will face major competition to carve out market share, especially in the LPG & LPFO space dominated by Oando, which has invested a lot of capital to position its brand in the market. Forte would need to equally invest a lot of funds to position its gas cylinders and LPFO to carve out market share.

Need for More Capital

Thus Forte Oil is in need of major capital injection to support its business diversification and cannot depend on debt to achieve its aim. Its interest-bearing debt to equity ratio stood at 91% as at H1 2015, while total debt to equity was above standard benchmarks of 150% (Forte: 166%). These ratios even represent an improvement on its condition in H1 2014, when they stood at 93% and 214% respectively. In my opinion, the company cannot accommodate more debt in any form, based on its current cash flows. In the last three years, the company has averaged a cashflow from operations to interest paid ratio of 0.53x. It dropped to 0.14x in H1 2015.

Diversification Plans

This for me is the make or break decision around Forte Oil – funding the diversification plan. If they go the Oando way and depend on the cash flow from the downstream business, they could end up having to do several right issues and equity offering over time to make up for the imbalance in their funding mix as that route will lead to more short term borrowing eventually. Furthermore, since very little is known about their capacity to handle upstream oil assets, a partnership is not negotiable. Communication also needs to improve about the strategic focus of the upstream E&P business. Lekoil is doing a good job on that.

Best way to run its proposed Upstream Business

The ideal approach would be for the company to partner with a PE or VC firm to acquire its upstream assets and raise equity from the market via private placement/rights issue, some of which could be deployed into its power business. The Company has hinted that it was in talks with potential equity investors, but I suspect an equity offer could still be in the works. I’d rather wait this out however, if it happens before the strategic partnership
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