Eni Buys Heritage's Ugandan Blocks; Genel Merger Called Off

Selling Uganda
Heritage Oil has entered into an agreement with Italian oil major Eni that will see Heritage divest of the 50% stake it holds in two oil blocks in Uganda. The deal has wide-ranging ramifications, as Heritage has now terminated its discussions with Genel Enerji (GE) on earlier plans to merge. This decision will create new opportunities and questions in Iraqi Kurdistan, where Heritage made a world-class discovery earlier this year.

Eni will pay Heritage US$1.35 billion for a 50% stake in both exploration area 1 (EA1) and EA3A, Ugandan acreage that covers in excess of 12,000 square kilometres. In addition, Eni will become operator of the two blocks. In a company statement Heritage said "Under the terms of the LOI, Heritage has granted Eni an exclusivity period of 60 days for the parties to reach agreement on the terms of a binding sale and purchase agreement".

Heritage's motivation to sell the assets in Uganda is most likely due to the multi-billion-dollar investment needed to monetise those reserves. Large-scale production is unlikely until the middle of the next decade. An export pipeline will need to be constructed from Uganda's oilfields in the west of the country to the Indian Ocean. Heritage has drilled six wells in Uganda, three in EA1 and three in EA3A, and has a 100% drilling success rate. Future plans in the country include a drilling programme of six exploration and appraisal wells, to begin in the first quarter of 2010, and least two wells offshore in Lake Albert before the end of next year with its exploration partner Tullow Oil. This latest deal could affect Tullow's own plans in Uganda, where it has a 100% stake in EA2 and a 50% non-operating interest in Blocks 1 and 3A. It currently intends to farm out its Ugandan assets to help finance the development of its reserves and last month opened a data room for interested companies. Eni was one of the companies known to have taken an interest in Tullow's Ugandan assets even before this latest acquisition. Nonetheless, Tullow has other companies keen to partner it, and Chinese NOCs are keen to enter the country. Eni's agreement with Heritage will give Tullow a benchmark for a valuation of its assets in Uganda.

Jilting its Groom

News that Heritage is now backing out of its US$6-billion merger with Turkey's GE means that the creation of Iraqi Kurdistan's largest single oil investor is being put off. For now Heritage will continue its own exploration programme in the autonomous region, which has hitherto proved very successful. As late as last week Heritage officially declared its continued commitment to the deal, which had been announced in mid-June but much delayed (see Iraq: 10 June 2009: Heritage-Genel Deal, Possible Addax Acquisition, Raise Potential for New Frontier Valuation). The merger would have been structured as a reverse takeover, giving Iraqi Kurdistan-focused GE a 50% stake in the combined company, known as HeritaGE, and immediately making the company large enough to make it onto the United Kingdom's FTSE 100 index of leading shares, opening up potential funding and project finance-raising opportunities further. GE is today controlled by Turkey's Cukurova Group, at whose head is Turkish tycoon Mehmet Emin Karamehmet.

Heritage seems in the end to have balked at the merger idea—which in the meantime showed something of its true worth, especially with regard to its hard-to-value Iraqi Kurdistan holdings—to international financial analysts. While Heritage and GE hold exploration and development and producing assets in Iraqi Kurdistan of a very high quality and much potential, the political risk still remains extremely high, with the conflict over the right of jurisdiction over the autonomous region's oil reserves between the national Iraqi government and the Kurdistan Regional Government (KRG) running very deep and all current production in the region being shut off from access to Iraq's export infrastructure. With the general conflict about the autonomous region's borders, the degree of its autonomy, and the status of the mutually claimed Kirkuk-area oil hub and ethnic powder keg looking likely to rise to the fore in Iraq following the coming general elections (currently anticipated for January), assets in Iraqi Kurdistan are today harder to value, given the political risk, than they were a few months ago when it seemed a deal had been reached between the KRG and the Iraqi central government to facilitate the region's oil exports and the creation of a mechanism allowing producers to be paid.

Merging with GE now would have meant that Heritage's shareholders effectively swapped much less politically risky Ugandan discoveries for greater risk in Iraqi Kurdistan exposure, which—while having a huge upside—also risked entrenching the company further in an area effectively still a conflict zone, through deals signed with a jurisdiction that lacks international—and national Iraqi—recognition.

Bringing the merged HeritageGE company onto the FTSE100 index would also expose the old GE-struck deals to a new level of transparency and regulation, posing a further risk to Heritage shareholders led by its entrepreneurial founder and CEO Tony Buckingham. There have been widespread rumours that GE, which has almost no exploration and production (E&P) experience, was able to secure its numerous Iraqi Kurdistan contracts through political deals. No misconduct allegations have been proven, but it is understood by the media that, along with ministerial changes in the KRG following the region's elections earlier this year, a key reason for the merger's delay was prolonged regulator investigations into GE. The KRG has been keen to see GE move in on a widespread number of licences in the region, as Turkish investment has been seen as a good relationship-builder between the two neighbours (Turkey, due to its own ethnic composition, has not thus far been keen on the idea of far-reaching Kurdish autonomy on the Iraqi side of the border). While GE might not have done anything outright illegal to secure such a degree of upstream access, its status as political favourite has raised a lot of questions, as has its involvement on the buying side in the KRG Oil Ministry-brokered sale of shares in Norway's DNO earlier this year, which provoked a significant spat between the KRG, DNO, and Norwegian authorities a few months ago (see Iraq: 6 October 2009: DNO's Suspension Lifted, Exports Uncertain in Iraqi Kurdistan and Iraq: 24 September 2009: Contract Loss Threat Sees DNO Shares Plunge; Questions Mount over Iraqi Kurdistan's Conduct).

Outlook and Implications

Eni's entry into Uganda's oil sector should come as little surprise to close observers. Not only has the Italian oil company shown an interest in farming into Tullow's assets and earlier dismissing a specious attempt at a full takeover of Tullow, but the excitement of the proposed transaction it also seems to have been forgotten that Eni's CEO Paolo Scaroni came to Uganda to meet President Yoweri Museveni in mid-August. Scaroni was accompanied by Claudio Descalzi, COO of Eni's E&P division, and spoke of Eni's intention to enter Uganda's oil sector and bring skills and training to the country. Eni seems to be an apposite partner to develop Uganda's oil reserves as the company's subsidiary Saipem (Eni holds a 43% stake in the firm) has vast experience in constructing pipelines. Uganda's crude is waxy, and any pipeline will need to be heated to avoid its solidification, raising the expense of building a 1,300-kilometre pipeline to the Indian Ocean.

Heritage has said that the government of Uganda has been consulted on the deal and supports Eni's proposed entrance in the country's oil sector. Eni must be aware of the timeframe expected in monetising the reserves in Uganda, and that the government intends to construct a domestic refinery to create employment opportunities and to provide oil products for the domestic and east Africa regional market.
The sale of the Uganda assets will render Heritage cash rich, and in an interview with Reuters chief financial officer Paul Atherton said Heritage wanted to grow "We'll have a billion dollars in cash so we've certainly got the financial resources to undertake some very large transactions". Heritage is now likely to pursue other acquisitions itself, but the company has disparate assets in its portfolio and is not focused on one particular region.