Step 3 KYC – What does AJ Lucas do?

I have heard of AJ Lucas before as they had drilling rigs on my husband’s family

cattle property (west of Mackay) where they were actively drilling close to the

existing Hail Creek mine. Apart from that, I do not know much about the company.

My first impression of the firm’s annual report is that it is long, very long. To me, it

appears to be a typical glossy long-winded sales document with lots of pictures of

happy employees. Whilst I already knew the company operated drilling rigs, upon

further reading of the annual report I was able to identify that the company is made

up of three core divisions all within the mining, oil and gas sector.

The first division is the drilling division, which I understand to be the company’s core

strength from which it was established. Lucas Drilling Services provides a

comprehensive suite of drilling services, including large diameter and directional

drilling, and remains unmatched by any other specialist drilling company here in

Australia. AJ Lucas has a proud history of long-term partnerships with top tier

multinational mining companies. AJ Lucas has been able to capitalise on these

good relationships with the extension of existing contractual agreements. It also

appears to have a reputation for coming up with drilling solutions for complex

situations resulting in an increased demand in their specialist drilling services. My

understanding is that the Australian drilling division has had a highly successful year

and has exceeded forecasted expectations. AJ Lucas wants to make it clear to

investors that staff safety is of paramount importance given that it is mentioned

throughout the annual report with no Lost Time injuries reported since December

2013. Whilst reading the annual report, I also broadened my research to the firm’s

website and Facebook page to look for consistencies in their messages. Below is a

testimonial from one of AJ Lucas’ tier 1 customers, South 32, highlighting their ability

to design a specialised solution to fit their customers needs. The testimonial also

reinforces the strong relationships AJ Lucas has with its customers.

Figure 1: Extract of Facebook Post, AJ Lucas (www.facebook.com/ajlucasgroup)

The second division is the firm’s Oil & Gas exploration division. AJ Lucas owns a

47% share in associate company Cuadrilla Resources Limited which is a British

private company. Cuadrilla owns four onshore tenements in the UK where the

company aims to realise value through the commercialisation of oil and gas wells. I

am not familiar with oil and gas exploration drilling or the values that can be realised.

It seems highly speculative to me, however, AJ Lucas believe they have the skills

and expertise to deliver value to shareholders through the commercialisation of gas

and oil in the UK. The exploration division seems to take write of passage in the

annual report. It is the first division discussed in the Chairman’s address and

company is implying it will be focusing on this division going forward. This is where I

get a bit lost in the annual report with the jargon associated with exploration drilling.

It appears that Cuadrilla has started a drilling program on 2 of its tenements and that

the Balcome (license name) well has shown encouraging results but further testing is

required to fully evaluate the viability. From what I can gather each license is in

different stages of government approvals, drilling and flow testing. To my knowledge

no commercial value has yet been realised.

I originally mentioned that AJ Lucas has 3 core divisions however the annual report

mentions that its closing down its third division being its Engineering & Construction

division in the current financial year.

KYC - What is AJ Lucas’s strategy

I understand in order to get a feel for a firm and to engage with its strategy I need to

also consider the firms competitive environment from a broader aspect. I need to

gain an understanding of how well the firm is positioned in its environment as well as

identifying what risks it might facing in its sector and broader economy. AJ Lucas

operates in the mining oil and gas sector both here in Australia, through its drilling

division, and abroad in the UK with its exploration division. After reading the

chairman’s report, business highlights and directors report I then looked outside of

the company’s annual report to help me better understand its competitive

environment. It is evident that AJ Lucas’ business is directly related to commodity

prices for gas, oil and coal. AJ Lucas clearly state in their Chairman’s address that

they are refocussing on servicing the coal industry for their drilling division and away

from the water and coal seam gas sectors. The company noted increase in demand

from exploration drilling services from coal mines across the eastern seaboard. I

researched current coal prices for Australian exports and read multiple articles on

the future for coal in Australia. It is evident that Australian coal prices have

recovered and the short-term outlook for 2019 suggest that prices should hold

steady. Depending on what news article or report you read the long term forecast for

coal prices in Australia is mixed, but the majority believe that coal prices will have a

steady decline. I am acutely aware of the accuracy of articles written by mainstream

media in relation to future commodity predictions. Media hype can exasperate a

small correction in the market therefore I can disregard most news articles. Below is

a graph from KPMG which indicates a steady decline in the future of coal prices. I

feel that whilst the coal prices have recovered and will continue to remain strong, the

long-term outlook is a risk for AJ Lucas’ Drilling division.

Figure 2 Extract of KPMG Coal Price & FX Market Forecasts January 2019 (www.kpmg.com.au)

To get a feel for the sector and its performance I would invest in an IBIS world report

on the coal industry (Australia) but at $999 I feel this is out of my reach for the

purpose of a university assignment. I have previous used Ibis reports when I worked

in business banking and I found them useful, factual and a good resource for

industry sectors and operating conditions.

Due to the firm’s focus on their exploratory division in the UK for shale gas, I believe

it would be prudent to gain an understanding for the demand in that sector. Fracking

for natural gas goes hand in hand with government politics as well as a host of

environmental factors which need to be researched and considered. AJ Lucas

indicates in their annual report that consumption for gas in the UK has exceeded

domestic production since 2004 and UK government predict the production-

consumption shortfall to widen further in the future. The Annual report also states

that Shale Gas remains of national importance to the UK Government. I researched

different sources to get an idea for the demand for gas in the UK as well as the

current and future political stance on the development of gas wells for

commercialisation through fracking. My research agrees that gas consumption in

the UK is on the rise and the country has gone from being a net exporter of gas to

importing over half (53%) of gas supplies in 2017. Furthermore, estimates suggest

that the UK could be importing 72% of its gas by 2030.

Figure 3 Where does British gas come from?, British Gas UK (www.britishgas.co.uk)

Whilst it is more economical for the UK to increase its own production of natural gas,

this raises the question of whether the government wants to support the drilling and

exploration of gas in its own country. I read the recently updated Guidance on

fracking: developing shale gas to gain an understanding of the current government’s

position on fracking for natural gas. The UK government believe that they need to

utilise domestic gas resources to the maximum extent, and to explore further the

potential for onshore gas production from shale rock formations, where it is

economically efficient, and where environmental impacts are robustly regulated.

Whilst it appears that the current government is in support of gas exploration in the

UK, several news reports and company updates indicate numerous application

denials and community outrage over recent exploration development submissions.

Based on my research the government red tape and lack of community acceptance

of fracking is the biggest challenge the firm is facing in its current operating

environment.

Figure 4 Fracking firm Cuadrilla loses planning appeal for second UK site (www.theguardian.com)

The UK’s involvement in Brexit makes the political environment volatile and whilst

the current government has indicated that it does support the exploration of gas to

an extent, there is no guarantee that the next government will feel the same way.

Therefore political uncertainty is another risk the firm faces in its current operating

environment.

It is evident that the firm does have several challenges in its current operating

environment, I now need to engage with the firm’s strategy to get a feel for the

direction it intends to take. Identifying the firms strategy will assist me to make a

judgement on whether the firm is addressing these challenges in order to create

value.

After reading through the annual report I get the feeling that AJ Lucas is going

through a transformation of some sort. I get a sense that the company’s roots are in

drilling for coal and gas, and over the years the firm has become an expert in that

field. The company has decided to divest away from the gas and water sector and

refocus on the coal industry, where their specialisation is (as well as the higher profit

margins). To me it sounds like the company is chopping and changing which can be

both good and bad. Good because the firm if reacting to market conditions and

commodity prices but bad because changing focus can cost money if they need to

invest in different equipment and expertise. As a potential investor I’m left wondering

where to next? Further reading of the annual report and reviewing more recent

company announcements, it appears the firm had an interested party to buy their

drilling division. AJ Lucas engaged a third party to review the value of the division

for sale.

A recent company announcement on 11 March 2019 said “The Board has

considered the findings and has decided to retain the business and pursue the

prospects for growth identified in the review.”

Strategy is about the future and I am struggling to decipher where the company is

going with their drilling division. Whilst coal prices are steady, the long-term outlook

indicates the sector is in steady decline. The company has not addressed this risk

factor in their annual report. They have made it clear that they are focussing on the

coal industry and will not be diversifying back into other sectors. Reading between

the lines, I believe that AJ Lucas are intending to sell their core business off at some

stage in the future and their strategy is to stay in the coal sector, where the margins

are higher, to make it more enticing to a potential buyer. Whilst I do not have a

crystal ball, this is the only strategy that makes sense given the long-term sector

outlook. With reference to Mintzberg’s 5 P’s this could be the firm’s “plan” on how it

intends to address current market conditions and challenges.

The firm has also decided to completely shut down its Engineering & Construction

division without much mention in the 2018 annual report. This solidifies to me that

the firm is going through a period of consolidation and transformation. The firm has

indicated in it is monetising its construction assets to free up cash, which it intends to

invest its in UK exploration activities. The firm has indicated that there is too much

competition in this sector. This is a definitive and intended course of action and

demonstrates the firm’s reaction to the challenges its facing in its operating

environment.

After reading the company’s website in conjunction with prior year’s annual reports it

appears AJ Lucas has had previous success in acquiring, drilling and selling two

tenements in Australia realising value of approximately $357 million for shareholders.

Whilst this may not be the core strategy the company intended, or set out to do from

its inception in the 1950’s, there does seem to be a clear pattern emerging. AJ

Lucas has had success buying tenements and using their knowledge of specialist

drilling to develop these tenements into realisable assets with considerable value.

The company has invested substantial financial resources into their partner company

Cuadrilla in the UK, where they hope to repeat this same strategy. The only

difference this time, is that they are operating in a different country, with different

political and environmental risk. Do AJ Lucas have a strategy to combat these

environmental challenges? Not that I can see.

Cuadrilla recently announced that it would not be appealing the governments

decision to refuse planning permission to one of their tenements in the UK.

Figure 5 Cuadrilla Decision on Roseacre Wood Announced (www.cuadrilla.com)

AJ Lucas appears to be moving away from their core business of being a specialised

drilling operator to become an international oil and gas exploratory company. Whilst

the firm has had success proving tenements to then on-sell here in Australia, they

are taking a risk by trying or repeat the pattern in the UK, where the current political

and environmental factors are different. It appears that the company is going

through a period of consolidation and transformation as it moves way from its income

producing drilling business to a capital-intensive exploration business. The current

share price has taken a nosedive (to say the least). In the past 12 months the share

price has dropped from a high of 88 cents to a low of 8 cents, with a drop from 40

cents to 8 cents just in the last 3 months. The company has also not paid a dividend

since 2009.

Figure 6 Westpac online AJ Lucas Company information (www.onlineinvesting.westpac.com.au)

Oil and gas exploration is considered to be highly speculative and capital intensive

and, in my opinion, very high risk. I am disappointed to see AJ Lucas is going in this

direction as it appears they are putting all their “eggs” in one basket. I hope that the

firm can prove their oil and gas tenements in the UK, to recoup some value to the

existing shareholders, who have suffered significant financial loss. Nevertheless one

person’s loss is another’s gain and as Baron Rothschild said “the best time to buy is

when there is blood in the streets”. With such a significant decline in the share

value, could now be the time to invest in AJ Lucas? More investigation is needed.

Links:

https://docs.wixstatic.com/ugd/6e9f66_2b721fdab7634e6cbe9b150ab35aca51.pdf

https://docs.wixstatic.com/ugd/6e9f66_48e7c9e089ef489bbf1dd3293ba87e7a.pdf

https://static.wixstatic.com/ugd/6e9f66_66c33071eca5455eb388cc39968142ea.pdf

https://onlineinvesting.westpac.com.au/Private/MarketPrices/CompanyProfile/Announcements.aspx?stockCode=AJL

https://www.gov.uk/government/publications/about-shale-gas-and-hydraulic-fracturing-fracking/developing-shale-oil-and-gas-in-the-uk

https://cuadrillaresources.com/media-resources/press-releases/cuadrilla-decision-on-roseacre-wood-announced/

https://www.theguardian.com/environment/2019/feb/12/fracking-firm-cuadrilla-loses-planning-appeal-for-second-uk-site

https://www.facebook.com/ajlucasgroup/

https://home.kpmg/content/dam/kpmg/au/pdf/2019/coal-price-fx-consensus-forecast-december-2018-january-2019.pdf