Nexen Upgraded to Neutral (CEO) (NXY)

We have upgraded our recommendation on Nexen Inc. (NXY) to Neutral from Underperform. Nexen is a major Canadian oil and gas company with a diversified portfolio of E&P assets including high-impact exploration prospects in the U.S. Gulf of Mexico (GoM), offshore West Africa (primarily Nigeria) and the North Sea. This provides the company with a multi-year inventory of development projects and a positive long-term production growth profile.

During the second quarter, Nexen’s total revenue jumped 11.5% year over year mainly due to the ramp-up of activity at the Usan project, offshore West Africa and robust performance by the UK assets, primarily the Buzzard platform. The production efficiency at Buzzard surpassed the company’s target of 85% and touched 88%. Further, the successful development of the Long Lake in the Oil Sands remains the key growth driver for the company.

Nexen enjoys an industry-leading pace of drilling activities at its shale gas operations in Horn River and enjoys strong interest in joint ventures. The incorporation of additional phases in support of the ramp up of the Long Lake in the Oil Sands and the advancement made on its shale gas assets in the Horn River will further improve productivity.

Nexen’s strong financial position (approximately C$1,255 million in cash as of June 30, 2012 and unused lines of credit as of June 30, 2012) and its disciplined approach to capital investment have emerged as positives amid the economic uncertainties.

The company’s completion of drilling at Appomattox has resulted in an oil discovery in the northeast fault block. Nexen has booked probable reserves of around 65 million barrels in the south fault block of the Appomattox with additional net contingent resources of 50 million barrels in the northeast fault block. Further, appraisal of the south fault block during the second quarter proved over 400 feet of net true vertical thickness of oil pay of excellent reservoir quality. The appraisal result exceeded the company’s expectations and is likely to act as a positive catalyst for growth in its probable reserves.

However, a major turnaround in Long Lake in the Oil Sands that commenced in mid-August is likely to result in lower production rates in the third quarter compared to the first and second quarters of 2012. The turnaround exercise is projected to lead to a downtime of approximately nine weeks.

Moreover, Nexen has been adversely affected by natural field declines obstructing development drilling activities, particularly in the GoM. Recently, the company abandoned drilling operations in the Kakuna sub-salt exploration well situated on Green Canyon block 504 in the deepwater GoM as it failed to excavate commercial hydrocarbons from the Kakuna well. The operations cost was about $120 million or $80 million after tax to Nexen. Such unsuccessful outcome at any of the prospective exploration wells results in waste of important resources – time, labor and funds.

Of late, Nexen has been in the news regarding Chinese energy giant CNOOC Ltd.’s (CEO) deal last month to purchase the company for approximately $15.1 billion in cash. Nexen holds a Zacks #3 Rank (Short term Hold rating).