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It’s no small feat exploring for oil but striking the black stuff can turn a company into a real cash cow. With such high drilling costs though it takes a smart investor to know when to get out on a high. Tom Sieber refines the business of striking the right oil plays

Exploration is perhaps the most romantic and fundamental concept in the history of human experience. It conjures up images of frostbitten, desperate men in the desolate white of the Arctic, Columbus on the deck of ancient ship bound for new worlds, ‘one small step for man’ as Neil Armstrong descended from Apollo 11 to the surface of our moon. It is unsurprising that the explorers in the oil industry attract a similar mystique.

The idea of heading to far flung, frontier and often dangerous parts of the world, and drilling wells which, if successful, can create millions of pounds of value at a stroke, is intoxicating to outside investors and industry professionals alike.

What happens though when the necessary cash has been raised, when a rig slot has been secured and the well has been drilled and tested to reveal a significant discovery? Really, it is then that the hard work begins. And when a decision needs to be made about whether now is the right time to sell up and move on.

Developing and sustaining a producing oil field is far from a simple business. The long-term costs of drilling, maintenance and ultimately decommissioning are enormous.

As an illustration, Tom Hickey, the finance director of Tullow Oil (TLW) estimates that bringing the massive Jubilee field in Ghana on stream will require $4 billion in capital expenditure.

In Tullow’s case there does seem to be a determination to continue its involvement in the development of the field. As KBC Peel Hunt energy analyst Tony Alves observes: ‘They have spent money and time putting a good development team in place so I think they will want to hold on to what they’ve got.’

That’s not to say they wouldn’t attract or couldn’t be tempted by a bid – the sheer scale of the discovery means it would be on the radar for any of the majors or the national oil companies, particularly in China.

As it is, not every E&P company on the market has a £4.5 billion market valuation and cash flow of nearly £500 million. In fact very few E&P companies have the means to develop something of even a fraction of that scale on their own.

The key to any oil company’s success is obviously intrinsically linked to the quality of its assets but an oil and gas project will not necessarily remain in the same hands throughout the course of its life. Often companies will work on an asset at different stages of the value creation chain and understanding where the next asset trade might happen, whether through the acquisition of an entire company, a farm-out agreement or a simple sale of specific assets can be lucrative to an investor.

The rising costs and lack of cash, particularly among explorers on the junior market, have led many to predict large scale consolidation in the sector. For at least the last two years most observers have anticipated it, but as yet it hasn’t happened and any activity has been relatively isolated.

Of course there would be no point in simply putting two struggling companies together and perhaps this is why the sector has failed to ignite. Nigel Burton, finance director of Granby Oil & Gas (GOIL:AIM), which last week accepted an offer from the Canadian firm Silverstone Energy, says: ‘There is no value in putting two small, underfunded dogs together and there aren’t that many bidders around that would consider what some of these guys have to be material.’

Burton says that Granby’s decision to do the deal with Silverstone, for a cash offer of 63.45p per share (a premium of approximately 30.8%) was in part informed by spiralling costs on its Tristan NW development in the North Sea: ‘We didn’t just rush into someone’s arms because of the overspend on Tristam, we have been actively engaged in the process of finding a partner since November, but I would be lying if I said it wasn’t in our thoughts.’

Burton also explains that management had felt for some time that they needed to do a deal in order to increase in size – so they could reach the level needed to cope in the current working environment.

‘What has changed since 2004-2005 is the costs. A well that cost a few million to drill in 2005 could now cost closer to ten million. This has made it very difficult for smaller companies.'

A few barrels more

For the moment the costs of development, and exploration, show no signs of abating. In fact with the price of oil topping $110 a barrel the opposite is true. Something that caused the CEO of Hardy Oil & Gas (HDY), Sastry Karra to observe recently that his margins were better at $60 than at $100. ‘It is not good news for anybody’, was his assessment of the current oil price.

In that context it should come as no surprise that companies frequently seek to exit their assets or farm-out their interests when development becomes the focus.

Tony Alves says: ‘The better quality class of explorer understands how challenging it is to develop an oil field – it is no walk in the park.

‘When they have managed to create sufficient value through successful exploration, they can start to think about leaving something there for the next person – who will take on a different stage of value creation. It is all about finding the right stage at which to exit.’

There is an oil industry adage that exploration for hydrocarbons always loses money, while production of hydrocarbons always makes money. But the way companies explore has progressed significantly in recent years and the development of 3D seismic technology has helped companies to gain a better understanding of the sub-surface and thus reduce the technical risks attached to projects.

This means that for many companies there are better ways of creating value than remaining a silent partner to a much bigger operator on a major development project. Selling these assets can provide the cash needed to fund exploration in a new province. Also, when investors buy a stake in an exploration-focused company they do so with prospect of a game changing discovery in mind – management may feel it has a responsibility to stay true to the story it has been selling.

Another important reason that an exploration-focused oil and gas firm might head for the exit door when it comes to fully developing an asset simply comes down to expertise. In a restaurant you would not expect your cook to serve the food, so why expect the company that has found the hydrocarbons to then necessarily go on and produce them. The type of financing needed for development differs greatly from that required in exploration and the profile of workforce is different as well.

Tim Bushell, CEO of Falkland Oil & Gas (FOGL:AIM), says: ‘You would have to change the way the company is financed and the people involved. Would it make sense to move into the development stage when shareholders are looking for exploration success? It could be an obvious point to return value by exiting and then using the team to do the whole thing again somewhere else.’

Beyond the relative merits of exploration versus long-term development there is a wider truth in the oil industry that, just as you or I used to collect and swap football stickers in the playground, the oil and gas E&Ps will trade their assets. Sometimes this means clearing out the dead wood to focus on the jewel in the crown. This is relevant when talking about SOCO International (SIA) for example – which recently disposed of its assets in the Yemen in order to concentrate on its exploration portfolio in Vietnam.

Further up the scale, the North Sea saw many of the majors exit because the rewards on offer in such a mature basin are marginal to them. A number of smaller companies for whom this is not the case have since taken its place and found that the scale of the discoveries on offer are very much material.

If one company doesn’t want to develop an asset it is fair to ask why another would. There is no sense in which larger oil companies act out of benevolence, willing to dip into deep pockets to help out the smaller firms on the market. However, there is a good reason why they would be interested in bringing a viable discovery into production. First because development work fits their profile much more closely. They have the manpower, the experience and the resources to do it effectively. And secondly because, particularly among the majors, reserves replenishment has become such an important issue.

No reservations

In a world where conventional reserves of oil and gas are becoming ever harder to come by and where the national oil companies are very much in the ascendancy – companies will pay a high price in order to secure access to substantial reserves.

As Craig Howie, analyst at Blue Oar Securities, says: ‘The big oil companies have deep pockets and face reserve replenishment issues. Some of the big US oil companies have been building war chests in order to address this.’

This is not a new development, witness Royal Dutch Shell’s (RDSB) acquisition of Enterprise Oil in 2002 or ENI’s takeover of Lasmo two years earlier. Both were motivated by a need to add to a rapidly dwindling reserve base. Shell’s current position is now even more desperate. The company faces an increasing struggle to ensure that the amount of new reserves being booked keep pace with the amount of oil and gas being pumped.

Even lower down the food-chain there is concern about this issue. Talking following the release of full-year results recently JKX Oil & Gas (JKX) CEO Dr Paul Davies explained that the company was looking to add to is reserve base through acquisitions.

If a firm attracts, or encourages a bid on the basis of an asset the benefits to an investor are obvious – assuming any resulting bid is at a premium to the company’s share price. Similarly if an asset is sold its value is crystalised.

However, even attracting a farm-in partner can provide a boost to a share price. Falkland Oil & Gas rocketed after it announced it was in talks about a farm-in agreement with ‘major resources company’ (eventually revealed as BHP Billiton (BLT)) last July – up more than 50% in the course of a single day.

Although, interestingly, when the details were confirmed that old adage about buying on the rumour selling on the fact came to mind, as the stock retreated. When fellow Falklands explorer Desire Petroleum (DES:AIM) announced earlier this month that it too was in talks with an ‘unnamed partner’ it also saw its shares take off.

Of course the Falkland Islands are something of a special case. For quite some time the companies looking for oil there were dismissed, not unfairly, on the basis that they would never be able to get a rig to the region.

The mobilisation costs alone were potentially astronomic, perhaps as much as £30 million and that supposed that a rig contractor could be persuaded to make the journey to the south Atlantic in a tight rig market and with plenty of work available in less remote regions. The arrival of BHP Billiton has made drilling far more likely – in fact the company has entered into a commitment to drill two wells by 2010 and Falkland Oil hopes that some drilling will take place next year.

There is another reason why a farm-in attracts buyers. Effectively it serves as a seal of approval on the company’s assets – particularly if the partner is someone of the profile of BHP Billiton. If a firm with that level of credibility is prepared to invest it inevitably boosts confidence in the prospects of eventual success.

Ultimately, as discussed above, if you can judge the quality of a company’s assets you can judge the quality of the company. Obviously having a good management team helps, as does a good track record and strong financial backing. But at the end of the day what really matters is the oil or gas in the ground – for a number of firms a farm-out, at one end of the scale, or a takeover, at the other, can be a good way of realising value.

And in order to tap into the potential excitement generated by asset trading we have

sought to identify companies which have large equity positions in projects attractive enough to snare a bidder or attract farm-in interest.

THE COST OF DEVELOPING AN OILFIELD

Oil field costs have doubled in the last three years according to a report from Cambridge Energy Research Associates (CERA) in Massachusetts.

According to James Burkhad, head of the global oil group at CERA: ‘Shortages of equipment and personnel are dramatically raising the cost of developing an oil field.’

These shortages are largely as a result of the under investment in the industry in the late 1990s when the current preoccupation with peak oil seemed a long way away.

An interesting example of the effect of rising capital costs can be seen at the massive Kashagan oil field in Kazakhstan. Despite the project being driven by ENI along with a number of other western oil majors, the Kazakh suspended operations last year after becoming frustrated over cost overruns and start up delays.

The overall cost estimate for the development has increased from $57 billion to $135 billion and while first output had been projected for 2005 it is not now expected until 2011 at the earliest. The companies involved were eventually forced to agree to a settlement and sell some of their interest to the Kazakh state oil company, KazMunaiGaz (KMG).

TIMELINE

•Pick up exploration acreage through licensing round or acquisition

•Acquire seismic data in order to identify prospects

•Conduct site survey in order to get prospects ready for drilling

•Secure a rig slot for drilling campaign

•Drill exploration well

•If hydrocarbons are encountered test flow rates

•Appraisal drilling to establish the level of

reserves

•Exit point?

Falkland Oil & Gas (FOGL:AIM) 123p

Market cap: £113.56 million

According to CEO Tim Bushell the company won’t be at the stage where it is ready to exit its position in the province for at least five years but if a drilling campaign, planned for next year, is successful he may have no choice in the matter. BHP Billiton took over operatorship of the company’s acreage in the south and east Falklands basins in January and the partners are working together to identify and prepare some drill-ready prospects. The targets are potentially huge – the top 100 prospects have an unrisked potential of over 60 billion barrels. FOGL retains nearly 50% equity in the acreage and has room for manoeuvere.

Volga Gas (VGAS:AIM) 387.5p

Market cap: £207.79 million

The Russian gas play joined the junior market last spring and its Vostochny-Makarovskoye field has seen extensive drilling since then. The company is still to discover the limits of the reservoir and recently announced that level of reserves could be much larger than the current estimate of 20 billion cubic feet. This is coupled with a rapidly increasing gas price in Russia and a reserves update due later this year, broadly expected to see a significant upgrade, might entice interest in the asset.

Nautical Petroleum (NPE:AIM) 9.2p

Market cap: £116.67 million

Management openly admits that the company is being watched and concede that it is probably only a matter of time before an offer emerges. The reason: the size and quality of the heavy oil assets they own in the North Sea. The presence of Norwegian heavy oil specialist Statoil Hydro as operator in the Mariner field, in which Nautical has a 26.7% interest means it could be seen as a possible bidder. Success on the two appraisal wells being drilled this year – at Kraken and Mermaid respectively – could accelerate interest. CEO Stephen Jenkins says: ‘We know we’re being looked at and we’ll do what is in the best interest of shareholders.’

Soco International (SIA) £19.49

Market cap: £1,420.29 million

SOCO, which disposed of its assets in the Yemen earlier this year in order to focus on its exploration acreage in Vietnam, has been subject to takeover speculation for some time. Merrill Lynch flagged it as potential target in the middle of 2006 when it initiated coverage on the stock Vietnam Block 9-2, is scheduled to come on stream in 2008 and the majority of capital investment was and remains in the country. Long-awaited news from the well on Prospect E will have the most significant influence on the share price in the short term and any success here could be the catalyst for a bid.

Faroe Petroleum (FPM:AIM) 145.25p

Market cap:

Recent stake building by Dana Petroleum led to speculation of a bid that has not yet been forthcoming and there have been noises from the gas utilities giant Centrica. What is there in Faroe’s portfolio to spark interest? Well for a start it is qualified to operate in Norway, only one of two Aim stocks in that position, and has a won 17 licences there over the last couple of years. It also has positions in a number of high-impact wells in the Atlantic margin, being virtually the only non-major to operate in the difficult and deep water province. CEO Graham Stewart is aware of the interest and is aiming to create as much value as possible as quickly as possible before interest translates into a firm bid.

EnCore Oil (EO.) 47.5p

Market cap: £146.2 million

Building farm-out agreements goes to the core of North Sea-focused EnCore’s strategy. It has engaged larger firms in order to get exploration work done and even advertises itself to potential partners on its website. In addition EnCore is still planning to demerge its exploration and production activities from its potential gas storage assets. Star Energy was a farm-in partner on the latter before being taken out by Malaysian state oil company Petronas last year. In the circumstances a bid for the gas storage assets, if not the entire company, appears likely.