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Oil & Gas Producers - July’s $20-plus correction in the price of crude oil means oil stocks have taken a pasting. Investors now have to decide whether this is an opportunity to pile in on weakness or a first sell signal as a bull run comes to and end.

by Tom Sieber

July’s $20-plus correction in the oil price last month can hardly have come as a complete surprise to those who follow the market, as the bubble had to burst at some point. From an industry perspective, the pullback means very little – so long as the oil price stays above $80 very few current exploration projects will be rendered uneconomic. Oil stocks, however, have taken a pasting and investors now have to decide whether this is an opportunity to pile in on weakness or a first sell signal as a bull run comes to and end.

The decision is more complicated than it looks, as oil stocks have not slavishly tracked the oil price all the way up. Despite a 30% leap in oil prices in 2008 alone, the Oil & Gas Producers sector has only just outperformed the FTSE All-Share, so any further weakness in the commodity price is unlikely to help. Shares believes the oil price could drift back to $100 as global economic weakness erodes demand. This should weigh heavily, alongside the prospect of cost inflation and resource nationalism.

Yet opportunities remain for investors with an appetite for risk. Prospects for the oil price mean companies with aggressive drilling programmes with potentially high-impact wells will be worth backing. Those fulfilling these criteria among the larger independents include Tullow Oil, Premier Oil and Dana Petroleum. Of the smaller caps Faroe Petroleum looks best placed.

Oil goes into reverse

Would-be oil stock investors must now address three questions.

Why has the sector failed to track the soaring commodity price?

There are a number of possible reasons for the failure of oil shares to follow the oil price upward. Many market participants continue to argue oil prices are not sustainable, even where they are today. Moreover, exploration firms have had to contend with rising costs for skilled staff, services and raw materials, such as steel. These cost increases prompted Sastry Karra, chief executive of Hardy Oil & Gas, to complain earlier this year his profits margins were better when oil was at $60 than when it broke through the $100 mark.

Of particular concern to the larger companies is the tendency of a high oil price to increase the risk of resource nationalism. The difficulties faced by BP over its Russian joint venture TNK-BP and the travails of recent float Cadogan Petroleum, which faces a legal dispute over its licences in Ukraine, are an indication of this.

Why has the price started to fall?

There are several possible reasons why oil quickly retreated from its near-$150 a barrel peak of mid-July to a figure in the mid-$120s in early August. The soaring price of oil has led to fears of demand destruction in the West as cash-strapped consumers turn to alternative sources of transport and energy. A global economic slowdown would also hit oil consumption. The need for a risk premium to be built into oil prices because of the potential for fresh conflict in the Middle East may not be as acute, now tensions have apparently eased between Israel and Iran. Finally, it is possible threats by the US House of Representatives to investigate what it calls ‘speculation’ in the oil price by purely financial buyers, such as hedge funds, may have caused some investors to jump ship. The United States Commodity Futures Trading Commission (USCFTC) and its London counterpart have already imposed limits on the trading of West Texas Intermediate crude on the ICE Futures Europe electronic exchange ‘amid fears that speculators are distorting the market.’

What pricing trends can be expected for the rest of 2008 and beyond?

There also remains the possibility India, China and other emerging economies will cut or remove subsidies on domestic prices for oil & gas to preserve their cash reserves, driving down demand for oil among those nations. If demand did weaken here, this would be a severe blow – China consumed a record average of 7.77 million barrels of oil a day in June.

Opinion on the future direction of the oil price is polarised. Alexei Miller, chief executive of Russian giant Gazprom, is on record forecasting $250 oil will become reality ‘in the foreseeable future’. Yet investment bank Lehman Brothers argues a fall to $90 is on the cards.

As global economic activity weakens, even in the BRIC (Brazil, Russia, India and China) powerhouses, it seems likely oil prices will drift downward toward the $100 mark. Yet a particularly virulent storm in the Gulf of Mexico or a significant geo-political event could still force a short-term spike in oil prices.

In theory this should not help oil stocks, which have fallen 13.8% this year and barely outperformed the UK equity market in 2008, despite a near-30% jump in one-month forward Brent crude prices. Yet investors must remember several themes when approaching the sector.

Period of consolidation

Merger & acquisition activity remains a potential catalyst. Some companies have lots of cash and others have very little liquidity and would struggle to raise fresh funds from the equity market if they were to try today.

That said, the first six months of the year have seen more than £140 million raised by oil & gas explorers on Aim: 16% of all the money raised on the junior market, the highest proportion for the past five years. The oil price correction and the misfortunes that have struck Cadogan in the Ukraine mean it would be unwise to expect this trend to continue.

The market will at least become increasingly selective about which cash raisings are successful and which are not. In those circumstances firms with decent balance sheets should get a chance to gobble up the cash-starved, hamstrung companies floating around the market. It should also be cheaper in an environment of cost inflation to acquire companies rather than individual assets.

It would be a spectacular loss of nerve on the part of the companies that do find themselves in a favoured position not to act. Admittedly there have been false dawns before. Last autumn saw Venture Production snap up Wham Energy and Cairn Energy’s subsidiary Capricorn Energy acquire both Plectrum Petroleum and medOil.

This burst of activity, like others before it, quickly petered out, but given there are 119 exploration and production companies on Aim, further consolidation seems inevitable, particularly as Ernst & Young estimated nearly two-thirds of them had net cash of less than $10 million as of February. A drop-off in the oil price may help in this regard as well, since valuations have come back to more sensible levels after July’s share price shakedown, and consolidation should help firms with credible stories flourish and not be dragged down by the dross.

In a recent research report Fred Lucas, head of oil & gas research at brokers JP Morgan Cazenove, was strident about the failure of investors to distinguish between different oil & gas explorers on the junior market. He wrote: ‘For all its attractions, we believe Aim continues to exhibit an unfortunate tendency to price all exploration stocks in the same way, regardless of their obvious distinctive features. This bears a number of risks – management’s share-based incentives do not work properly, companies cannot raise capital efficiently and may ultimately be left vulnerable to opportunistic predation.’ A period of consolidation would clearly address some of these issues.

Major problems

In theory higher oil prices should have been a catalyst for significant re-ratings at both the UK’s oil majors, BP and Royal Dutch Shell. The truth is somewhat different, as interims from the pair revealed last week.

Headline figures such as ‘BP earns £1.5 million an hour’ sound impressive but investors should not let such noise conceal the problems the company faces, particularly over its Russian joint venture – TNK-BP contributed more than 10% of the company’s upstream profits.

Shares in BG Group slipped 5% when the the firm unveiled record interim profits last month as the figures were ultimately no better than expected.

Despite buoyant commodity prices, the UK’s majors face an increasingly difficult environment. Figures published by the Financial Times revealed the world’s major international oil firms now control just 6% of global oil reserves and a quarter of production against 75% and 80% respectively 30 years ago. Oil nationalism in Russia, Venezuela and other producers has begun to squeeze the traditionally dominant players out of the largest new fields and left them having to spend ever larger amounts of cash on smaller fields in more difficult environments for less oil. Production growth and reserve growth remains modest as a result, even though BP, for example, has budgeted for a 25% increase in capital expenditure in 2008.

Gas fired?

Of the majors BG does at least have the advantage of being leveraged to the gas price – another potential theme to play for the rest of 2008.

While oil prices are in retreat the price paid for gas could yet push higher, particularly in Asia and Europe, where it is in demand as a relatively clean source of energy. Although there has been a sell-off in the past few weeks, there tends to be around a six-month lag in European gas prices catching up with oil prices. Given the oil price peaked near $150 less than a month ago, it seems safe to assume gas prices will only reflect the early summer spike by the beginning of next year.

A report from the Cambridge Energy Research Associates (Cera), a US-based consultancy, supports this view. Cera suggests the rise in the oil price from about $70 a barrel a year ago to late July’s $125 will result in the gas price more than doubling from around $350 per thousand cubic metres in January 2008 to $730 by April 2009.

Exploring other options

If gas plays are one way to avoid the worst of any oil price volatility, another will be to focus on companies drilling high-impact wells rather than those focusing on incremental, small-scale developments – the latter will be more significantly exposed to an unpredictable oil price. Credit Suisse has identified companies drilling wells with a potential value equivalent to ‘15%-60% of market cap in coming quarters, a significant potential offset to oil volatility.’

According to the broker, this includes companies such as Tullow Oil and Premier Oil, both drilling potentially high-impact wells in the next six months. Exploration could therefore regain some of the lustre it had earlier this decade before a string of disappointments soured investors appetite for such investments.

After a period of relative outperformance the picture for the sector in the rest of 2008 is not that rosy. The market is not likely to be discriminating in terms of who gets punished for these trends and, at the lower end of the sector, as we have already noted, this could lead to a shakeout. In a few months’ time though, after the trash has been cleared away, there should be the opportunity for investors to bag some bargains.

TRADES TO MAKE THIS WEEK

Tullow Oil, 743.5p Buy

Exciting prospects

Ireland’s Tullow Oil offers excellent exposure to high-impact exploration. If the firm’s drilling programme meets the upper end of expectations, then the share price could reach £20, according to independent broker Evolution Securities.

The west African-based company is likely to drill a minimum of a well a month for the next two years. If any one of these are successful it would have a significant effect on the share price – despite the fact Tullow has already scored a heady ascent to the FTSE 100 in the past 12 months.

The £5.7 billion cap’s efforts are focused most intently on Uganda and Ghana. The former should see plenty of activity as the group looks to confirm the potential of its acreage in the Albertine basin. Analysts at broker Credit Suisse value the upside in the group’s exploration programme in the country for the rest of 2008 at more than £2 a share. In Ghana, the company is drilling three appraisal wells on the massive Jubilee field, which helped provide a lot of the excitement last year and this could lead to an increase in the level of proved and probable reserves attributable to the field.

Elsewhere in Ghana, Tullow is to follow up on the Odum-1 discovery, made in February, with two more wells targeting up to 1.25 billion barrels of oil, although these wells could potentially be pushed back until next year.

BG Group, £11.20 Buy

Strong points

Shares in BG dropped 6% after the firm’s interims only met, and did not exceed lofty expectations. This represents a good buying opportunity.

BG’s stock was marked down after its exploration & production division showed a mere 2% year-on-year increase in output to 601,000 boepd. Yet the disappointment looks overdone, as BG has three things going for it that differentiate it from its peers. Firstly it is leveraged to a gas price that could prove more resilient in the short term than the oil price.

Secondly it has comfortably the best record in terms of nearly all the majors when it comes to exploration, having made massive discoveries in Brazil and less heralded but equally notable successes with the drill bit in Algeria, Norway, Thailand, Trinidad and the UK. The second half of this year should see updates from Norway, Egypt and Oman.

Finally, BG is also a world leader in the burgeoning LNG sector, where interim profits more than trebled to £762 million. Prolonged weakness in the stock could also draw out a bid for the group, a rumour that has done the rounds before, although BG’s AS$13.8 billion lunge for Australia’s Origin Energy has acted as a drag on the stock in recent weeks.

Premier Oil, £12.95 Buy

Eastern promise

Recent weakness prompted by the falling oil price represents a good entry point into Premier Oil.

Like Tullow Oil, Premier is in the middle of a busy and potentially high-impact exploration and appraisal drilling programme. Premier is benefiting from an improved and more focused strategy under chief executive Simon Lockett, who took the reins two years ago.

Although the company has operations in 13 different countries around the world, the £1.1 billion cap has increased its emphasis on South-East Asia and Vietnam in particular. Results from the Chim Ung well in Vietnam are imminent and the company will drill three more wells in the country before October.

The activity in Vietnam was prompted by success at Ching Sao in May – with prospectivity in the block previously having been confirmed by the Chim Sao and Dua discoveries. The group’s move into the Nam Con Song basin was led by an understanding of the geology and represented an extension of success in Indonesian waters in the South China Sea. Elsewhere the company is also drilling wells in Norway and Egypt and should be drilling in Congo in the first half of next year.

BP, 511p Sell

Oh, those Russians

When BP entered into a joint venture in Russia in 2003 the mood was relatively convivial, as Lord Browne spoke of continuing to ‘build trust’. Five years on and the whole deal has turned very sour – the CEO of TNK-BP, Robert Dudley, is in an unknown location having been denied a visa to work in Russia, and AAR, the other major shareholder in the venture, has expressed discontent with how it had been run. The Russian oligarchs want at the very least a greater say in the strategy and direction of the company. And while there have been media reports of a potential agreement between the two parties, there remains a chance BP could be frozen out completely.

The wrangle is likely to weigh on BP’s shares for some time to come, not least because TNK-BP represents a quarter of the company’s global production and a fifth of its reserves. It may even leave the group exposed to a hostile takeover, with some observers suggesting the best way forward is for BP to seek a merger with Royal Dutch Shell, despite the benefits of a new broom from chief executive Tony Hayward, who took the reins last May. The proposed turnaround is on track, as Hayward seeks to restore BP’s reputation after a string of high-profile incidents such as the Texas City refinery explosion, pipeline fractures at the Prudhoe Bay field in Alaska and allegations of irregular propylene gas trading.

Cairn Energy, £26.35 Sell

How long Cairn you wait?

Cairn has been promising jam tomorrow for some time now as investors have waited for its massive fields in Rajasthan to go into production. This has not been a simple task for the company: the oil is waxy and the development of the field, which is expected to yield daily production of some 175,000 barrels a day, has necessitated the construction of a £408 million pipeline – permission for which was a long time in coming from the Indian authorities. Cairn has said the project will come onstream at the end of 2009, although this date has already slipped from the end of 2007 and much of the good news is already discounted by the firm’s £3.6 billion market capitalisation and prospective PE of more than 30.

The most recent set of results saw revenues slip a little as output from the company’s already producing fields fell 17% to 87,031 boepd. Investors also expected more newsflow from the company’s exploration focused subsidiary, Capricorn, which was established when the company floated Cairn India as a separate entity last year.

Venture Production, 724p Sell

Wrong strategy for the times

Venture’s strategy of adding reserves and production through small-scale deals in the North Sea is not suited to the current oil price environment.

As a result of this incremental approach to creating value the company has been left too exposed to any decline in the oil price, and on that basis Venture is likely to underperform for the rest of the year.

In the longer term there is nothing necessarily wrong with Venture’s approach, as it has driven impressive growth. Turnover has gone from £1 million to more than £350 million in the past nine years. A prospective PE of 6 looks good value in a sector that trades at 7.6 but, without a significant catalyst, this will not be enough to support the shares in the face of a retreat in the oil price.

SPOTLIGHT

Faroe has the drill bit between its teeth

This go-getting little explorer has plenty of chances to make a lucky strike

The main reason for investors to look at the smaller end of the Oil & Gas sector is the potential for ‘step change’ discoveries that can transform a company’s prospects and share price. On that basis, investors should be prospecting for a company drilling wells – and lots of them. Faroe Petroleum, which is principally based in the Atlantic Margin, Norway and the North Sea, fits the bill.

Foroya Kolyetini (FK) was formed in 1997 and registered in the Faroe Islands in January 1998. After a private placing the company, in partnership with Italian giant ENI, participated in the first Faroese licensing round, winning two licences. Faroe Petroleum was established as the holding company for FK at the end of 2002 and in June the following year it listed on Aim, raising £14 million in the process.

The company has both broadened and diversified the portfolio since, with a shift in emphasis from high-risk exploration in the Atlantic Margin to a more solid exploration and production portfolio in Norway and the North Sea. The company has interests in seven North Sea gas fields Schooner and Minke, which are already on stream, and Wissey, due to start producing before the end of the year. In addition there are Orca, Topaz, and Breagh in the southern North Sea and Trym in Norway.

Bid potential

Chief executive Graham Stewart believes it is only a matter of time before the company is taken out – mid-tier independent Dana Petroleum has a 27% stake in Faroe and there were rumours of a bid earlier in the year.

But in the meantime Stewart is determined to create as much value as possible. ‘We’re not that far into a two-year, 26-well drilling programme so it would be crazy to sell now.’

This drilling campaign has so far turned up some disappointing results, leading the share price to retreat from 169p to 114p since May, but a recent note from Panmure Gordon notes 2008’s campaign is ‘back end weighted’.

Stewart adds: ‘We’re fully funded [having agreed two separate £25 million debt facilities earlier this year] to drill what we have and more. Unfortunately not all the wells will work out, but if you’re looking for low-risk drilling, you’re looking at something that is going to add much less value and, if you have that approach of targeting small developments that will only add reserves incrementally, then you are much more exposed to the oil price.’

Technical team

A further cause for confidence is the company’s well-respected technical team. In 2006, in order to secure pre-qualification rights as a licence holder in Norway, Faroe secured a first-rate Norwegian squad of highly experienced professionals, and opened offices in Stavanger. Norway is known for having significant barriers to entry – but once you’re through the door it offers extremely attractive fiscal terms designed to incentivise exploration.

Key milestones in the next six months include the Topaz appraisal well, an undeveloped gas field in which Faroe has a 7.5% stake. This is currently drilling and should be completed soon, with production expected early next year. In the Marsvin exploration well, Faroe has a 14% working interest, and there is also the East Breagh appraisal well (10%). In total the company is likely to drill at least five wells in the second half and any success would spark a rapid turnaround in the stock. If all goes wrong, there is also the potential for a bid.

Unlike some of its mid-cap peers Venture is not involved in the kind of high-risk, high-impact drilling that could add significant value at a stroke. At least the company’s emphasis on acquiring assets that no longer fit the portfolios of other operators should have ensured it has not paid over the odds for acreage bought when the oil price was at record highs.

CONCLUSION: FAROE PETROLEUM

Risk to earnings forecasts: 4 (5=upside risk, 1=downside risk)

Earnings predictability: 2 (5=very high, 1=very low)

Valuation: 4 (5=cheap, 1=expensive)

Balance sheet strength: 4 (5=cash rich, 1=heavily indebted)

Cashflow: 2 (5=very strong, 1=very weak)

Over-owned? 1 (5=all brokers negative, 1=all positive)

TOTAL 17 / 30

RATING - BUY

TREND SPOTTING

Another rise due

The black stuff looks poised to resume its long climb, so now could be a buying opportunity

by Simon Griffin

Expectations are high that explorers’ share prices rise with the value of the product they seek. A large strike can transform the valuation of a smaller explorer overnight.

After bottoming near $16.50 in November 2002, oil has risen almost nine-fold in less than six years. The decline in the dollar, in which oil is priced has contributed to the apparent rise in the commodity, but does not account for most of the price spike.

Explorers as a group saw their capitalisation-weighted measure bottom in spring 2003, as they shared the general decline in the 2000-03 bear market, although during this period the drop was relatively small at around 25%.

Subsequently the rise has been a little under four times to exceed the high seen in mid-1996 and outperform the wider market by some 160%.

Late May’s high stretched the deviation from the 200-day average and some would interpret the one-way March-May move as possibly a final bull climax. The subsequent downward correction has returned the sector to its long-term bull trendline support on the log scale chart, during which the index has underperformed the FTSE 100 by some 12%. Current levels are key as further weakness could signal a change in sentiment.

A technical view suggests momentum is oversold: maybe a chance to trade for further gains. Stops should be applied to protect against the possibility of an often-repeated autumn price fall, especially if the global economy keeps slowing. Such a trend might push this sector lower and the trigger to go short may be only 6% below current levels.

Petrel Resources (PET)

BUY - 56p

TARGET - 86p

STOP LOSS - 48p

Petrel operates in Iraq, a top oil-producing area, and is contracted to the Iraqi government, which removes at least one variable. It will find oil. But there is still the political uncertainty of doing business there. The chart shows how the market saw Petrel’s potential from 2003 to 2005, when the shares soared 45-fold, then realism kicked in.

Technically, investors can see a broad bull channel has developed on the log scale chart in the past three years. The shares have fallen for much of the past year, at one stage losing over 70% of their value. The fall hastened when support near 86p failed after several tests this year. Petrel’s channel baseline has been tested near 44p, along with the nearby historic congestion that offered support too.

The trend is currently negative but it could just be the worst is over. Even a corrective bounce could see worthwhile profits. Risk-averse investors might first wish to see the shares rise above 60p, then, protected by a close stop, trade for a rise from the channel baseline toward my 86p target level, which is coincidentally the 38.2% Fibonacci retracement of the past channel wide downmove and a level that could also approximate to the declining 200-day average shortly. Should the channel support break, then investors should look instead for losses to extend toward 30p.

Emerald Energy (EEN)

BUY - 395p

TARGET - 605p

STOP LOSS - 324p

Things seem to be looking up for the explorer mainly focused on South America and Syria. After a 96% fall from 1998 to 2003, the shares rallied sharply in 2004, then gently rose: on the chart it resembles a sideways consolidation, albeit one with quite a large range. This year the shares have already climbed by some 98%, outperforming their sector by 125%.

In the recent broad sector pullback the shares have barely corrected below their 50-day average and again press best levels for the year so far. Recent rises in volume also suggest buyers coming in. If a bull flag is forming then a move akin to what preceded its start must be sought on a climb above 405p. This would give a gain of 200p and take the shares toward a test of 600p, which produced support and resistance some ten years ago. Investors must remember another scenario gives a bull channel over four years long, with a mid-line currently preventing the shares rising further. A decisive move up would still allow a rise to test the channel upper return line, again near my 605p objective. Only a fall below 325p would question the bullish outlook and risk a drop toward 250p.