Friday, 31 August 2012

Investing in oil shares

I am heavily biased towards oil stocks since

inflation hedge

can buy tangible assets at discount, often with exploration upside in for free. Hence attractive risk:reward.

takeover targets. The larger oil companies have strong cash flow. Cheaper and less risky for them to buy up smaller companies with proven reserves than explo drill themselves. Smaller companies vulnerable since funding markets poor, hence can't access finance to develop their assets.

I'm not so keen on gold shares since gold price a bubble that will eventually burst albeit short term bullish.

I prefer UK focused oil companies since IMO lowest political risk. Others take opposite view after Osborne tax grabs but I believe his fingers badly burnt so concessions more likely.

Medium term not keen on gas since impact of shale gas unclear.

Ditto LNG - vast amounts of gas with no viable infrastructure being discovered off Africa. Add on USA becoming net gas (ie LNG) exporter by end of this decade. Will there be sufficient new demand?

This leads onto principle risk - China meltdown. If China bubble bursts commodity prices will plummet. Marginal cost of new production about $80 per barrel. Hence if prices fall significantly below this supply will self correct. However as we know from 2008, small cap oil prices will be decimated but will eventually rebound strongly.

Hence need to ensure that company has sufficient cash reserves to survive.
My three largest holdings are Trap, Serica and Sterling Resources.
I am not buying at current prices.
I bought Trap before the Athena purchase when downside protected by over £30m cash and multiple carried to development explo/appraisal wells offered significant upside. I wasn't expecting them to invest pretty much the whole cash pile into Athena. Whilst Athena looks to be a good buy (attractive price, significant upside potential, tax benefits and synergies) it increases the risk profile.
Now exposed to falling oil price, development risk (one well has blockage) and reservoir performance. So far the reservoir performing as hoped and only need another month or so to be confident that no concerns re unexpected flow rate decline. (Normally takes 4 - 6 months to establish this data).
Once Trap are confident that there will be no reservoir problems they will be able to hedge production and raise bank finance to pursue other opportunities.
To sum up Trap appears cheap and Athena should cover current share price. With the multi well drill programme about to re-start there will be news flow to re-rate share price.
Serica has made steady progress and now has farm out agreements covering one potential well in Namibia and two wells in Morocco. They appear to be in farm out talks re another three wells (two UK, one Ireland). Share price is pretty much covered by tangible assets - cash, Columbus, Bream and (rapidly declining) production from Kambuna. Plus significant tax losses although these seem likely to go with Columbus.
Serica face two short term problems:
How do they finance development of Columbus. IMO they are too small to take on this risk.
Do they farm out their imminent drill of Spaniards. Will cost circa $7m, perhaps up to $10m if problems/bad weather, which is about half their cash pile.
My guess is that they will hive off the UK assets into a JV vehicle or sell for equity. Hence still no CEO.
Sterling Resources has bounced of recent lows ahead of drilling two wells in Romania. Downside should be covered by its two UK assets, Breagh and Cladhan. Breagh should be in production by year end and Cladhan sold.
Romania is potentially transformational - the first well, Ionna, is on trend and close to a recent major Exxon discovery. Sterling are in farm out talks so terms will be revealing. Aside from these two prospects (Ionna and Eugenia) Sterling have a 65% interest in the Ana/Doina gas discoveries. I'm assuming that the farm out deal will include a development carry.
Share price has suffered as a result of development problems at Breagh (not Sterling's fault) which have resulting in 10% cost overruns. This has pushed Sterling to the edge of its cash limits. The good news is that the development wells drilled to date have shown reservoir to be thicker than expected, hence its possible that increased reserves will compensate.