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THE TIMES: Oil independents offer opportunity and barrels of risk

By Peter Klinger
IT WAS a busy end of March for Britain’s independent oil and gas companies, with most of the big guns reporting full-year results. The profits showed a massive gain on 2004, not surprising given the spike in oil prices over the past two years. Even a mug with a solitary barrel of oil would have improved his worth, and companies with a prudent growth strategy fared as well as the market had expected; Tullow Oil’s profit soared 261 per cent, Burren Energy was up 196 per and Dana Petroleum gained 232 per cent.
The independents will never challenge BP or Royal Dutch Shell for FTSE 100 domination, but that is not to say that the likes of Premier Oil and Tullow cannot produce barrel-loads of oil and — most importantly — growth opportunities for canny investors.
Yet with production levels hovering below 100,000 barrels of oil and gas-equivalent a day (Shell’s output last year was 3.5 million bpd) and market values of less than £3 billion (BP’s is £136 billion), the independents attract a different breed of investors.
Whereas it is virtually impossible for Shell to double its daily production profile within the next four years, or even come close, Premier Oil wants to boost its output from 33,300 bpd last year to just over 60,000 bpd by 2010. It is an ambitious target for Simon Lockett, Premier’s chief executive, but possible. These realisable goals and resultant profit boosts make the independents, as a sector, a potentially lucrative investment proposition.
Over the past two years, the FTSE 350 oil and gas index has easily outperformed the FTSE all-share index, driven by a rampant oil price. Even more impressively the oil and gas sector’s outperformance was greater when excluding BP and Royal Dutch Shell, whose weightings dictate the sector’s overall performance. In other words, whereas BP and Royal Dutch Shell shareholders enjoyed a stellar two-year period, investors in the independents had even more reasons to cheer.
The independents offer a far greater leverage to changes in the oil price. They are also far more exposed to outcomes of drilling programmes that can determine a company’s prospects — both on the upside, if results are favourable, and the downside, if a well is dry. BP does not have to report updates on each well that it participates in. Burren, however, does, and it felt the brunt of market disappointment this week when it said that an outer well at the M’Boundi oilfield in Congo-Brazzaville, one of its key assets, was dry. It contributed towards Burren downgrading the oil-in-place estimates for M’Boundi from 1.6 billion barrels to 1.4 billion barrels.
Premier, often seen as an unlucky explorer, is trying hard to alter its image and yesterday said that its Lembu Peteng-1 well in Indonesia had flowed at a modest 610 bpd. Lembu Peteng alone will not propel Mr Lockett to his target, but every barrel helps. Premier’s key exploration wells, in Vietnam and Guinea-Bissau, are due to be drilled this year and have potential to be company-defining. No one doubts the potential, but everyone understands the risks and costs associated with drilling — dry wells will be punished by investors.
The independents have no shortage of cash to invest in exploring and developing assets. Tullow, the biggest of the independents, wants to boost its production from 58,450 bpd last year to 80,000 bpd by next year. It has set aside £280 million for capital expenditure this year and also has not ruled out further acquisitions. With oil prices forecast to remain well above $40 a barrel in the medium term, acquisitions even in this highly priced environment can make sense.
A year ago, Roy Franklin, Paladin Resources’ chief executive, said that his company would boost production from 41,000 bpd in 2004 to 100,000 bpd by 2008. The only way that he would fail, he said, was if Paladin was taken over. Whether Mr Franklin was marketing Paladin for sale or not is open to debate, but seven months later Talisman Energy swooped with a £1.2 billion bid.
Analysts at Morgan Stanley argued this week that mergers involving Europe’s biggest oil and gas groups should be on the agenda. They cite the problems that the majors have in replacing the oil and gas that they produce, as well as relatively low valuations, as the triggers. The market’s herd mentality means that once one deal is announced, others will follow, as observers of Britain’s telecoms or ports sectors will know. The independents will not be immune from corporate activity should their larger peers start the consolidation process.
Takeover activity cannot be guaranteed, and only a carefree investor — or an insider trader — would blindly back a company on that basis. There are two likely scenarios: the independents will need to acquire assets to meet or exceed production targets, thereby triggering corporate activity, or they will successfully explore and develop on their own, and thus become the target of bigger players. A third scenario is for the company, and its share price, to fall from grace because of management or operational failures. That is why Regal Petroleum and BowLeven should be avoided. For many of the other independents, the future looks bright — but handle with care. Overzealous support of high-risk exploration programmes can result in the biggest rewards, but also the largest losses.

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