When will oil and gas exploration come back into vogue with investors?

In Insight by Nick Elwes

When Cairn Energy made a series of discoveries in Rajasthan, India in 2003 / 2004, it provided one of the catalysts that attracted investors back into oil and gas exploration companies. The Cairn Mangala discovery was, at the time, the largest onshore discovery in India for 25 years and was responsible for Cairn’s entry into the FTSE 100 in 2004. A rash of oil and gas listings followed, resulting in oil and gas companies making up a significant proportion of AIM stocks. The majority of these companies were exploration plays with acreage and a plan to prove up prospects that would deliver considerable shareholder returns, largely through farming out commercial discoveries to the majors.

Inexperienced investors flocked to oil and gas during the bull market

The issue is that oil and gas exploration is not an exact science and until you spin the drill bit there is no telling what’s actually in the ground. As a result, more than a few exploration efforts failed to meet their original objectives and several were plugged and abandoned, leaving companies short of funds and share prices in tatters. The ensuing slew of capital raises further diluted the original shareholders and, unsurprisingly, investors became risk averse and fell out of love with the sector.

So, what should an investor be thinking about before dipping a toe back in the sector?

From an investor point of view, what should they be looking for before making an investment? In my view, there are at least four key factors that any investor should take into consideration.

1. Take a good look at the management team: Firstly, who’s in the management team. How experienced are they and have they got the right balance of industry expertise and financial acumen? These are the people who you are trusting with your money, so are they capable of delivering their exploration strategy and making a success of things? Has the team been successful before? Has the team got experience in the region where the company operates and with the assets in question?

2. Make sure you understand the asset: What are the assets, have they been looked at in the past, is there any information on them? Where are they, are they in basins and rocks that have yielded commercial discoveries in the past? Also, never forget “closeology” – are these assets next to other discoveries and do the plays continue into the acreage?

3. How strong is the balance sheet and do they have sufficient funding: Is the company well funded and has it got enough money to carry out the proposed exploration programme? It is essential to ensure that the company is well funded because if success takes longer than expected, it is highly likely the share price will suffer and discounted placings will follow, further diluting your shareholding. Numerous exploration companies that listed on AIM were “one asset plays”, meaning they had enough cash for one well on the asset in question, but nothing else. If that well didn’t work, they pretty much ended up as a “busted flush”, owning a dubious asset with no money to invest.

4. Does the company have partners with an interest in the asset? Most exploration companies will look to farm out their acreage to other players with a view to giving away some of the interest, once exploration work has proved the acreage to be interesting. The idea being that the new partner pays a substantial amount towards the future work programme (and, sometimes, pay a proportion of costs incurred to date). In effect, this de-risks the asset for the company and, usually, greatly reduces the outlay required. For an investor, this is a key consideration. Not only does it reduce the capital required, but if the partner is a “household name” or a major oil and gas company, it will provide investors with confidence, as well as an endorsement of the asset.

These should all, in my view, be key considerations for any investor before making an investment in an exploration company. A further factor worth considering is whether to take a portfolio approach because not every project will be a success. As such, it is worth considering if you want to invest in an individual company or a selection of those that you consider have the potential to do OK, making sure it includes one or two star performers that will more than cover any losses if things don’t go according to plan.

When will the market come back?

In my view, given what has happened to the oil price over the last few years, companies have been unwilling to spend money on exploration and many have put their exploration programmes on hold; however, confidence is returning and exploration costs are close to being at the bottom of the cycle. In the last year, there have been several significant equity raises completed by the likes of Diversified Gas & Oil, Savannah Petroleum as well as the IPO of Energean. These, supported by the stronger and more stable oil price in the $70-80 per barrel range, is helping to stir the industry into action. Exploration seems to be back on the agenda and a number of major oil and gas companies have been farming in to exploration acreage, including the likes of Exxon, Total and ONGC. Investors though, despite the recent raises, still seem somewhat risk averse and, as yet, have not necessarily followed this trend.

One of the smaller independents needs an exploration success

What is needed is for someone, a smaller independent, to make or be part of a major discovery. This would have a significant positive impact on its share price and thus remind the investment community of the sector’s potential.

Currently, there are several exciting wells planned, including Tullow’s Cormorant well (spudded on Tuesday 4th September) and Chariot’s Prospect S well, both drilling this year offshore Namibia. I would hope that one if not more of these does come in and re-ignites the interest in exploration, as happened with Cairn 15 years ago.

The rise of the electric vehicle

So, if you are an investor, should you still be looking to get into oil and gas or is the massive apparent move to adopt electric vehicles going to finally turn the tide away from fossil fuels. In BP’s latest Energy Outlook Forecast, providing the company’s models are correct, electric vehicles will account for 15% of total cars in 2040. Whilst BP Plc Chief Executive Officer Bob Dudley sees “tremendous” opportunities around the arrival of electric cars, he said they’re “not the silver bullet that everyone’s looking for. Crude and natural gas will remain a part of the global energy mix for decades, and the pace at which oil demand declines after peaking will be very slow.”

So, still very much here to stay from an investor point of view!