The first Falklands drilling campaign in 12 years is causing quite a media stir.
Discussion board regular Hallucigenia continues his series on oil investing.
You will have heard a lot recently about Argentina rattling her sabres over the start of oil drilling in the Falkland Islands on Monday. The media may present this as deliberate provocation by the Royal Navy, but of course it's not really like that. Oil exploration in the islands is driven by four AIM-listed companies looking to make money for their shareholders. Should you join them?
| Company | Market cap | Share price |
|---|
| Desire Petroleum (LSE: DES) | £336m | 103.25p |
| Borders & Southern (LSE: BOR) | £271m | 63.25p |
| Falklands Oil & Gas (LSE: FOGL) | £231m | 158p |
| Rockhopper Exploration (LSE: RKH) | £107m | 61.5p |
In this article I will give an overview of exploration in the Falklands, and in a follow-up piece I will look at the individual companies.
Geography and geopolitics
As you probably know, the Falklands are an archipelago 300 miles east of the southern tip of South America. They are a self-governing territory of the UK -- their defence is provided by the Royal Navy and RAF, but are largely independent in other matters.
Notably that includes taxation -- with a 9% royalty and 26% corporation tax, the fiscal terms are among the best in the world for oil companies. This makes a huge difference; 200 million barrels (mmbbl) of oil in the Falklands might be worth more to shareholders than 500mmbbl of oil in somewhere like Kurdistan, or 1,000mmboe of gas in North Africa.
Argentina has a long-standing claim on the islands that is fiercely rejected by the inhabitants and by Britain. The Royal Navy may be in no state to launch another 1982-style taskforce, particularly during the "carrier gap" around 2014-17 if indeed they get their new carriers at all. However, it can be assumed that there will be British hunter-killer submarines in the area to disrupt Argentine supply routes should they attempt another invasion, a threat that they will be well aware of.
On the other hand, Argentina's armed forces are in even worse shape than Britain's thanks to years of economic crisis; they would need help from their South American allies to launch a serious attack on the islands and it would make more sense to invade after billions of dollars had been spent on exploration and production platforms rather than before.
I view the current noises from Buenos Aires as little more than rabble rousing ahead of next year's elections from a president who is even less popular than Gordon Brown. You can't dismiss the claim entirely, but I don't think it will be particularly relevant for investors during the next 3-4 years of exploration other than as part of market "noise".
Geology
Three areas around the Falklands could hold oil, each independent of the other. Desire and Rockhopper have licences in the North Falklands Basin to the north of the islands, Falklands Oil & Gas (FOGL) and Borders operate in the South Falklands Basin to the southeast, and the Malvinas Basin lies to the southwest. A border dispute with Argentina separate from the main sovereignty claim means that no licences have been awarded in the Falklands bit of the Malvinas Basin.
Exxon drilled a few wells in the latter back in 1980 and found signs of hydrocarbons but lost interest after the 1982 war. This year the Malvinas Basin will see drilling in Argentine waters by a consortium of Repsol YPF, Petrobras and BP (LSE: BP) subsidiary Pan American Energy.
North Falklands Basin
The North Falklands Basin is a failed rift system geologically similar to the Albertine Graben in Uganda or the Balmer basin in Rajasthan that have proved happy hunting grounds for Tullow (LSE: TLW) and Cairn (LSE: CNE) respectively. However it's worth noting that such systems tend to have fields of the order of 50-500mmbbls, as a rule they don't have multi-billion barrel fields although the North Falklands Basin may contain one such giant field.
Small fields are less of a problem onshore than offshore, but Desire's consultants reckon that a 50 mmbbl field would break even at about $55/bbl oil and anything bigger than that would be seriously profitable, a 400mmbbl field would be worth over £4bn at current oil prices and exchange rates.
At least Desire and Rockhopper know that they are drilling an area with a working petroleum system and the second-best source rock in the world. The British Geological Survey has estimated that the main source rock in the North Falklands Basin has generated between 11 and 60 billion barrels of oil.
Only a small fraction of that might be recoverable, and then only if it has migrated into a suitable reservoir and trapped by a suitable seal. There are particular risks of poor reservoir quality and that the oil has not migrated in many cases, the limited data available suggests that it's quite hard for oil to move through the rocks of the North Falklands Basin.
1998 drilling campaign
Desire was one of several companies to licence blocks in the North Falklands Basin in the mid 1990s, conducting a joint drilling campaign of six wells in 1998. Since each company wanted to drill the single best prospect in their block, they all ended up drilling into the sediment (mostly mud) in the middle of the old rift lake.
They found lots of organic matter there -- five wells had signs of oil and one of those also had gas -- but the mud wasn't a good enough reservoir for oil to flow in commercial quantities. Shell recovered 27˚API oil to surface, but then the oil price sank to $10 and the majors lost interest in exploration full stop, let alone exploration in remote frontier regions such as the Falklands.
Things look different now at $75 oil.
With fewer companies involved this time, each well can be aimed at a different geological setting. Desire recognises 14 different such environments that could hold oil, the first priority is to drill the sand deposited by rivers flowing into the former lake.
Unlike in 1998, the current campaign recognises the importance of having the flexibility to change drilling plans depending on the result of each well. Investors may get frustrated at the gaps in one company's drilling whilst the geologists pore over well logs and generally have a think about things, but it's essential if the rig is to be directed at the best targets.
South Falkland Basin
Confusingly Desire have started talking about a southern (sub-) basin within the North Falklands Basin, but the South Falkland Basin to the southeast of the islands is very different. No wells have been drilled in the South Falklands Basin, the nearest relevant one is a scientific research well 500 miles to the east, so exploration is much riskier. However the potential is also much greater, with several multi-billion barrel targets; in the past FOGL has estimated that the basin could hold 60 billion barrels recoverable, as much as the whole of the North Sea.
Weather conditions are much more challenging than in the North Falklands Basin, similar to west of Shetland. However fields such as Foinaven prove that oil can be produced in such conditions and FOGL has conducted surveys at the height of the austral winter, although they'd prefer to avoid drilling in winter if they can help it.
Another issue is that most prospects in the south are in 1,000-1,500m of water, which means a top-of-the-range (hence expensive!) rig is needed to drill them. In contrast most of the prospects in the North Falklands Basin are in 150-300m of water and can be drilled by a mid-range rig such as the Ocean Guardian currently on site. Weather conditions in the North Falklands Basin are no worse than the central North Sea, unpleasant but not exceptional by industry standards.
www.falklands-oil.com is a site run by the British Geological Survey on behalf of the Falklands government that has lots of technical information and discussion of the 1998 campaign. The company websites and presentations are also useful, particularly www.desireplc.co.uk .
In the next article, I look at the companies looking for oil around the Falklands.
More from Hallucigenia on oil investing:
The author has a beneficial interest in Desire and FOGL.
