Why do four companies with no oil reserves have a market capitalisation of nearly £1bn?
Discussion board regular Hallucigenia continues his series on oil investing.
In my last article I described the drilling plans of the four companies exploring for oil around the Falkland Islands. I'll now explain how I value them even though they have yet to find any commercial oil.
You have to treat the shares as lottery tickets or betting slips, worth something because they give you a chance of a big future profit, rather than as an asset generating income today.
Valuing Falklands oil
So what would success with the drill bit be worth? As I said in the last article, I wouldn't try to overanalyse things when the inputs to any valuation model are so uncertain. I'll discuss how to value an oil company in much more detail in future articles so forgive me for assuming some knowledge here.
I don't expect everyone to agree with the way I value these companies, but I'll explain my reasoning and you can adapt it to fit your own prejudices!
If you assume $60/bbl oil then any oil discovery would have an NPV of around $8/bbl, assume $80/bbl and it goes up to about $15/bbl but I'll stick with $60/bbl for now.
However in the real world, the markets generally knock off 30% from the "real" NPV of listed E&P's. Throw in a bit of a political discount for the next time Argentina makes some noise (the volume will surely increase in the event of a discovery) and we're looking at $5/bbl for booked oil reserves.
You can halve that for oil in structures that have flowed oil but in areas of the structure that have not yet been appraised. Typically a single well might book 50mmbbls, 100mmbbls if the geology is good but structures like Ann or Ernest will probably need another two wells before the geologists have a sufficient handle on them to book all their oil as official reserves.
There's a good argument for assigning no value to gas until there's sufficient for export infrastructure, and even then it might be worth half as much as oil would be. We'll get a much better handle on the gassiness of the basins once there's been more drilling.
For now though, I'll arbitrarily knock 40% off NPV's of small prospects and 20% off big prospects to incorporate the risk of gas. A different approach would just ignore the likes of Dawn and Ernest altogether until we've got some results from early wells.
I'll also knock 20% off Jacinta to reflect the risk of degraded heavy oil in this shallow reservoir, and ignore Beth as Liz would be a preferable alternative. You could discount the small prospects further as they are more likely to be subcommercial in size even if hydrocarbons are found, and proportionately more expensive to develop.
Many directors of "sensible" companies with both exploration and production would argue that they don't get any credit from the market for their exploration potential, so pure exploration companies should be valued at zero.
There is an element of truth in that, but I'd suggest companies should stop whinging and concentrate on their own exploration so that they have a story of imminent, high-impact drilling to communicate to the market.
What is Desire Petroleum worth?
I listed Desire's (LSE: DES) drilling programme in the previous article. The first well should be approaching target depth sometime in the next week or so. We'll know a lot more about Desire's prospects -- not just Liz -- when the result of the Liz well is known.
For now I reckon that Desire is worth about $457m or 94p/share, with an unrisked upside potential of $4.3bn (880p). That assumes every single well in the current campaign succeeds in finding commercial reserves -- which they won't. The current shareprice is about 101p.
Those are the numbers I get using the chances of P90 success from the Senergy report and applying them to the best guess volumes. This is inappropriate but it's not that significant given the other guesses we have to make, and I'm being pretty conservative with my other assumptions.
If you are less grumpy about the oil price, or the chances of success, of the likelihood of finding gas, then you could easily come up with numbers that are 50%-100% higher than mine. All we do know is that the share price will go up a lot or down a lot in response to the result at Liz.
It's always satisfying when you value a company from first principles and end up with a number within 10% of the market's current valuation. But it's not very helpful when looking for cheap shares to buy. In the next article, I look at the preliminary results from the first Falklands well drilled since 1998.
More from Hallucigenia on oil investing:
The author has a beneficial interest in Desire.
