...with great difficulty!
Shareholders in Encore Oil (LSE: EO) have had an exciting year as their shares have risen from 14½p to just over 90p. What caused such a rise? Encore has recently struck oil in the North Sea not just once, but twice. The first strike was the Cladhan prospect, of which it is the operator and holds a 15% stake, whilst the second was as part of the consortium which drilled the Catcher discovery well.
In contrast shares in Frontera Resources (LSE: FRR) stand at 6p having been as high as 133p in 2008. Falkland Islands explorer Desire Petroleum (LSE: DES) is back to where it started the year, at around 100p, but shareholders have had a horrific scare when the share price fell of a cliff in late March, reaching 37p in early May. If you're in the mood for a horror story look at the chart for Victoria Oil & Gas (LSE: VOG); how would you feel if you bought shares at over 250p when they're 3½p today?
The contrasting fate of these companies illustrates the problems faced by investors in one of the most speculative sectors of the stock market, small oil & gas explorers.
Exploring for oil and gas poses a danger to your finances. Drilling is very expensive and, despite the best efforts of petroleum geologists, the majority of wells fail to find commercial quantities of oil or gas.
It's bad enough for the likes of BP (LSE: BP) when a well fails. When it happens to a small company it can be a disaster as we saw when Desire Petroleum's share price collapsed earlier this year because a much touted drilling failed to come up with anything.
Valuing small oil companies is difficult because conventional accounting metrics are of little use. Most small oil explorers are loss-making, even those with actual production, because their exploration and drilling costs are far larger than any income that they earn. This means that valuation tools like P/E and PEG ratios can't be used.
Investors should focus upon the company's assets and prospects, particularly any oil and gas reserves that have already discovered. But be warned, value investors who pay close attention to the balance sheet need to be careful because oil and gas reserves aren't valued there. Instead there's an entry under intangible assets which represents what has been spent to find commercial quantities of oil and gas; this figure has an extremely loose relationship with the market value of the reserves.
The last few paragraphs might have put you off this sector -- that was the intention. You should only touch these companies if you understand the risks and are prepared to suffer big losses because you are virtually guaranteed to lose money at some time in this sector. The idea is that your gains will hopefully be bigger than your losses.
Small oil companies come good when they make discoveries. Otherwise their share prices often drift, sometimes for years whilst investors are heavily diluted by rights issues which are required to keep the company afloat. But when a small company makes a big strike its share price can rocket.
A successful small oil company may never still produce oil because it's quite common for them to be taken over, often by one of their bigger partners. There's already been a considerable amount of speculation that one of the bigger companies with North Sea production such as EnQuest (LSE: ENQ) or Premier Oil (LSE: PMO) will bid for Encore Oil (Premier just happens to own the biggest share of Catcher; 35%).
Encore Une Fois
Although Encore's shareholders have come out smelling of roses, back in 2008 Encore shares hit 55p only to collapse after some inconclusive results with its proposed gas storage project. Just imagine how you'd have felt having paid 55p only to throw in the towel as the shares fell to just over 8p in early 2009.
Even worse for those investors since the price has since risen by over 1,000%. It's often a good idea to never look at the price of shares which you have sold!
This level of volatility will scare off many investors; it takes a lot of nerve just to hold on and perhaps buy more during these times (my first lot of Encore shares cost just under 30p and I held on through the trough).
How To Invest
A strategy followed by some oil investors is to buy shares in several small oil companies (maybe ten or more) and treating them in a similar manner as how venture capitalists treat their investments. You assume that some will fail, but you expect/hope that the failures will be outweighed by the successes.
There isn't much in the way of investment trusts and unit trusts which specialise in this sector; the only one that springs to mind is the Junior Oils unit trust.
Most small oil & gas companies are listed on AIM (a full listing requires actual production) so they can't be put in an ISA unless they are listed on an overseas exchange (there are a fair few Canadian oilers listed on AIM).
Care is needed if a company starts to make confusing announcements. Some companies deliberately obfuscate -- I'm not going to name names -- but when a company talks extensively about its production but is then vague about actual production rates this should set off warning bells.
It's vital to keep an eye on the company's cash reserves; small oil companies burn through cash like crazy when they are drilling. Amazing prospects but no money means that the company is forced into rights issues and placings, diluting their investors' stakes.
The words "drilling result" and "drilling report" are what the business is all about. When small oil company investing works the payoffs can be truly spectacular which is why some of us pay particular close attention to this sector.
More from Tony Luckett:
> Read Hallucigenia's series on oil investing and take a look at our oil and gas discussion board.
> Tony owns shares in Encore Oil, EnQuest and Premier Oil.