Are these North Sea firms the best buys in the oil sector?

Shares in North Sea oil and gas firms Faroe Petroleum (LSE: FPM) and Hurricane Energy (LSE: HUR) saw heavy trading this morning after both released their latest well results.

Faroe announced a small discovery that should boost the reserves of one of the firm’s existing production assets, while Hurricane’s latest well test appears to confirm the production potential of its Lancaster field.

In this article, I’ll explain why I believe Hurricane and Faroe are among the best small-cap buys in the UK oil and gas sector.

Creating value for shareholders

Faroe Petroleum said this morning that the Njord North Flank NF-2 well in the Norwegian Sea had found between 1.9 and 28.3m barrels of oil equivalent. A sidetrack well was used to confirm the extent of the discovery, which contained separate reservoirs of oil and gas.

Although Faroe’s interest in this fairly modest discovery is just 7.5%, it lies close to the firm’s existing Njord field. Production from Njord is currently suspended as part of a major expansion project, but I expect that in due course these latest discoveries will be tied into the Njord platform for production, boosting the group’s reserves.

Faroe’s strong reserves and its equally strong balance sheet make this stock a compelling opportunity, in my view. This year’s acquisition of the DONG assets in the North Sea is expected to increase Faroe’s 2P reserves by 2.5 times to 81mmboe. The balance sheet remains strong, with no debt and hedged cash flow from existing production.

The company expects production to rise from 16-18mboepd at the end of 2016, to 40-50mboepd over the next five years. A number of major projects are being developed that should benefit from lower-than-expected costs.

Faroe’s current market cap of £279m values the group’s 2P reserves at $4.20 per barrel. Today’s share price of 78p puts the stock on a P/E of 13 times 2017 forecast earnings. In my view, the medium-term value of the business is likely to be significantly greater than this. A takeover bid is also possible.

I rate Faroe as a buy at current levels.

The North Sea’s most exciting prospect?

Hurricane Energy’s Lancaster field is fast becoming one of the most exciting prospects in the North Sea. The group said this morning that a horizontal well designed to help plan the Lancaster field development had flowed at 14,500 bopd without producing any water.

That’s more than the 11,000 bopd maximum that flowed from the company’s first well, so seems like positive news to me.

Hurricane is still working on the final numbers for the Lancaster field, but chief executive Dr Robert Trice said recently that he believes the field is “likely to be significantly greater than the 200mm bbls 2C case.”

The company is working towards a development plan for the field, which it believes will have lifetime operating costs of $26 per barrel.

An updated set of contingent resources estimates are expected later this year, once well operations have completed. If Dr Trice is proved correct and the mid-case estimate rises above 200m barrels, I believe Hurricane could see fresh interest from investors. In my view the shares remain decent value at under 40p.

A simple route to your first million?

I believe that Hurricane and Faroe Petroleum could deliver significant gains for patient investors. Indeed, history suggests that longer holding periods are one of the best ways to boost your returns.

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Roland Head has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.