Risk-Averse Investors Shun Small Oil Cos, Boosting M&A

LONDON Dec 13, 2007 (Dow Jones Newswires)

As the credit crunch bites, risk-averse investors are taking flight to quality energy stocks and hammering many small oil and gas companies, potentially triggering a wave of consolidation that could see two-thirds of energy listings on London's Alternative Investment Market vanish, say industry executives.

Ninety-dollar a barrel oil may have helped such companies to weather the worst effects but the sector is still in for a rough ride as investors shun companies struggling to execute projects in an overheated market.

"We've seen a material shift from investors," said Simon Ashby-Rudd, Executive Managing Director of Corporate Finance at Tristone Capital Ltd, adding that they are favoring medium-sized companies that already have oil and gas production, leaving smaller more speculative exploration stocks in trouble.

The collapse of the market in subprime U.S. mortgage securities this summer has prompted many banks and investors to shun risky investments as quickly as they had gobbled them up. But even as previously staid markets like interbank lending have seized up, the high risk oil and gas sector has avoided the worst of it.

"Banks generally view lending to the oil and gas sector as much more secure because you have a hard asset there to take security over," said John Hamilton, Executive Director of Oil and Gas at Dutch investment bank ABN Amro Bank Ltd. (AABPL.KA). The rise in the oil price close to $100 a barrel last month has also helped, he added.

"It's not quite as negative as it has been in other sectors...but it should become a more conservative lending environment," Hamilton said.

A more conservative approach from investors in AIM-listed oil and gas companies has begun to have a significant impact, quite apart from the credit crunch.

As the oil price rose from $35 a barrel in 2000 to around $90 currently, around 100 new oil and gas exploration companies were listed on AIM. For several years, investors couldn't get enough of them.

The oil price has stayed high but the huge exploration boom it stimulated has left everything from drilling rigs to geoscientists extremely expensive and hard to come by.

"In 2004 we drilled a well offshore Equatorial Guinea in 1500 meters of water and it cost us $12 million. I don't think anybody is drilling deep water West Africa now for less than $40-60 million, and there are wells over $100 million," said John Doran, Chief Executive of ROC Oil (ROC.AU). Other industry costs have suffered similar inflation.

Even for companies with the cash in hand, many are struggling to secure access to vital equipment in a world still dominated by global giants such as ExxonMobil Corp. (XOM) or BP PLC (BP).

Tony O'Reilly Junior, Chief Executive of Ireland's Providence Resources PLC (PZQ.DB), said his company has only been able to drill one well this year, despite having several good prospects, because of the difficulty of securing rigs.

Many other executives operating everywhere from India to Angola described problems finding the right people and equipment.

Investors are realizing that the smaller pure exploration companies simply do not have the resources to execute their business plan, said Asbhy-Rudd of Tristone.

"The average capitalization on AIM at the end of 2006 was $70 million. $70 million is simply not big enough to be active on the international stage. It will cost $20 million to drill a well in the central North Sea," he said.

"You cannot have your entire capitalization used on three wells. If you drill your first two wells and they are dry, which statistically they will be, your share price will be in the toilet, as Wham found out," he said.

Wham Energy's share price almost halved shortly after listing on AIM in 2005 when its first well came up dry. The company struggled on for another 18 unsuccessful loss-making months before agreeing to be bought for around half its original market value by Venture Production PLC (VPC.LN) in August.

The shares of Wham's fellow AIM-listed explorers have consistently underperformed compared to better capitalized companies with their own production, like Venture.

A report published last month by Ernst and Young said half of small oil companies on AIM are trading below their issue price. Investors are starving these companies of capital with 65% of them having less than $20 million in net cash, the report said.

"The (capital) raisings that have occurred in 2007 have been from successful companies," like Imperial Energy (IEC.LN), which produces 10,000 barrels of oil a day, Ashby-Rudd said. "A lot of smaller companies have not been successful and have not been able to capitalize."

"If capital markets aren't open, they are going to run out of money within 12 months. That is what is driving the mergers and acquisitions market," Ashby-Rudd said.

In addition to the Wham transaction, Cairn Energy PLC (CNE.LN) last month bought AIM-listed explorers MedOil and Plectrum Petroleum.

"We believe that somewhere in the region of two-thirds (of AIM-listed oil and gas companies) will disappear over the next two years. They will be replaced by more mature companies who are in the wings and better capitalized," said Ashby-Rudd.

A report by equity analyst Tim Heeley at investment bank Daniel Stewart published Thursday identified companies like Europe-focused explorer Ascent Resources PLC (AST.LN) as being in the most difficult position, with just $5.5 million on their balance sheet, but without proven reserves. Twenty-three other AIM-listed companies are in a similar situation, the report said.

Companies like U.K. North Sea operator Nautical Petroleum (NPE.LN), which has 65 million barrels of proven and probable heavy oil reserves but is likely to face high development costs and will need to raise additional cash, have a mixed outlook, the report said.

Large reserves are themselves no guarantee of success as Russian gas operator Victoria Oil and Gas (VOG.LN) has discovered. "With 35 million barrels of oil equivalent (Victoria) should be well positioned. However constant problems, both technical and political, have prevented value add for investors and the stock currently sits at 70% of its listing price," Heeley said.

Most likely to survive the current turmoil are small companies like Faroe Petroleum PLC (FPM.LN). Well capitalized, with limited reserves but operating in low risk environments with growing production to generate cash flow, Heeley gave the company a buy rating.

Survivors of the current turmoil face a reasonable future. In addition to continued high oil prices, they are likely to benefit from an influx of capital from North America.

"A lot of North American investors have become frustrated with Canadian operations, the change of the tax royalty system in Alberta has been the final straw that broke the camel's back," said Ashby-Rudd. Funds and private equity groups based in North America are starting to allocate 15-25% of their capital internationally, he said.

"Despite the market turmoil, I believe the bank market is very open and very aggressive for well-structured oil and gas transactions," said ABN Amro's Hamilton.

Ashby-Rudd said Imperial Energy's latest capital raising was fulfilled within 45 minutes and Tristone raised $90 million for Faroe Petroleum last month.

"We've been involved in seven financings in the last two weeks, so the market is there for good companies," he said.

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