Who Will Win The Falklands Oil Race?

Published in Investing on 2 May 2012

Who is most likely to strike big oil and reward patient shareholders?

Anyone interested in investing in oil and gas can hardly avoid coming across the Falkland Islands, which remains a popular topic with Fools on the Oil & Gas Board and continues to generate strong investment interest and share price action.

Despite this, the area currently has no proven reserves and only one substantial oil find -- so what's really happening?

Oily history

The Falkland Islands oil and gas story stretches back to 1998, when oil was first discovered. Estimates of potential oil finds around the Falkland Islands go as high as 60bn barrels, giving it North Sea-style potential.

The first oil was found last year and this year should see further developments that will strengthen -- or demolish -- the commercial case for oil and gas production in the area.

The current situation

The waters off the Falkland Islands are divided into two main exploration areas, the North Falklands Basin and the South Falklands Basin. So far, oil has been found in the north basin and gas in the south -- but it is the southern basin that is thought to have most potential.

Five London-listed companies are exploring the region. All of them are dedicated to the Falklands and have no other significant interests. The two limited companies are registered in the Falklands, the others are British:

Rockhopper Exploration

Rockhopper is the biggest of the Falklands explorers by market capitalisation and the only one so far to have found oil. Founded in 2004, it operates in the North Falklands Basin and last year managed to find 355m barrels of oil in the Sea Lion field, which have been classified as a 'contingent resource' -- discovered and potentially commercial.

The latest CPR (competent persons report) on Rockhopper's Sea Lion finds suggests that they have a 90% chance of being commercially viable. The size of the discovery means that even if nothing else is found in the area, Sea Lion may make it into production.

Rockhopper is currently looking for partners to help fund the development of the Sea Lion field, a project expected to cost about $2bn.

Desire Petroleum and Argos Resources

I've grouped Desire and Argos together because they are both North Basin explorers and neither have a current drilling programme.

Last year, Desire drilled a number of failed wells, ran out of money and offered a stake in one further well to Rockhopper, which drilled it and found oil. Desire's remaining 40% stake in this 85m barrel find -- should it go into production -- is estimated to be worth about 45p per share for the company, whose shares are currently trading at around 28p.

Argos Resources has not found anything yet, but has new 3D seismic data covering its licence area from which it has identified 28 prospects, with the most recent CPR providing a best estimate of a potential 2.1bn unrisked barrels of oil.

However, Argos has yet to find the money to fund further drilling, so its prospects are very uncertain at present.

Falkland Oil & Gas

Falkland Oil & Gas (FOGL) is rated by many as the best of the bunch in the Falklands. It operates in the South Falkland Basin, for which it has the highest number of licences and some of the best prospects, including its flagship 4.7bn barrel Loligo prospect.

FOGL's first well will be drilled in the Loligo prospect when it takes over the rig it is sharing with Borders & Southern. Operating a rig in these locations can cost $1m per day, hence the cost-saving decision.

FOGL believes that any oil find over 500 million barrels would have attractive economics and that any gas find over 10tcf (trillion cubic feet) would be similarly viable. As a bare minimum, its 2011 investor presentation states that 100 million barrels of oil at $60 per barrel would be viable, as would 5tcf of gas.

Significant developments are likely from FOGL over the next six months.

Borders & Southern Petroleum

Shareholders in southern basin explorer Borders & Southern had an exciting time in April, as they watched the value of their shares rise from 69p to 131p and then fall back to 81p in the space of a week!

The excitement was due to a build-up of expectation and subsequent disappointment in the results of Borders' first well, in its Darwin prospect. A substantial amount of gas was found, but investors were hoping for more commercial oil.

Borders has moved on to drill its second prospect, Stebbing, which is a little larger than Darwin. The eventual commercial viability of Borders' finds will probably depend on what Falkland Oil & Gas finds; in this kind of expensive, deep-sea location, sufficient scale is required to make anything commercially viable.

What's next?

FOGL and Borders & Southern both have ample funding to meet their drilling commitments for this year, while Rockhopper is searching for a partner to help develop its finds.

Substantial finds by FOGL or Borders in the South Falkland Basin would inevitably lead to larger oil companies buying stakes or taking over the companies concerned, as we have seen recently with Cove Energy (LSE: COV) and Royal Dutch Shell (LSE: RDSB). On the other hand, a failure to find anything big could mean complete failure.

The recent legal threats made by the Argentinean government don't seem to have bothered anyone involved: it has no jurisdiction over Falkland waters and none of the companies involved have assets or business in Argentina. That said, if the eventual finds prove large, a solution that keeps everyone happy and opens up Argentinean ports to the Falklands would be desirable... and is perhaps the most likely outcome.

Buying into the Falklands

Investing in any of these companies is still highly speculative. While Rockhopper might seem the safest bet, it is not yet a sure thing and may lack potential scale compared to Falkland Oil & Gas. On the other hand, Rockhopper's find is the most de-risked resource in the area.

I would probably choose FOGL; size matters in this game, and the company that finds something really big will rapidly be taken over or funded by the oil majors, resulting in a decisive profit for its shareholders. FOGL seems to have the best chance of a big oil find.

An outside alternative

Finally, for an unusual and slightly illiquid alternative, take a look at Falkland Islands Holdings (LSE: FKL).

This is a small company with a range of business interests in the Falkland Islands. It isn't cheap, but it would inevitably prosper should oil take off in the area -- regardless of who produces the oil. It will also continue to exist if the oil companies leave, and even pays a small dividend.

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Further investment opportunities:

> Roland does not own any share mentioned in this article.

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