Value And Excitement From A Small Oil Firm

Published in Company Comment on 1 June 2011

This small oil company is an attractive risk-reward play.

Trying to pin an accurate valuation on small oil and gas E&P (exploration and production) companies is a bit like swinging blindfolded at a piñata for most private investors. 

Often, fundamental valuations seem to fly out of the window as the share price becomes a law unto itself, defying gravity as traders go in and out playing a momentum game.

This kind of thing is not for me. I much prefer to try and find small E&P companies whose valuation seems to be underpinned by cash, production income, and assets, and where the potential excitement is in the price for free. On this basis, I believe AIM-listed Serica Energy (LSE: SQZ) to be a good risk-reward play. 

Long-term shareholders may disagree, as Serica's recent history with the drill bit hasn't been a happy one and the share price has followed suit. It's dropped from a recent peak of over 90p a year ago, to its current level of just 27.5p, which values the company at £48.5m.

What you get for your money

In return for an investment at this level, investors are buying into a company with cash of $22m (£13m) with ongoing cash flows from its Indonesian operations, an undrawn bank facility in place to fund exploration, a field close to development decision in the North Sea, and various as yet undrilled prospects -- most notably, perhaps, in the North Sea and Irish Sea.

But no small oil company comes without significant risk and Serica is no different -- so this is most definitely not a share for the proverbial widows and orphans. 

To illustrate the point, last year, Serica's unlucky drill bit found only guano in the East Irish Sea and Central North Sea, then found non-commercial gas in Indonesia -- and the share price tumbled accordingly.

In fact, the company has drilled 12 prospects over the past five years without commercially viable success. Serica says its overall strategy is to strike the right balance between established areas where the chances of success are high, and untested basins where success is less certain but the rewards of success are more significant.

Extracting value

It has previously stated its intention to try and realise the value in its remaining 25% holding in the producing Indonesian Kambuna gas field -- the proceeds from which, it is hoped, will enable the company to try its hand with the drill bit elsewhere.

It will achieve this by selling all or part of its Indonesian business, or exchanging its Indonesian production for UK or Western European production.

A sale looks the most likely option and the share price action will reflect the value the company achieves. The last time Serica sold its previously held additional 25% of Kambuna, the company received $98.5m.

But pressure declines in excess of expectations in one well (indicating lower reserves) led to an impairment charge which looks likely to be reflected in the eventual sale price.

Nevertheless, such charges have their upsides, helping Serica become a more attractive target for a larger E&P company looking to take advantage both of its assets and ring-fenced tax losses which now amount to $126m (c£77m). This figure is particularly attractive for the right predators following last March's budget which controversially raised taxes on North Sea oil production.

In the absence of a predator, though, what it really boils down to is the price Serica gets for its Indonesian assets -- and its future fortunes with the drill bit. It is a little circumspect on exactly where the drill will be biting next -- so a lot will depend on the Indonesian sale. But it looks likely that Serica will concentrate on its UK and Irish prospects -- probably in partnership.

Overall, valuing Serica isn't an easy job, but its valuation certainly seems to make a lot more sense to me than most small E&P companies.

More from David Holding:

> David owns shares in Serica Energy.


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apprenticeDRL 05 Jun 2011 , 6:38pm

I purchased some shares on Friday for 25.6, it has already risen so this looks to have been a good call. I think it has now bottomed out and will start to rise especially if they get good news from the Namibian operation at the AGM end of June

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