Five oil explorers with upside potential

Investors wanting exposure to the resources sector should put their money into company shares rather than physical commodities, argues Baring Asset Management. Global demand for raw materials is on the rise, yet valuations for resources companies are currently trading below historical levels. They do, however, look set to revert to their long term mean, so these discounts may not last long.

"We believe the opportunities in the sector are as strong as they have been for several years and expect a positive re-rating of the sector and associated gains for our resources fund irrespective of the macro," says Duncan Goodwin, head of global resources at Baring.

The right investment choices could see shareholders benefiting from what he calls "superior" returns and an improved chance of tasty earnings as companies try and turn their fortunes around.

"After several years of a benign-to-negative commodity pricing backdrop and associated de-rating by shareholders, companies are finally taking action to improve margins and returns driven by self-help and or restructuring," says Goodwin. The largest stock contributors to the Baring Global Resources Fund in the second quarter were Anadarko Petroleum, BHP Billiton, Petra Diamonds, Weyerhaeuser and Tullow Oil.

He points to the hydrocarbon sector as being an attractive investment opportunity, as well as the oil and gas industry as a whole, as countries look to secure a stable and competitive source of energy to sustain economic and population growth. "Valuations for resources companies are currently trading below historical levels and look set to revert to their long-term mean - making them very attractive for active investors with a strong understanding of the sector," says the asset manager. "On a longer term basis, continued population growth will drive absolute demand for natural resource, energy production and raw materials, which, in turn, will create growth opportunities for resources companies throughout the value chain."

Goodwin might not be excited by the commodities pricing backdrop, but JPMorgan is. The broker has just upgraded its Brent Crude outlook for 2014 to $111 from $105.5, and its target for next rises from $100.25 to $115. It has also set a new 2016 forecast of $120.

Westhouse Securities oil and gas analyst Jamal Orazbayeva also believes the sector is trading at a decent discount to its core net asset value (NAV), after being pretty "beaten up" recently. Although she notes that there are many reasons why, she pins much of the blame on production delays and a lack of large liquid discoveries.

Sharing the same sentiment, JPMorgan analyst James Thompson says exploration is the "lifeblood" of the sector, and holds the key to its revival.

"Exploration may not be in fashion right now but it remains a vital part of the sector," which Thompson believes missed an opportunity for outperformance in the first half of 2014.

He adds: "The market sensed a group of stocks near a valuation support level and as sentiment began turning more positive for Big Oil, the stage was set for sector outperformance. Instead exploration continued to malfunction and geo-political risks trended higher, damaging the sector's rating."

Goodwin is confident of the long-term outlook for resources equities. "Over the very long term, we are adamant that resource equities retain a valuable role in investment portfolios. As commodity prices are closely correlated with rises in consumer prices, investment in the resources sector has the potential to act as a hedge against inflation. We believe the opportunities in the sector are as strong as they have been for several years and expect a positive re-rating of the sector and associated gains for our resources fund irrespective of the macro."

Interactive Investor takes a look at four oil and gas companies investors should keep an eye on to benefit from this increase in demand.

Northern Petroleum, 21p

One option to tap into exploration and production is Canada-focused Northern Petroleum. It announced on Thursday that the first of its new three-well programme will be spudded this week, with both oil and cash flow expected to be delivered by the end of the year. The new programme is set to double its production and cash flow, Westhouse Securities analyst Orazbayeva told Interactive Investor. It totalled 165 barrels of oil per day (boepd) in July from just two wells.

At the end of June, Northern had a cash balance of $22 million (£13 million), above Westhouse's $20 million forecast, which means it is fully funded for the summer campaign. Orazbayeva reckons Northern is keen to accelerate the process and sees a lot of upside opportunity for the shares which have halved since last November.

The company also has a "free option" in its Italian asset, and is awaiting ministry approval to un-tap the 400 million barrel gross resource. Orazbayeva sees this process speeding up with the new government in place, as Prime Minister Renzi seems more business friendly than his predecessor Berlusconi. Due to the length of time this permitting process has taken, the asset is not reflected in Northern's valuation, but when the go-ahead is given, there is really only one way the share price can go, reckons Westhouse, which has set a 110p target price.

Faroe Petroleum, 107p

Faroe Petroleum is working away in Norway, the Atlantic Margin and the UK North Sea. It has access to 100 million barrel reserves in Norway and an enterprise value of around $3/$4 per barrel, cheaper than the $5/$7 per barrel benchmark, says Orazbayeva.

Last month, it announced a find at the Bue prospect in the Norwegian Sea. The bottom end of the gross recoverable resource range at the nearby Pil discovery has increased significantly, too.

True, May's disappointing results at the Butch East exploration well has driven the price down to 107p, but Faroe is one for the longer-term investor. At the end of last month, it had restarted production at the Njord and Hyme fields after upgrade works, and plans a 2015 drilling campaign which will start to tap into its discovered resource.

With a 204p price target, Faroe is Panmure Gordon's top pick in the sector.

Ithaca Energy, 130p

Another production delay at Ithaca Energy's 16,000boepd asset in the North Sea was not taken well by the market. But, Orazbayeva sees this as a good opportunity for an investor with patience.

"The delay is not related to the quality or deliverability of the asset," she said, adding that the weather window was missed by reasons out of its control. However, she sees the share price picking up again in mid-2015, which is when the next window will open. In its second quarter production update, Ithaca averaged 11,900boepd, below consensus estimates.

Investec is equally bullish on prospects, believing that it works in a low-risk environment and that production start-up from the Greater Stella Area in the middle of next year should double group production by 2016. According to analyst Alwyn Thomas, the value of this hub alone is estimated at 105p per share (risked).

"The stock is inexpensive at a 25% discount to our risked core development NAV," said Thomas. He also forecasts cumulative net cash flow to equity of $1.2 billion during 2014-2019 - 1.3 times its market value. "This should allow Ithaca both to reinvest to maintain production and consider cash returns that could yield up to 15%."

Premier Oil, 315p

Premier Oil has reassured investors following its hefty share price fall earlier this year. Beating forecasts, production was up 10% at 64,700boepd, driven by the UK which, thanks to the Huntington and Rochelle fields, leapt over 50%. Two thirds of its $300 million non-core asset disposal programme has been completed, supporting its $245 million cash position, say VSA Capital. It has also won shareholders over with an attractive dividend/buy-back policy.

It added: "Premier has earmarked development capex of $1 billion for 2014, which will be spent on projects such as Catcher, where first oil production is expected by mid-2017 before reaching plateau of 50,000boepd, or on the pre-development of the Sea Lion project in the Falkland Islands with a geotechnical survey planned for the second half of 2014."

Deutsche Bank certainly liked the July production data at Huntingdon, enough to keep its 'buy' rating and 495p price target.

And it will be a busy year for £1.7 billion Premier, with an exploration programme in Indonesia and further wells to be drilled in Kenya. With earnings per share of 0.6p, Premier is more expensive than Ithaca, trading on a price/earnings multiple of 9.6 times, but having drifted back since May, the shares look interesting.

SOCO International, 430p

SOCO International has operations in Vietnam and Africa, and an operational update last week certainly gave the City some confidence ahead of interim results at the end of August.

The Te Giac Trang field, offshore Vietnam, makes up 86% of broker Jefferies' 14,259boepd production estimate for 2014. But output is set to increase with a third production platform for the H5 fault block on schedule, the first new production well at the Ca Ngu Vang field still drilling, and exploration in West Africa underway. As these latter projects progress the risk of having most of its net asset value in one field will lower.

Jefferies analyst Mark Wilson said: "Our 480p share target price builds from a 399p core NAV including 100 million barrels of oil (mmboe) of Vietnam 2P reserves (vs. Soco's 117mmboe 2P reported). On overall reported group 2P of 130mmboe, the stock trades at US$16/boe versus a weighted sector average of $13.6/boe we estimate. The stock is therefore not significantly cheap but certainly worth the metric when compared to oil-weighted M&A metrics of recent times."

In its interim results, SOCO will announce the timing of its cash return to shareholders, with Jefferies estimating at least $100 million for a 4.4% dividend yield. That should underpin the premium valuation.

Note: 2p is proven and probable reserves

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.