Interactive Investor

AIM oil sector - who's winning and who's going bust

30th January 2015 10:47

Andrew Hore from interactive investor

Falling oil prices are bad news for AIM oil and gas companies and research by Company Watch shows just how poor the financial health of some of these companies is at the moment.

Company Watch calculates the financial position of a company using what it calls H-scores. This is a calculation used by some fund managers, including Anthony Bolton who has stated that he looks at the H-Score of a company when he is considering investing.

H-Scores are calculated by analysing the accounts and financial statements of companies and assessing the characteristics of financially distressed companies and the characteristics of successful companies. The warning area for financial frailty is classed as an H-Score of less than 25. Share prices of companies in this area are twice as likely to more than halve and ten times as likely to slump by more than 90%.

Companies with an H-Score of more than 25 outperform the rest on average by more than 8%.

There are 98 AIM companies in the oil and gas sector and 38 of these have an H-score of less than 25.

There are seven factors that are taken into account. The first is the contribution of profit to the balance sheet and 42 of the companies have a score of 0 for this. That includes some of the companies with a high overall score.

Asset management factors include liquidity, stocks and debtors and current asset cover. The final three factors come under funding management and are the adequacy of the capital base, dependency on debt and dependency on current liabilities in the financing of the company.

Price plunge guesstimate

The oil sector background is a concern for all of the companies but many in the sector may find it difficult to raise cash to keep going. Analysts are uncertain about when the oil price, which has fallen below $50/barrel will bottom out. Westhouse is predicting that Brent crude will average $50/barrel in 2015 while RFC Ambrian forecasts an average of just $35/barrel.

Westhouse sets out the previous four large declines in the oil price in the past three decades in its recent sector report. The oil price has already more than halved which puts the fall on a par with the declines in 1990-91 and 1997-98. In 1985-86 the price declined by nearly two-thirds, while the oil price slumped by three-quarters in 2008-09 but it did recover quickly.

In three of these periods the time from peak to trough price was four or five months. The latest decline started last June. The 1997-98 oil price slump lasted for 18 months.

Source: International Energy Agency (IEA)

Westhouse says that capital expenditure is already estimated to have fallen by 20%-30%, which will hold back additional supply. One of the reasons behind the recovery in the oil price back in 1998 was that supply started to fall, whereas demand was growing. OPEC has decided to maintain supply and non-OPEC supply is forecast to grow, so there may still be some time before lower supply and falling inventories helps the oil price to recover.

Westhouse estimates that oversupply could be 1.3 million barrels per day (mmb/d) in the first quarter of 2015 with an increase to 1.6mmb/d in the second quarter. In the second half supply is likely to be nearer to demand levels with higher cost production withdrawn.

Who's got the best H-score?

However, companies still need to be around to take advantage of any upturn and many of those companies with an H-score of less than 25 may find it difficult. Consolidation seems likely for the sector, with the financially stronger companies leading the way, but this may not happen until there are signs of a recovery.

Like any individual way of assessing a company the H-score, which focuses on the financials, does not tell the whole story. This is particularly true of a sector such as oil and gas where geographical and political risk can be highly relevant.

For example, the two companies with H-scores of 100 are Regal Petroleum and Volga Gas. Both companies generate cash from operations and have cash piles in their balance sheet. That means that they will be around for some time, but conditions are not ideal.

Regal is focused on Ukraine, so having a strong balance sheet and financials is a good thing, but political risk is highly significant. Regal has been able to continue production at its 100%-owned gas and condensate fields, but uncertain gas prices and volatile exchange rates, combined with tax changes, have hit the recent performance of the company. The Ukrainian government increased subsoil taxes in the period between August and December last year - effectively nearly doubling the tax paid by Regal. The tax change has been extended into 2015 even though it was meant to be temporary.

Volga Gas is an oil and gas explorer and producer in the Volga region of Russia. A drop in the rouble exchange rate in terms of the dollar means that gas prices have held steady in terms of roubles but they have fallen in dollar terms. Tax changes have also occurred in Russia with the extraction tax levied on gas increased to the same level as oil, although there may be a positive effect from the reduction in oil export tax rates.

Timing is also an issue. The H-score is based on the latest published results so it can be many months behind. Some companies with a poor H-score may have successfully refinanced themselves since the calculation.

That said, H-scores do provide a useful, standardised way of providing information that can be used as part of the assessment of companies.

Many of the companies that have a H-score in single figures, or even nought, are fairly obviously short of cash. Excluding, Regal and Volga, the companies with the highest H-scores are Bankers Petroleum, Amerisur Resources and Empyrean Energy, which is undergoing a strategic review. All three of these companies are highly profitable and cash generative because of their relatively low cost production and they can cope better with a fall in the oil price than their weaker counterparts, although it will still be tough. Bankers and Empyrean, though, are relatively dependent on debt.

Westhouse tips vs H-scores

It is interesting to compare some of Westhouse's main buy recommendations for the AIM oil sector with their H-scores.

Circle Oil has an H-score of 89 and is profitable and cash generating. Westhouse believes that it has an interesting portfolio of production, development and exploration assets in the Middle East and North Africa. Production is stable and there is potential upside from exploration. Westhouse says new executive chairman Steve Jenkins has a record of turning around under performing companies and selling them.

Faroe Petroleum has an H-score of 46 with the weak equity base a concern. Faroe made a small profit in 2014 but it is expected to lose money this year. Exploration is focused on near-term opportunities. Westhouse believes that asset swaps and the rationalisation of the portfolio are likely. The broker is also positive about the fact that Faroe has cash in the bank and has drawn down only $35.7 million of the available $250 million debt facility.

Nigeria focused Lekoil has an H-score of 55 with the main weaknesses being the lack of profit and current funding. Since the H-score calculation Lekoil has raised £22.4 million at 67.75p to buy a 40% interest in the Otakikpo marginal field, which could start to generate production revenues by June. Expected capex of $95 million this year would use up the cash in the balance sheet and move Lekoil into a net debt position with even higher capex expected in 2016. This means that the concerns flagged by the H-score are still relevant despite the cash in the bank because it may not last long, although the risks should reduce when production starts to generate cash.

Another Nigeria-focused oil explorer, Sirius Petroleum, is the most fascinating of the Westhouse recommendations because it has an H-score of 0. This is based on the 2013 accounts and Sirius raised £11.7 million before expenses at 3p a share last summer, although this was not straightforward with some of the original placees not paying for shares and other investors subscribing for them. A further £9.375 million is being conditionally raised at 2.5p a share and a £9.6 million loan secured although this financing will not be completed until charges over assets have been agreed. Westhouse likes the fact that first production should commence from Nigerian offshore project Ororo by the middle of this year. However, even with positive cash generation expected this year Sirius needs to complete the financing to afford the $35 million it is expected to spend on capex in 2015.

Looking at these examples, the concerns highlighted in the H-scores still appear relevant even when additional cash has been raised. Westhouse's perspective as a broker is forward-looking and focused on what could happen, but there is no certainty that the companies' will achieve what is expected of them.

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