Waiting for pay dirt

One such special situation I have highlighted in the past is Global Energy Development (GED: 100p). Shares in the Aim-traded Latin America-focused petroleum exploration, development and production company have yet to fulfil the promise I envisaged when I highlighted the investment case at the end of last year ('Insiders major buy signal', 17 Dec 2012). In fact, the share price is roughly where it was nine months ago, a lacklustre performance compounded by the fact that equity markets have enjoyed a fantastic rally this year.

Still, I am not bailing out as the company's half-year results yesterday confirmed that Global Energy has not only recovered strongly from a number of setbacks last year, but that the long-awaited farm-out deal I have been banking on is likely to happen in the coming weeks.

Sharp profit recovery

The key take for me was the fact that the company managed to more than treble pre-tax profits from $1.2m to $4.1m on revenues of $19.7m in the six-month period, despite facing a 10 per cent fall to $91 a barrel in the market price of oil sold. A 16 per cent increase in gross oil production to 235,000 barrels helped to mitigate the price weakness and restrict the revenue shortfall to only 2.5 per cent on the same stage in 2012. The profit growth largely reflects cost-saving initiatives management put in place last year. These include the purchase of the surface plant facilities at its Rio Verde water injection well and more consistent production (last year Tilodiran-2 experienced 120 days of downtime), which significantly boosted profitability.

The majority of Global Energy's oil production currently comes from its contract areas located within the Llanos Basin of Colombia, South America. The focus here is on maximising production volumes, reducing operating costs and utilising cash flow to develop projects within the Middle Magdalena Valley contract areas (Bocachico and Bolívar Association Contracts).

Further cost-saving initiatives include the construction of a saltwater transfer line from Tilodiran to Rio Verde in the fourth quarter this year. This will cost $1.5m to implement, but is worthwhile doing as it will reduce water trucking and related road maintenance costs.

Global Energy's cash flow performance was also notable, as the company generated almost $7m of operating cash flow and ended the six-month period with $11m of net borrowings, down from $11.7m at the start of the year, despite spending $8.15m on capital expenditure. Deferred consideration from an asset sale last year brought in a further $3.3m of cash.

The bottom line is that analyst Andrew McGeary at broking house Northland Capital will be "reviewing forecasts with a positive bias in light of the interim results". For the financial year to end-December 2013, Northland was previously expecting Global Energy to produce revenues of $45.8m, up from $44m (£29m) in 2012, but in the absence of the issues that dragged down profits in 2012, full-year pre-tax profits were forecast to rise from $2.7m to $6.2m. But with profits of $4.2m already booked for the first half, these estimates now look on the low side, as does Northland's previous underlying EPS forecast of 11.4¢, or 7.1p.

So pre-upgrades, the shares are priced on 14 times earnings and on almost half Northland's risked-reserves-based price target of 186p. To put the extent of the undervaluation into some perspective, at the current price the company is being valued at only £36m, or almost 30 per cent discount to net asset value of £50.7m.

Awaiting news of a farm-out deal

In part, the undervaluation is due to delays in Global Energy announcing a farm-out deal on a material portion of the company's interest in its Bolívar shale oil properties, located within the Middle Magdalena Valley in Colombia.

Global Energy plans to ramp up production and exploit Bolivar's large reserve base, but it has to significantly increase drilling activity, which will require additional and substantial technical expertise and manpower to undertake the management of this massive shale oil development project. Hence, it has been working together with investment bank Jefferies to find a farm-out partner.

The company has also gained additional technical insight and feedback from discussions with several large international petroleum exploration and production companies with regards to its development plan of the Bolívar Contract Area. These insights, along with the June 2013 report from the US Energy Information Agency that described the Magdalena Valley of Colombia as a "world class stacked (vertical) shale oil play", led Global Energy to make a substantial revision in its development plans.

The new plan is based on the high natural fracture permeability of the Bolívar area within its five formation zones (La Luna, Simiti, Salada, Rose Blanca and Tablazo). Given the thickness of the vertically stacked oil zones and the high fracture permeability, the plan now is to drill single vertical wells through the five zones instead of a separate horizontal well in each of the five formations. The single vertical wells would then be completed, hydraulically fractured and simultaneously produced from all five formations. The obvious benefit is that it should increase the company's recoverable 3P reserves.

It is well worth doing, too. As managing director Stephen Voss rightly points out: "Following the completion of our updated Bolívar Development Plan, we have resumed the partnering process, focusing on independent and mid-sized companies with higher flexibility for deal terms. The timeframe of these efforts has been lengthened from original expectations, but we are optimistic of a successful conclusion of our strategic partnering efforts in the near future." In other words, we shouldn't have long to wait for a farm-out deal to be announced.

I also firmly believe a farm-out will be achieved given the presence of high-quality operators in the area, including oil majors ExxonMobil (NYSE: XOM) and Royal Dutch Shell (LSE: RDSA), indicating that the Bolívar properties are within the premier area of the Middle Magdalena Shale Oil play. In my opinion, any disposal or farm-out deal can only highlight the chronic undervaluation of Global Energy's shares and will bring into sharp focus the miserly valuation currently being attributed to the rest of the business even though these operations clearly generate significant profits.

Directors have significant interests

It's worth remembering, too, that Mr Voss has a significant interest in making sure a farm-out deal happens, and at a good price. At the end of last year, he spent £202,000 increasing his holding from 125,568 shares to over 323,000 shares. That's the equivalent of 0.9 per cent of the company's share capital. Mr Voss started buying at 90.7p a share and spent more than £100,000 in three trades in late November, topping up his holding at 105p and 106p a share.

Other directors were keen buyers, too. At around the same time chairman Mikel Faulkner spent over £52,500 buying shares at 105p to take his holding to 350,000 shares, or almost 1 per cent of the issued share capital, and non-executive David Quint splashed out £13,750 buying 12,500 shares at 110p.

So with Global Energy's shares priced on a bid-offer spread of 98p to 100p, all three directors are showing paper losses on these deals. Or, to put it another way, for 100p a share you are getting assets worth around 140p at current exchange rates and a chunk of these are likely to be worth a lot more than book value in the event of a successful farm-out deal on the Magdalena properties. And it is one that is expected to happen "in the near future", according to Mr Voss.

Re-rating beckons

In the circumstances, I am comfortable reiterating my buy recommendation on Global Energy's shares. Moreover, I still believe that a target price of 140p is not only feasible, but could be conservative if the right farm-out deal is struck. Please note that, by my reckoning, 86 per cent of the issued share capital is controlled by the top nine shareholders. As a result, Global Energy's shares can be volatile due to the lower-than-average free float. I have taken this into account in making this recommendation.

Major shareholders in Global Energy Development

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