Buy ahead of a farm-out deal

Losing trades are a different breed altogether and, if my experience is anything to go by, then positions in the red use up far mental energy, and research time, than possibly the capital employed in these holdings warrants. That said, with the bull market in equities lifting all boats, I have not been losing any sleep on a handful of losing trades.

I have also been keeping faith with the special situations I have highlighted and where investors have yet to factor in the hidden value in the assets held on a company's balance sheet. It is my view that it pays to be patient in order to eventually reap the financial rewards as, and when, other like-minded investors note the investment potential.

And one such special situation I have highlighted in the past is Global Energy Development (GED: 84p). Shares in the 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). The share price then was 103p, so we are the best part of 20 per cent under water on the holding - a performance which has been compounded by the fact that equity markets have enjoyed a fantastic rally this year.

In fact, the capital employed here would be worth 50 per cent more than it currently is if I had simply bought a FTSE Small Cap tracking fund. Still, I am not bailing out as I believe there are two major catalysts which could drive a rerating in the coming weeks and narrow the huge share price discount to book value.

Awaiting news of a farm-out deal

To put the extent of the undervaluation of the company into some perspective, at the current price Global Energy is being valued at only £30.3m, or a hefty 42 per cent discount to net asset value of £52m.

This is partly due to the fact that the potential farm-out of a material portion of the company's interest in its Bolívar shale oil properties, located within the Middle Magdalena Valley in Colombia, South America, has taken far longer than the company’s board had envisaged. 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. We shouldn't have long to have news on this front as guidance is for an announcement to be made by the end of this month.

The process of due diligence and hammering out terms clearly can take time and the timing is subject to third parties. But it is realistic to assume that 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 the Bolivar properties are within the premier area of the Middle Magdalena Shale Oil play. Global Energy's reserves within the Bolivar Contract area are included in the Rosa Blanca, Salada and La Luna formations which can be developed by drilling vertical and horizontal wells along with multi-stage hydraulic fracturing technology that is currently in use for developing shales containing oil in North America.

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 generate significant profits. 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 to maximise production volumes, reduce operating costs and utilise cash flow to develop projects within the Middle Magdalena Valley contract areas (Bocachico and Bolivar Association Contracts).

Significantly undervalued

This view is supported by analyst Andrew McGeary of broking house Northland Capital. Commenting on July’s pre-close trading update, Mr McGeary noted: "The Rio Verde water disposal well and more consistent production (last year Tilodiran-2 experienced 120 days of downtime) should significantly enhance this year's profitability as per our forecasts. The company remains inexpensive on earnings and robust given cash generation. On reserves metrics, the shares are exceptionally cheap and the Magdalena assets remain potentially high impact. We await further news as to the appraisal and farm-out prospects in Bocachico and Bolívar respectively."

For the financial year to end-December 2013, Northland expects Global Energy to produce revenues of around $45.8m, up from $44m (£29m) in 2012, but in the absence of the issues which dragged down profits in 2012, full-year pre-tax profits are expected to rise from $2.7m to $6.2m. On this basis, expect underlying EPS of 11.4¢, or 7.4p at current exchange rates. This means the shares are priced on a very modest 11.4 times earnings estimates and on less than half Northland's risked-reserves-based price target of 186p.

It’s also fair to assume that when Global Energy reports half-year results later this month, pre-tax profits should be more than double the level reported in the first six months of last year. This will undoubtedly be seen as a positive by investors and can only highlight the undervaluation of the shares on an earnings basis, as Northland's estimates indicate.

Directors have significant interests

It's worth remembering too, that managing director Steve Voss has a significant interest in making sure a farm-out deal happen, and at a good price. In fact, 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 over £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 currently priced on a bid-offer spread of 82p to 84p, all three directors are showing paper losses on these deals. Or, to put it another way, for 84p a share you are getting assets worth around 144p 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.

Rerating beckons

The combination of half-year results at the end of September and news on a farm-out deal should be strong share price catalysts. Interestingly, Mr Voss and Anna Williams, the company’s finance director, will be giving an investor roadshow to clients of research house Equity Development on Wednesday, 25 September, around the time of both announcements. The timing looks intriguing to say the least and it would be odd for the directors to make a presentation at this stage unless there was a good news story to tell.

In the circumstances, I am comfortable reiterating my buy recommendation with Global Energy's shares priced on a spread of 82p to 84p. Moreover, I still believe that a target price of 140p is feasible. 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

Please note that my next column will appear on our website tomorrow. In response to requests from dozens of readers, I have published an article outlining the content of my new book, Stock Picking for Profit: 'Secrets to successful stock picking'