Gushing higher

I have more than a passing interest here as a couple of months ago I recommended buying shares in Faroe Petroleum (FPM:103.5p), an independent oil and gas company primarily focused on exploration, appraisal and production opportunities in Norway and the UK, to play the oil price recovery (‘Six seductive small-caps’, 11 Sep 2017). That’s because there is a strong correlation between the oil price and Faroe’s share price, quite understandable given that it is a critical factor in determining the commercial viability of the company’s projects. Importantly, the fundamentals driving the oil price higher are sound and should support further share price gains towards my 115p target price, and perhaps beyond.

Firstly, global oil inventories have been falling, down by 500,000 barrels a day to 3bn barrels in the second quarter of 2017, according to the Paris-based International Energy Agency (IEA), reflecting supply cuts from big producer countries. Oil analyst Dougie Youngson at broking house FinnCap informs me that excess inventories have been cut by 180m barrels since the start of the year, with a further drawdown of 160m barrels required to get back to the five-year average for 2012-16.

The inventory drawdown has been accentuated by the US hurricane season as refineries in Texas struggled to import crude because of outages at port facilities. At one stage, 3m barrels a day of US crude oil refining capacity was grounded, or a sixth of the country’s total, due to disruptions at Gulf coast refineries, including the largest one, the Saudi-owned Motiva refinery in Port Arthur, Texas. Shale oil producers were hit too as pipelines from the largest US shale field, the Permian Basin, to refineries in Texas were shut down.

Secondly, the market is moving into equilibrium as the move by big producers to rein in output on the supply side has coincided with increased demand from industrialised countries. Global demand rose by 2.3m barrels per day (bpd) in the second quarter, the highest quarterly year-on-year rise since mid-2015, prompting the IEA to upgrade its global oil demand growth numbers, which now suggest total consumption hitting 97.7m bpd this year, a rise of 1.6m bpd. Opec, a body that represents nations that control a third of global oil output, raised its global demand forecasts too, and lowered estimates for production outside of the cartel.

Thirdly, the rebalancing of the oil market is attracting speculative interest too: hedge funds increased their net long position by 35m barrels to 918m barrels in the last week of October, according to Mr Youngson at FinnCap. It was no coincidence either that the oil price subsequently gushed almost $5 a barrel higher to break through $60 a barrel.

Company newsflow to underpin rally

Of course, oil explorers need company-specific newsflow to support share price gains and not just improving supply and demand equilibrium in the industry driven by macroeconomic factors. Faroe is delivering on this front, having commenced drilling operations on the Tambar development project in the producing Tambar field in Norway in which it has a 45 per cent interest. The project consists of two new infill wells and the installation of a gas lift in three existing wells to increase overall field production markedly and extend field life by up to 10 years, contributing to lower unit operating costs. The infill wells, which are being drilled by the Maersk Interceptor drilling rig, will target undrained areas of the field identified with the potential to increase 2P reserves. Drilling operations are expected to continue to the end of March 2018, and the aim is to have the two new wells on stream before the end of April.

Graham Stewart, chief executive of Faroe, points out that “the significance of this work programme is not only the impact on reserves and production, but it shows our ability to drive value and upside potential from the existing portfolio”. Analyst Daniel Slater at brokerage Arden Partners notes that Tambar is one of the six planned projects to boost Faroe’s daily production to in excess of 40,000 barrels of oil equivalent (boe) by 2021, up from management guidance of between 13,000 and 15,000 boe this year. He adds that “relative to some of Faroe’s larger projects (Njord/Hyme/Bauge, Fenja, Brasse, Oda), Tambar is an easy win, with new wells being linked up to existing infrastructure and quickly brought on stream. This will help maintain production as existing fields decline, and provide important cash flows to support funding of the larger projects”.

Mr Slater believes that “Faroe is a relatively low-risk way of playing the exploration and production sector”, adding that its production growth profile and results from the ongoing drilling campaign should drive positive momentum for the shares in the coming months. I wholeheartedly agree. For instance, Faroe’s high impact Iris/Hades (Aerosmith) exploration well, in which it has a 20 per cent interest, is due to spud before the year-end.

So, with the shares priced well below Arden’s risked net asset value per share of 122.8p (147.2p on an unrisked basis), based on an oil price of $60 a barrel and a gas price of 40p per therm, I maintain my positive stance. Buy.

Out of Africa

One of the direct consequences of the precipitous collapse in the oil price between June 2014 and December 2015 is that rig rates and utilisation tumbled to a record low. For instance, Mr Youngson at FinnCap says that Ophir Energy (OPHR:64p) drilled the Ayame-1X well in May for only $19m, making it one of the lowest-cost exploration wells ever to be drilled, adding that rig utilisation across all types is currently just over 50 per cent with around 130 new-build rigs stranded or under construction.

Having just returned from Africa Oil Week, a meeting place for Africa’s upstream oil and gas market, which brings together governments, national oil companies, investors, independents and financiers, Mr Youngson “heard several companies say that it is now possible to drill multiple wells for the same cost as one well in the era of $100-per-barrel oil”.

That’s interesting because the major oil companies have been focusing on getting high-margin barrels on stream during the oil price downturn, and reduced their focus on exploration. That’s understandable, but with the oil price rebounding Mr Youngson points out that “there has been a realisation that portfolio rationalisation has arguably gone too far and that exploration needs to be done in order to replenish the hopper for future developments”, adding that “we are seeing an increase in farm-ins by the majors into junior oil company acreage during 2017, including activity in West Africa”. He cites Impact Oil and Gas’s successful farm-out to Total (Namibia and South Africa), Statoil (South Africa) and CNOOC (Senegal); and Aim-traded Eco Atlantic Oil and Gas's (ECO:22p) farm-out to Total and Tullow Oil (TLW:181p) in Guyana, and to Tullow and Azinam in Namibia. Mr Youngson also says that “exploration is becoming increasingly important to the majors, and junior companies with exciting and drill-ready prospects are able to secure farm-ins on reasonable terms.”

The backdrop of attractive rig rates and increased farm-out activity really interests me because two of the constituents of my 2017 Bargain Shares portfolio are operators in Africa: Chariot Oil & Gas (CHAR:16p), a small-cap exploration company with activities in Morocco, Namibia and Brazil; and Bowleven (BLVN:32.5p), a company with valuable interests offshore Cameroon.

In the case of Chariot, investors are now cottoning on to the potential exploration upside from the forthcoming drilling programme by oil giant Eni at the Rabat Deep Offshore permits in Morocco, which have an independently audited gross mean prospective resource estimate of 768m barrels. Drilling is scheduled for the first quarter next year. Chariot has a 10 per cent equity interest and a capped carry for its share of an exploration well which will cost over $50m (£38.6m) to drill.

Larry Bottomley, chief executive of Chariot, says that “the prospect offers potential to create transformational value due to the large-scale prospective resources, excellent commercial contract terms and robust economics.” He also adds that “success will materially de-risk other targets we have identified within our neighbouring Mohammedia and Kenitra permits in which Chariot holds a 75 per cent interest". Chariot is actively seeking partners to drill Prospect-S in Namibia (prospective resources of 300m barrels) in the first half of 2018 and Kenitra-A in Morocco (prospective resources of 350m barrels) in the first half of 2019.

The point here is that with the company’s £43m market capitalisation backed by net cash of £16.5m, a sum worth 6p a share, drilling success at the Rabat Deep Offshore permits could send the share price soaring, as could a successful partnering in Namibia and Kenitra-A in Morocco. So, having first advised buying Chariot’s shares at 8.29p in my 2017 Bargain Shares portfolio, and banking a 111 per cent profit on two-thirds of the holding a few months later at 17.5p (‘Bargain Shares on a tear’, 3 April 2017), I feel that there is potential for the share price to double again to FinnCap’s conservative looking target price of 35p if drilling in Morocco hits pay dirt early next year. Run profits.

Bowleven is significantly undervalued

I included shares in Bowleven (BLVN:32.5p) in my 2016 Bargain Shares portfolio when the price was 18.9p, and was so convinced of the upside to my 50p break-up value that I also included them in my 2017 Bargain Shares portfolio at just shy of 29p. I last updated my view in the summer (‘Bargain Shares: second chance’, 17 August 2017), and continue to believe the shares are worth buying for several reasons.

For starters, the board, led by activist and 25.8 per cent shareholder Crown Ocean Capital, is pursuing a strategy of turning Bowleven into a holding company that does not pursue any new exploration activity; is streamlining costs, with monthly overheads being slashed to $350,000; and is relying on contractors for any additional support needed to ensure a proper stewardship over the company's Etinde and Bomono assets in Cameroon.

Secondly, Bowleven has a cash-rich balance sheet. Analysts at Edison Investment Research expect net funds to decline only slightly to $86m (£65m) in the financial year to end June 2017, a sum representing 62 per cent of its market capitalisation of £105m. The company also has a $40m (£30m) net drilling and testing carry to cover its share of two appraisal wells on Etinde which are expected to commence in 2018, thereby reducing its cash requirements, and is entitled to an additional $25m (£19m) payment on achieving the final investment decision at the project.

Moreover, the board is in the process of de-risking its other operations in Cameroon. Discussions are ongoing with the Cameroon authorities in relation to the outstanding approval of the Bomono farm-in, whereby Bomono hydrocarbons can be produced into the Victoria Oil & Gas (VOG:46p) Gas du Cameroon pipeline and connect Bomono into the domestic gas market through the existing pipeline infrastructure. Expect news on this front before the year-end.

The bottom line is that cash on the balance sheet, and the drilling carry on its 20 per cent interest in Etinde, are worth almost Bowleven’s market value alone, so you are getting a free ride on exploration assets with a carrying value of $216m (£163m). In addition, once all the development options for the gas monetisation of Etinde and Bomono assets have been determined, Bowleven's board will be able to assess the cash requirements of the business and make a decision on whether surplus funds can be returned to shareholders. Buy.

Finally, I am now on annual leave and my next column will be published online on Wednesday 22 November.

■ Simon Thompson's book Stock Picking for Profit can be purchased online at www.ypdbooks.com for £14.99, plus £2.95 postage and packaging, or by telephoning YPDBooks on 01904 431 213 to place an order. It is being sold through no other source. Simon has published an article outlining the content: Secrets to successful stock picking