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Supply crunch to reignite interest in oil juniors?

There was a positive update this week from the curiously named Eco (Atlantic) Oil & Gas (ECO), an Aim-traded explorer with interests in offshore Guyana. The Stena Forth drillship is now sailing from Ghana towards Guyana to spud the company’s first well on 26 June. Nothing too exciting there, until you notice that Eco’s Orinduik prospect, in which it holds a 15 per cent working interest, is adjacent to ExxonMobil’s (US:XOM) Stabroek block, which contains an estimated 5.5bn barrels of oil equivalent (boe).

It also appears that Exxon’s Hammerhead discovery extends into the Orinduik block. A Competent Person's Report, released by Gustavson Associates LLC in March, gave a projected ‘P50 best estimate’ of 597m boe as Eco’s net share in the block.

The company raised $17.4m (£13.7m) via an oversubscribed March placing, so it’s fully funded for this year’s drilling campaign and for at least two more wells in 2020. And it’s in interesting company: Tullow Oil (TLW) is operator and 60 per cent stakeholder, and French major Total SA (Fr:FP) has taken a 25 per cent working interest.

The share price has doubled since the start of the year, but, at 77.5p, it’s still well adrift of target prices provided by Stifel (125p) and Cantor Fitzgerald (110p), but as the former broker warns, it’s essentially a “high risk, high reward play” – and they’re no longer in vogue.

Yet, despite an accelerated rate of attrition, natural resource stocks still account for just under a third of the companies trading on Aim. Of those, around half nestle within the oil and gas sector. London’s junior market had been the preferred destination for undercapitalised oil and gas exploration companies. But the knock-on effects of the global financial crisis, followed by the collapse of Brent crude prices in 2014, put paid to the ambitions of many drillers engaged in the greenfield end of the market.

For junior oil and gas explorers, the ability to raise capital was a relatively straightforward affair when the oil price was pushing $160 a barrel, as it was in the lead-up to the collapse of Lehman Brothers in 2008. Aim's oil exposure had just passed its high-water mark, at least in terms of constituent numbers, hitting 103 in May 2007 against 80 today. It’s telling that their shares were processed through four times as many trades in 2008, while their aggregate value was considerably higher than the 2019 comparative. Aside from relative valuations, this also points to the dilutive effect of corporate actions in the intervening period – 9.23bn shares from the sector changed hands during the first five months of 2008, against 11.3bn shares in the same period this year.

If you needed confirmation that the appetite for higher-risk oil and gas stocks has been on the wane, you need only consider that they constituted 12 of the 25 most actively traded stocks on Aim back in 2008 – that’s now down to three: Hurricane Energy (HUR), Diversified Gas & Oil (DGOC) and Sound Energy (SOU).

Investments in the extractive industries are inherently risky, if for no other reason than their performance is linked to the price of an underlying asset. But the oil majors aren’t wholly dependent on the success of one project. They can drill any number of dry wells without it posing an existential threat to their businesses. Not so junior exploration plays. Investors know this, but might consider some projects worthwhile, at least from a speculative angle, given the heady rates of return on offer. There’s an obvious caveat – the risk/reward dynamic may be apparent when oil prices are surging, but rather less so when the market is in surplus and spare capacity is expanding.

But the ‘risk off’ sentiment on junior oil stocks that has prevailed since the 2014 slump mightn’t last forever, but surging production from the Permian Basin may have lulled us into a false sense of security. Analysts at Wood Mackenzie estimate that projects representing around 27bn barrels of oil and natural gas were cancelled in 2015 – the year after the collapse in crude prices. And an estimated $170bn in capex spending was delayed or cancelled for the period between 2016 and 2020.