Investment View: Falklands factor looks like a good deal for Premier

Premier Oil. Our View: Hold. Price 361.8p (-6.5p)

If investor reaction is anything to go by, Premier Oil got itself a good deal on Thursday when it bought into the only commercially viable source of hydrocarbons to be discovered so far off the potentially lucrative coastline of the Falkland Islands.

Shares in the FTSE 100 oil group jumped by 3 per cent on the day, while Rockhopper Exploration – the far smaller company at the other end of the Premier deal – tumbled by 9 per cent.

The agreement, for what the market has indicated is a decent price, sees Premier take a 60 per cent stake in the Sea Lion discovery for about $1bn (£643m).

This will be transformational for the group, with its share of the estimated 320 million barrels of oil the Sea Lion field contains expected to add about 50,000 barrels of day to its current output of 60,000 after production begins in 2017.

Furthermore, because the deal gives Premier 60 per cent of all Rockhopper's licences in the North Falkland basin – not just the scene-stealing Sea Lion discovery – it is quite likely that the company could strike further black gold in nearby prospects such as the Casper and Casper South fields.

Premier indicated that financing the transaction wouldn't be a problem, saying that it would be funded out of its cash reserves and existing banking facilities and cashflow from operations.

However, as Premier Oil boss Simon Lockett himself admitted as he announced the deal, it is not without its risks.

Buenos Aires has stepped up its claim to sovereignty over the Falkland Islands in recent months, and is threatening legal action against any foreign company operating in its waters.

While few analysts believe that the threats will come to anything, the dispute is nonetheless a blot on the landscape.

There are also some geographical concerns around the region, which is remote, virgin hydrocarbon production territory, with uncertain development costs.

The nearest drilling rigs are based in South America and have to be dragged across to the Falklands at substantial cost, while the crude is complex and waxy, making it harder to refine.

Some analysts saw the deal as a clear sign that Premier is starting to "bulk up" and to fulfil the potential of its well-respected management team. But others are disappointed with Premier's Falkland acquisition, saying the group should be concentrating its resources on developing the assets it already has, with its interests in the North Sea and Indonesia – which are already producing oil – showing particular promise. The company also has interests in the Middle East, Africa and Pakistan.

Premier's purchase of Encore Oil last October bulked up its presence in the North Sea, taking its share in the key Catcher field to 50 per cent and giving it the operator's role. Furthermore, Premier calculated that the expansion of small field allowances in March's Budget by the Chancellor, George Osborne, will give it about £63m in tax relief in fields it was likely to have proceeded with anyway – so it seems to be sitting pretty in that department as well.

Opponents to the Falkland deal would also like to see Premier – which is soon expected to begin paying a "token" dividend – returning more of the cash it is generating to its patient share-holders, rather than pouring it into new projects in the Falklands.

Although Premier has already committed about $1bn to the Falklands through its deal with Rockhopper, its total investment in the project is likely to be a lot higher.

Getting to first oil at the Sea Lion prospect – which will only generate cash flow in 2017 – is estimated to cost between $2bn and $3bn – most of which will be borne by Premier. That's a lot for a company with a market cap of about $3bn.

But, despite these misgivings, Premier looks to be in good shape – even if the company's shareholders are going to have to wait a bit longer for a pay-out that, as a result of the Falklands transaction, just became a little less likely but potentially much bigger. Hold.

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