The Investment Column: Prospect the oil sector for riches

The surging price of oil to post-gulf war peaks this week has dragged many shares in the exploration and production sector to 52-week highs. The correlation between the two is usually close, but, as our graph shows, even after a good run this year, the explorers have not benefited to the extent previous experience would suggest they should. Two factors help explain the apparent caution surrounding the sector.

Perhaps most important is the outlook for the oil price itself. Its recent surprising strength has been caused by a squeeze on world-wide stocks of oil caused by higher-than-expected demand as a result of severe winter weather in the Northern Hemisphere and a shortfall in forecast production from countries outside the Organisation of Petroleum Exporting Countries cartel. That has resulted in the oil price soaring by more than a quarter since the start of the year, coming within sight of $24 a barrel on Thursday, a price not seen for more than five years.

But analysts remain steadfastly bearish about the prospects for the price for the rest of 1996. The biggest shadow darkening prospects is the return to the international oil market of Iraq, still locked out by the US and Britain for its part in the gulf war. If current talks with the UN prove successful, there could be a limited return of Iraqi supplies, leading eventually to its full restoration to the market.

Even without that threat, however, the consensus view is that the threat of oil supply exceeding production this year is likely to weigh on the price in the second half of 1996. A bounce-back in non-Opec production is expected to match the modest increase in world demand forecast for this year. With Opec production also expected to rise, even without Iraq, the outlook is for a substantial surplus developing during the course of 1996.

The other problem for investors in the exploration sector is that, as our table shows, share prices have nearly all caught up with net asset values. After a disappointing five years, the past 12 months or so have been marked by new signs of life in the sector.

Bid activity lit up share prices last year and observers believe the cycle has not ended. Biggish foreign groups such as Statoil and Talisman, which snapped up Aran and Goal, showed there is a continuing interest in acquiring UK acreage. And with the majors generating plenty of cash, there is no shortage of resources to back acquisitions. But even on fundamental grounds, the explorers have been increasing their own attractions. Lasmo has drastically cut its operating costs over the past few years and the full potential of its big Algerian find is not included in Kleinwort's net asset figures. The Hassi Berkine fields could eventually contain double the 1.5 billion reserves indicated. Even if such hopes prove optimistic, the prospects of a bid should underpin the share price. Its gas interests in Algeria and Indonesia could be highly attractive to a well-capitalised group like Shell. One of the world's leading corporate natural gas producers, Shell is unrepresented in Algeria, one of the world's leading gas producing nations. The wild card is the potential for civil unrest there.

Hardy Oil & Gas is another player attracting interest now that John Walmsley, the respected former finance director of Enterprise Oil, has taken the reins. The shares have responded to efforts by the new team to give more focus to the rather sprawling group spun out of Trafalgar House. But there could be more to come if current prospects live up to expectations.

The results of a third appraisal well on the potentially big Bayu discovery in the Timor Sea are expected within the next few days. Estimates suggest the gas and condensate field could contain 1 billion barrels of oil equivalent.

Another group analysts are warming to is Cairn Energy, whose shares soared earlier this year on hopes for an interesting gas discovery in Bangladesh. The preliminary results announcement on Thursday is expected to bring news of an appraisal well being completed on the Sangu field. If that brings further evidence of a substantial gas find, there could be further significant upside potential in the shares. Apart from the massive latent market of 110 million people in Bangladesh, there is also the prospect of tapping into the nearby Indian market. Such considerations could attract the attention of predators like Occidental or British Gas, keen to establish a presence there.

More speculatively, shares in British Borneo Petroleum have leapt this year, fired by optimism surrounding its deal to develop Shell's Morpeth field in the Gulf of Mexico.

Much of this is "blue sky" potential, however, as the SeaStar tension leg production platform to be used is untried as yet and the field would be marginal using traditional methods.

So after the recent rerating, much of the exploration sector has caught up with events. Given that and the rather cloudy outlook for oil prices this year, stocks should not generally be chased higher. Even so, careful selection by investors could still reap rewards.