Future of oil production favours the small

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Commodities - May 2013

The resources sector was hit hard in early April by reports of slowing Chinese growth.

At the time of writing the oil price is trading just below $100 per barrel – the level that Saudi Arabia has stated it wishes to defend.

In the meantime, the International Energy Agency has increased its forecasts for demand growth and data indicates that crude oil inventories declined by roughly 6m barrels year on year.

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While the fundamentals point to higher oil prices, short-term sentiment has pushed prices lower. This, however, is unlikely to last and the price of Brent will head to $120 a barrel before long.

Smaller oil shares appear to have found support in the year to date, exhibiting lower volatility compared to recent years. Weak holders have come out of the sector, with current registers populated by investors who are attracted by fundamentals and the deep undervaluation of listed oil companies.

Well-capitalised smaller companies, with active exploration programmes that could add significantly to reserves, have survived the past two ‘bear market’ years and are likely to benefit first from a re-rating in the near future. The scarcity of capital-inhibiting exploration programmes has meant that earlier-stage plays, which keep burning through their cash reserves, are near failure.

Most are looking for farm-ins or an acquisition by cash-rich large producers, but deals naturally favour those with assets that have a proven record. Consolidation in the sector is likely to persist.

The North Sea continues to be an exciting place for smaller operators. New finds, such as the North Uist discovery, west of the Shetlands, where Faroe Petroleum is involved, are notable. The use of existing infrastructure in many parts of the region also reduces the costs of production considerably.

The tax regime, after much deliberation, is supportive of new investment and there is healthy corporate activity. The political stability, higher margins and the high activity levels in the region is likely to deliver superior returns in the medium term.

Angelos Damaskos is chief executive officer of Sector Investment Managers