AIM oil & gas companies: a ‘small craft advisory

As I understand it, a ‘small craft advisory’ is a type of warning issued by the National Weather Service in the USA, most frequently in coastal areas, when winds have reached, or are expected to reach within 12 hours, a speed marginally less that that which is considered gale force. The sign denoting a small craft advisory is one red, triangular flag; two such flags, one placed above the other, signify a gale warning. The National Weather Service does not specify what constitutes a “small craft”, although the US Coast Guard informally assigns the designation to boats with a total length of less than 33 feet.

Perhaps you’ve already guessed where I’m going with this – in the oil & gas business, AIM-quoted companies are “small craft” and the wind has got up, and is now blowing a full gale or worse. Hunkered down safely with their PCs or Blackberries, many investors hear and see the “storm” and debate on the Discussion Boards – or maybe at the Chiswell St Vaults – the hoped-for appearance of a predator to swallow up their beleaguered investment choice.

Now one of the problems with the AIM sector is that there is a shortage of advice that can be considered truly independent. However, my ex-colleagues at Richmond Energy Partners (REP: www.richmondep.com) have for the last 3 years been filling that gap by analysing the 90+ oil & gas companies now found on AIM and their conclusions may be found in several interesting reviews available as Downloads on their web-site. The difficulty with AIM companies is that whereas it’s possible to value companies that have an established performance ‘track record’, for example the Major Integrated Oils and the US and UK Independents, the conventional “top down” approach fails with AIM companies as one is more often than not listening to optimistic management teams talking about, by and large, unproven resources. Thus cross-plots of say market capitalization against 2P reserves, or valuation of exploration via neat but superficial stories about a famed baseball batter’s (Ted Williams) “three rules to hit by”, fail. What’s needed is a “bottom-up” approach that addresses the quality of the assets and also the ‘track record’ of the individuals in the management team. After all, we listen to Ted Williams’s views on ‘swinging at good and bad pitches’ because he had an incredible life-time ERA, just as we listened hard to Sir Donald Bradman’s views on batting, and new batsmen, mainly because he had a test average of just less than 100!

What is clear is that only a small percentage of AIM companies – perhaps as few as 10% - are truly successful; perhaps as an aid to avoiding the other “90%”, REP offer some Lessons Learned for Investors:
• Verify the management team is functional, coherent and fit-for-purpose
• Beware of hype and wishful thinking
• Verify that corporate governance is effective
• Get an independent expert view on the technical and commercial aspects of the assets
• Use analogue and peer comparisons to sense check volumes and values
• Take inability to secure debt financing for a development as a warning signal.

It’s worth spending a few moments on this latter point as of course one component of the current “storm” is a shortage of debt finance and so it might be argued that a failure to secure financing is a not in fact a fair warning signal. I disagree! In my humble opinion, the reality is that good management teams with good ideas and/or sound assets will still be funded - in contrast, there are some “small craft” out there that should not be boarded, whatever the weather!

If these Lessons can be Learned, then it’s possible to pick a “winner”; as REP points out, the best-performing 30 smaller international exploration companies can in principle be ‘consolidated’ into a single company which is the size of say BG and has increased its production significantly faster than its larger counterparts. However, this is a ‘virtual armada’; individually each of these “small craft” have significantly lower profitability than their larger peers (due to lower revenue per barrel) and a higher cost base (particularly capital costs and overheads). They are vulnerable and suffering in the present “storm” and at first sight actual consolidation by predatorial acquisition seems inevitable but one wonders by whom? It’s difficult to see super-tankers like a Shell, an ExxonMobil, a BP or even a Statoil ‘hoovering-up’ 30 or so “small craft”, or even 10, despite the fact they undoubtedly have the cash to do it. Once one drops outside the ranks of the Major Integrated Oils and the large US and UK Independents, then debt financing may be needed to fund the acquisitions and this may be hard to come by.

This suggest to me that the oil & gas investor, especially the private one, may be best to ride out the current “storm” in the safe harbour provided by one or more of the Majors or larger Independents. When this storm has passed, “small craft” both deserving and undeserving of their fate may have simply disappeared - think of XL, Zoom, SilverJet.