Questor share tip: Falkland Oil jumps ahead of drilling

Falkland Oil and Gas
30.9p+1p
Questor says BUY

FALKLAND Oil and Gas [LON:FOGL] shares have jumped almost 10pc over the past two days as investors focus on the potential of a major oil discovery from a fresh drilling campaign set to begin in the first half of next year.

Six new wells are scheduled in 2015 and this will mark the first new exploration activity in the region for more than two years. Falkland Oil and Gas announced the drilling contract in June; the Eirik Raude rig is currently 300 miles (260 nautical miles) off the Cape of Good Hope and steaming towards the Falkland Islands.

The floating rig will drill in six sites. Two wells in the North Falkland Basin (operated by Premier Oil) followed by two wells in the South & East Falkland basin operated by Noble Energy (not listed) and then a further two Premier-operated wells in the North Falkland Basin. Falkland Oil & Gas has interests in five of the wells ranging from 40pc to 52.5pc. The whole operation will take about 240 days.

Analysts from broker Peel Hunt estimate the drilling programme could be worth a total of 48p per share to Falkland Oil and Gas when adjusted for the chance of failures. However, in the event of success with their wells, the upside for all of the 5 prospects rises considerably to 277p per share.

The Falkland Islands have not been a happy hunting ground for oil companies in recent years. The initial enthusiasm about the hydrocarbon potential in the region has been somewhat tempered after a series of failures. Falkland Oil and Gas had disappointments at two major prospects in 2012 called Loligo and Scotia. Neither site was found to have commercially viable reserves of the black stuff and the company’s shares have gone sideways ever since.

At about 31p yesterday, the shares are down more than 80pc from early 2010 when they traded at 150p. The problem is that there is only limited drilling kit around the world and demand is high with oil above $100 (£60) per barrel. And the Falkland Islands are a long way from anywhere else. It is much easier to secure funding for drilling projects in the North Sea or to explore prospects in Asia. Oil discoveries in these regions also occur at less extreme depths and closer to oil infrastructure than those in the South Atlantic.

Even when oil is discovered near the Falkland Islands, extracting it cheaply enough to make the enterprise worthwhile is still a tough ask. Rockhopper Exploration and Premier Oil are the only explorers to have found viable reserves off the Falkland Islands at the Sea Lion discovery.

Premier plans to cut its 60pc stake in the Sea Lion by half within six to nine months. The company and its partner Rockhopper Exploration are designing the project, negotiating with potential contractors, and plan further exploration in the area before making the final investment decision around the middle of 2015. The project will probably require about $5bn.

Make no mistake, backing oil exploration off the Falkland Islands remains about as high risk as investing can get. That said, with Brent Crude at $102 per barrel it could still make sense – just.

The shares in the sector are also totally bombed out after the disappointments from two years ago. With a catalyst for potential rises once again on the horizon they are worth considering.

Falkland Oil and Gas is trading at about 31p and investors are only really paying for the $151.4m in cash, or 28p per share, on the balance sheet, though admittedly between $70m and $80m of that cash will be required for the next round of drilling, which is now fully funded. The key dates for investors will be Premier Oil’s sale of its Sea Lion stake; they should watch out for any oil majors buying into the drilling programme ahead of next year.

This is highly speculative but Questor retains a buy.