Offshore oil or gas platform

7 oil stocks with long-term recovery potential?

Offshore oil or gas platformDisclosure: I have no financial interest in any company mentioned in this article.

This isn’t an article calling the bottom for the oil market — although I do expect this to happen at some point in 2016.

Instead, what I thought I’d do would be to suggest a few small and mid-cap oil stocks which appear to me to be well-positioned to ride out the storm and have attractive fundamentals for a long-term recovery.

This post was prompted by an article I wrote for the Motley Fool last week, in which I commented:

With oil now trading below $28 per barrel, I believe investors looking to invest in oil stocks need to ignore revenue and profit forecasts and focus on assets.

I’m looking for companies with cheap oil and gas reserves and enough cash to ride out the slump. I believe this approach has the potential to deliver big gains when oil prices do recover to more sustainable levels.

That’s the premise for this post. I’m looking for companies with three key qualities:

  • Net cash and minimal debt
  • Low valuations relative to their 2P (proven and probable) oil and gas reserves
  • Low production costs

To help create a short list, I used Stockopedia (disclosure: I work as a freelance writer for Stockopedia) to screen for oil and gas companies with net cash, as this is non-negotiable for me*. With hedging benefits fading away and debt becoming scarce and expensive, any company that may need refinancing in the next 18 months is a non-starter, in my view.

*With one exception, see below!

Here’s the short list of UK-listed companies I came up with. This isn’t a complete list — I manually filtered it to remove obvious junk, micro caps and companies with no significant production:

  • Amerisur Resources
  • Cairn Energy
  • Exillon Energy
  • Faroe Petroleum
  • Genel Energy
  • Ophir Energy
  • SOCO International

This is intended to be a fairly mechanical process. I’m not speculating about any of these firms’ future exploration/appraisal successes nor about their bid potential.

Company EV/2P Production Op. cost/boe Net cash/gross debt Market cap
Amerisur Resources $8.50/bbl 4,524 bopd $16/boe $55.6m/none £184m
Cairn Energy $6.60/boe 0 boepd n/a $603m/undrawn £740m
Exillon Energy $0.36/bbl 15,298 bopd $6.50/bbl $6m/$54m £130m
Faroe Petroleum $2.10/boe c.10,350 boepd $22/boe £81.7m/£21m £117m
Genel Energy $1.55/bbl 75,900 bopd $2/boe Gross cash $455m/Net debt due 2019 $230m £309m
Ophir Energy $7.62/boe 13,400 boepd $7.36/boe Est. 2015 Y/E: $250m/$325m £593m
SOCO International $12.46/boe 12,000 boepd $9.88/boe $96.6m/none £459m

I can’t guarantee the accuracy of these figures: they were compiled after a quick trawl through each company’s latest results/website to gather the relevant information. DYOR.

A few comments:

  • Operating cost/boe are not comparable between companies as they are not all calculated the same way. I’ve relied on company provided data or made my own estimates, but the methodologies vary.
  • Operating cost/boe is not an analog for cash flow breakeven (which is far more important). For example, SOCO says it can achieve operating cash flow breakeven with an oil price in the “low $20s”. Genel says it can breakeven with Brent at $20. Yet both companies have much lower production costs per barrel.
  • Obviously some of these companies have specific political risks. For example Exillon (Russia) and Genel (Kurdistan/Iraq/ISIS). Funnily enough Exillon and Genel are the cheapest two in the list, based on a sum of operating cost/boe and EV/2P.
  • Ophir’s valuation should probably also take into account its 900mmboe of 2C gas resources — but who knows when they will be commercialised or how much equity the firm will give away to fund their development? I suspect this could be a great long-term asset play, though.
  • Cairn doesn’t yet have any production. We also do not really know what the operating costs for its North Sea developments will be when production does start in 2017.

Overall, it’s clear that even some oil companies with strong balance sheets and exceptionally low costs are currently valued very cheaply, relative to their 2P reserves.

I’d hazard a guess that at least some of the companies in the list above will deliver multi-bagging recoveries over the next 2-5 years. But I suspect one or two may not do, or will perhaps be forced to do heavily dilutive fundraisings.

Finally, I’d like to reiterate that these aren’t buy tips and I am not suggesting we’ve seen the bottom. I have no near-term plans to buy these stocks myself, although I do intend to monitor how they perform.

It’s worth remembing that even if we have seen the bottom for oil, it would be unwise to bet on a rapid recovery.  In my view, there’s a strong likelihood that prices will to stay below $50 for an extended time. Certainly I think it’s likely that companies which still have hedging protection, such as Faroe, will see theses hedges expire while oil remains well below $50. This is likely to have a very significant effect on cash flow.

Indeed, I suspect hedging expiries could trigger something of a shakeout among the more indebted North Sea operators, whose costs remain relatively high.

Disclaimer: This article represents the author’s personal opinion only and is not intended as investment advice. Do your own research or seek qualified professional advice before making any trading decisions.

Sale sign

Hargreaves Services acquisition makes good sense for shareholders

Sale signDisclosure: I own shares in Hargreaves Services.

What should shareholders make of Hargreaves Services’ surprise £11.85m acquisition of earthworks and civil engineering firm C A Blackwell Group Ltd? As I’ll explain in a moment, I think this is another astute move from Hargreaves’ management, who I regard highly.

I last wrote about Hargreaves in December when I pointed out that the stock appears significantly undervalued at the moment, thanks to uncertainty about the firm’s future. The gist of my comments were that the shares were valued roughly at their net current asset value, without recognising a further 222p/share of net fixed assets such as land and plant.

What’s new?

Hargreaves needs to replace its coal mining and sales business with something new. The group already has considerable expertise in bulk logisitics, heavy plant operation and mining. Acquisition of a company that specialises in earthworks, civil engineering and mining and quarrying services seems logical, and that’s what Hargreaves has now done.

C A Blackwell appears big enough to make a material difference to Hargreaves’ results and the deal seems to have been cautiously structured.

Deal valuation

Hargreaves will make a net cash payment of £8.5m, of which £5.25m will be held in escrow pending the settlement of certain historic claims and the post-acquisition sale of two investment properties with a book value of £6.5m. Blackwell shareholders will also have transferred to them a £3.35m property at Earls Colne.

The total consideration will thus be up to £11.85m.

Blackwell currently has net debt of £13m and net assets of £13.5m (including the Earls Colne property). This suggests the group is quite heavily geared at present. However, by stripping out the apparently unecessary properties and using them to reduce debt Hargreaves has been able to reduce its cash outlay and de-risk the business.

Once the deal is completed, the underlying enterprise value paid by Hargreaves should be £15.0m, including around £3m of debt.

Blackwell sales and earnings

According to Hargreaves, Blackwell is expected to have generated an operating profit of £3.3m on revenues of £89.0m in 2015. Included within these totals are exceptional operating profit of £1.2m and revenue of £12.2m.

Stripping out these exceptionals, Blackwell appears likely to report an operating margin of 2.7% on revenue of £76.8m. To put this in context, Hargreaves is expected to report revenue of £477m and net profits of £4.6m for its current financial year.

Blackwell’s adjusted EBITDA for the year just ended is expected to be £4.1m, giving an underlying EV/EBITDA entry multiple for Hargreaves of only 3.7. This seems reasonable to me.

Big synergy

One of the biggest fixed assets on Hargreaves’ balance sheet is its fleet of heavy plant. This kind of equipment tends to be difficult to sell in bulk without marking it down. That could be a problem as the wind down of Hargreaves’ coal operations means that much of its plant fleet could become surplus to requirements. Trying to dispose of this quickly could result in big accounting writedowns and might be disappointing in cash terms, too.

Hargreaves’ management implicitly recognised this risk in yesterday’s statement (my emphasis in bold):

The operations of Blackwell are highly complementary to those of Hargreaves in terms of skills, experience and, critically, the equipment that they utilise. In the opinion of the Directors, the integration of Blackwell into Hargreaves creates new and exciting opportunities to deploy one of the largest heavy plant fleets in Europe within a large and well-funded Group.

After averaging down recently, I continue to hold.

Disclaimer: This article represents the author’s personal opinion only and is not intended as investment advice. Do your own research or seek qualified professional advice before making any trading decisions.

Argos logo (copyright Home Retail Group)

I’ve sold Home Retail Group without waiting for an offer

Argos logo (copyright Home Retail Group)Disclosure: I have no financial interest in any company mentioned in this article.

Earlier today, I sold my holding in Home Retail Group for just short of 140p.

The result is a 31% profit in about six weeks. It’s a little short of the 150p I was originally targeting and my move — before any firm offer has been made — may end up being premature.

However, this week’s news that Sainsbury made an unsuccessful offer for Home Retail in November and the subsequent share price rise caused me to look again at this situation.

I decided to sell for three reasons.

1. Is a SBRY/HOME combo going to win investor backing?

I’m not convinced that having Sainsbury buy Home Retail is a very smart deal, for reasons eloquently explained in this FT Alphaville blog post (registration required). In short, there seems to be a demographic mismatch between the two firms’ customers and their brand images. The operational and financial success of what would be a fairly challenging deal isn’t certain, either.

Opinion among Sainsbury shareholders and City analysts appears to be pretty mixed, at best. Although an improved offer is possible — and of course another bidder might enter the fray — it isn’t a foregone conclusion.

2. Argos/Homebase outlook uncertain

We don’t yet know what kind of trading Home Retail will report for the Christmas period.

Homebase does appear to be something of a burden. My impression from a brief visit to an Argos store just before Christmas was that the store chain’s modernisation still has some way to go, although in fairness I have not tested out their website/same-day delivery proposition. This is at the core of the firm’s plan to reinvent itself.

3. Value largely outed?

Despite the reservations above, I stand by the value case for my original buy (albeit with a caveat about Home Retail’s lease commitments of c.£333m/year).

But at 140p, the scale of the opportunity is now greatly reduced. There may be another offer — I suppose 160p-ish is possible and probably reasonable. However, I don’t think this smaller upside potential is worth the risk of a disappointment, so I have banked a quick profit instead.

Ultimately, I’m not a massive fan of the Home Retail business, so my investment was based on the potential for the obvious value to out, hopefully in a bid situation.

That’s now happened and given the uncertain outlook for UK retailers and Argos/Homebase in particular, I’m happy to bank a partial success rather than risk a defeat.

Disclaimer: This article represents the author’s personal opinion only and is not intended as investment advice. Do your own research or seek qualified professional advice before making any trading decisions.

A tunnel in a deep mine

Is Lonmin becoming a contrarian buy?

A tunnel in a deep mineDisclosure: At the time of writing,I do not own shares in Lonmin.

So the dust has settled and Lonmin shares now trade at just over half their theoretical ex-rights value of 1.2p, or 120p after taking into account this week’s 100:1 share consolidation.

I promised to take another look at the stock after the rights issue was completed, so here goes.

Book value trap

It’s tempting to say that because Lonmin now trades on a price/book ratio of about 0.2 and has very little debt, it must be a bargain.

The problem is that the book value of the firm’s mines and platinum reserves is dependent on their commercial viability. If Lonmin can’t find a way of making money from its mines (or persuade someone else to buy them) then they are potentially worthless.

Thus the firm’s massive discount to book value, while relevant, is not a standalone reason to invest, in my opinion.

What I’ve done instead is to consider what’s changed since the last time Lonmin reported a profit, which was in 2013. In that year the firm reported a post-tax profit of $166m. At today’s share price, this would equate to a P/E of 1.2! I’d argue that a sustainable profit of even one-tenth this amount would be enough to justify the current share price.

Can Lonmin make a profit again?

Leaving aside the strike-related disruption Lonmin has experienced since 2013, there are three main variables which govern the firm’s profitability (or that of any mining firm, come to that):

  • Foreign exchange rates — commodities are generally sold in USD but production costs are paid in local currencies, in this case ZAR (South African Rand);
  • Commodity prices — the price of platinum group metals;
  • Operating costs, principally labour and energy. Labour costs are paid in local currency, but energy may be either or a mixture. For the purposes of this discussion, I’ve included factors such as ore grades within operating costs — after all, the cost of producing metal tends to rise and fall with ore grades.

Currency effects

Emerging market currencies have tended to weaken against the US dollar over the last few years. The South African rand is no exception and the exchange rate has changed significantly (figures taken from Lonmin’s reported full-year averages for y/e 30 September):

  • 2013: ZAR/USD = 9.24:1
  • 2014: ZAR/USD = 10.55:1
  • 2015: ZAR/USD = 12.0:1
  • Today: ZAR/USD is currently c.15:1

In other words, $1,000 of platinum sales in 2013 generated ZAR9,240.

Today, it would only require $616 of platinum to generate revenue of ZAR9,240.

Platinum price

Platinum isn’t mined in isolation — miners such as Lonmin typically produce platinum group metals (PGM). These are platinum, palladium and rhodium. Lonmin typically focuses on the PGM basket price in its reporting, rather than simply the price of platinum.

Here’s how the PGM basket price has changed over the last three years:

  • 2013: $1,100/oz
  • 2014: $1,013/oz
  • 2015: $849/oz

However, when the effect of the ZAR/USD exchange rate is included, the average PGM basket price has remained much more stable:

  • 2013: ZAR10,614/oz
  • 2014: ZAR10,687/oz
  • 2015: ZAR10,188/oz

The improving exchange rate wasn’t enough to offset falling PGM prices in 2015. But whereas the USD PGM basket price fell by 16% in 2015, the ZAR value of the PGM basket only fell by 5%.

But here’s the interesting bit…

In late December 2015, the USD prices of platinum and palladium are about 20% lower than the averages reported by Lonmin for last year. If we assume that the group is working with a PGM basket value around 20% lower than last year, this works out at about $680/PGM oz.

However, the exchange rate has also changed. As I write, the rate is about 15.1:1. This gives a PGM basket price of about ZAR10,200. In other words, exactly the same as last year.

What about costs?

The final factor in our trio of variables is costs. Lonmin’s old, deep platinum mines are notoriously labour-intensive and costly (and dangerous) to mine. As a result of the industrial unrest over the last couple of years, Lonmin has, like most other South African deep miners, increased pay rates for mine workers. (Deservedly, in my view).

However, the firm has also reduced the workforce and announced plans to shut various shafts to focus production on the lowest-cost areas of its mines.

The most sensible way of viewing costs is probably to consider Lonmin’s reported production costs for the 2015 financial year, which were ZAR10,339 per PGM ounce. At the current exchange rate, that’s $684 per PGM ounce.

This suggests to me that the price of PGM metals would only have to improve by a small amount to enable Lonmin to breakeven at an operating cash flow level.

Unit costs are expected to be relatively flat at c.ZAR10,400 until 2018. However, the firm also that it is targeting workforce and overhead reductions of ZAR700m in 2016 and of ZAR1,600m in 2017, which could help achieve breakeven.

What could go wrong?

This article is getting quite long, so I’ve condensed this section into a list. These are all known unknowns, in my view — risks that investors have little way of quantifying:

  • The exchange rate could move against Lonmin
  • Further industrial unrest
  • What is the state of global PGM stockpiles?
  • How healthy is platinum/PGM demand?
  • How will PGM prices move from here?

Clearly there are risks, but it seems to me that Lonmin has a reasonable chance of getting into a situation where it can breakeven and generate a modest profit. In my opinion, such proof of the firm’s viability might be enough to trigger a substantial rise in the share price.

Although I think Lonmin remains risky, I also think the platinum sector may be moving into contrarian territory. I am considering a small buy.

Disclaimer: This article represents the author’s personal opinion only and is not intended as investment advice. Do your own research or seek qualified professional advice before making any trading decisions.

Sale sign

How much is Hargreaves Services really worth?

Sale signDisclosure: I own shares in Hargreaves Services.

What do you call a company that trades on the following valuation?

  • 1.6 times trailing free cash flow
  • 0.64 times its tangible book value
  • Net cash of 109p per share versus a share price of 280p

I suspect many people would say it looks too good to be true and is thus a sell. That view may turn out to be correct, but this isn’t a China fraud, it’s a well-run and reputable UK company.

Shares in Hargreaves Services have fallen since I bought mine, but I averaged down earlier this week on the basis of the firm’s solid value credentials and asset backing, which I hope will generate a return from current levels.

Good or bad assets?

A discount to book value is all very well, but in a situation such as this one, where the firm’s core coal business is in structural decline, it can be a trap. Are the asset values on Hargreaves’ balance sheet realistic and obtainable?

Here’s a quick overview based on the firm’s most recent accounts:

  • Net cash (inc. netting off receivables and payables): £34.7m (109p/share)
  • Net current assets: £88.0m (275p/share)
  • Net fixed assets: £70.7m (222p/share)

The big appeal here, in my view, is that net current assets are roughly equivalent to the current share price. Net current assets in this case are a mixture of cash and inventories. Although the inventories (mainly coal and related products) might be worth slightly less than at the end of May, they should still be convertible to cash.

You might argue that this is an appropriate valuation, given the bleak future for Hargreaves’ mines. Yet the firm has substantial land assets too, which it hopes to use for renewable and property development projects. The current share price does not assign any potential value to the firm’s land and property, despite the balance sheet showing net fixed assets worth £70m.

Hargreaves book value is currently 461p per share. I don’t expect my investment to yield this kind of return but I do believe there is scope to realise significantly more than the current share price.

Other attractions

There are a couple of other reasons I’m keen on Hargreaves Services. The firm’s management, led by chief executive Gordon Banham (who has a 7.1% shareholding) has consistently impressed me with the way it has managed the decline of the group’s main business.

The board seems to have taken an objective and realistic approach and appears to have been quite transparent in its communications with investors. Cash generation has been excellent and net debt has been eliminated, leaving a strong balance sheet.

Hargreaves also benefits from significant institutional backing. The firm’s largest shareholder, Schroders, has increased its holding from 10% to 18% so far this year, while BNY Mellon has expanded its shareholding to more than 10%.

Disclaimer: This article represents the author’s personal opinion only and is not intended as investment advice. Do your own research or seek qualified professional advice before making any trading decisions.