Financial Times: Buoyant E&P sector “Shell has a particular problem at the moment. It is running out of oil in the ground and has lost a chairman and faced public humiliation following surprise cuts in its oil reserve estimates earlier this year.” (ShellNews.net)

Posted 28 August 04

From Antrim Energy, through Cairn Energy and Paladin Resources, to Tullow Oil and Venture Production, the 20 oil and gas exploration and production companies that represent about 97 per cent of the sector by capitalisation have increased in value by an average of about 70 per cent this year.

And the superlatives do not stop there. Canaccord Capital analyst Charlie Sharp points out that the E&P (exploration and production) index has outperformed the FTSE All-Share consistently over the past five years.

Mr Sharp is beginning to worry that the sector's chart is reminiscent of the TMT rally in the late 1990s, pointing to the possibility of a correction.

The problem is not so much chronic overvaluation. What is really worrying is the speed with which the E&P index has rushed up to levels not seen since 1990.

At the start of the year, the E&P index was trading well below its peak relative to the FTSE All-Share, hit in 1990, when a correction took hold. It has taken only a little more than six months to retrace those highs and fundamentals must now be readdressed.

Clearly the rise in crude oil prices lies behind the E&P stocks' meteoric rise. The shares may be underpinned by current record highs, but the E&P sector is one in which a lot of money can be lost very quickly. For example, Ramco Energy fell 30 per cent in a day recently after the Aberdeen-based company delayed a report on its troubled Seven Heads gas field in the Celtic Sea.

Continuing fears over the security of Middle Eastern supplies have also prompted renewed interest in potential oilfields outside the Organisation of Petroleum Exporting Countries regions.

In May, Tullow Oil paid £320m to acquire Energy Africa, which has assets that will complement the company's mainly UK-based interests. And Cairn Energy famously struck 1.1bn barrels of crude oil under the sand in Rajasthan, India, from a licence bought from Shell for just £11m.

Shares in Cairn Energy have more than trebled this year, yet most analysts say there is still a lot more to play for.

The company has a sizeable acreage to explore, its technical team is highly regarded, with a notably consistent success rate to date, and Bill Gammell, chief executive, has put his money where his mouth is. The former Scottish rugby international has recently bought more shares in the company.

Like almost every other broker, Canaccord Capital rates Cairn Energy highly. The broker also says there is plenty of potential positive newsflow to lift First Calgary, which has discovered oil and gas in Algeria. But it recommends selling Burren Energy, Paladin Resources and Regal Petroleum, which it sees as most exposed to the possibility of an E&P sector correction.

It must be stressed, however, that with the crude oil price set to remain high, any correction looks unlikely to be as severe as the one that rocked the TMT sector.

There is also bid speculation. Cairn Energy and Tullow Oil are getting to the stage where they could register on the radar of the oil majors. Historically, the bigger the mid-cap E&P companies get, the more attractive takeover targets they become.

Shell has a particular problem at the moment. It is running out of oil in the ground and has lost a chairman and faced public humiliation following surprise cuts in its oil reserve estimates earlier this year.

It remains to be seen whether Shell would be prepared to face the further humiliation of paying more than £2.5bn to buy Cairn and get back the Rajasthan field, which it sold for a pittance. But the issue is part and parcel of the market's refocus on the oil majors.

BP and Shell are traditional “haven” investments. Their shares outperform the FTSE All-Share when the broader market is falling and underperform the index when it is rising.

Last year was disappointing for BP and Shell. But with the FTSE All-Share on the slide, BP at least has been a good investment this year. While the All-Share has fallen by 3 per cent, BP has risen about 10 per cent since the start of the year. And although Shell is down about 5 per cent, this is not a bad performance given that it suffered a 7.5 per cent fall in one day in January when it owned up to its reserves problem.

With the equity market looking flat at best, it would be wise to remember “major oil”. Do not be totally seduced by the giddy heights of the E&P sector, where a correction is overdue and investment decisions will have to become more selective.michael.neill@ft.com