This is counter-intuitive, especially as the futures market for oil are in sharp contango pricing near-term forward deliveries of oil at a large premium.The situation demonstrates, once again, how the world’s financial trading is highly correlated among various asset classes, in certain instances disregarding fundamental macro-indicators.
The recent weakness in oil prices has appeared in the last three to four months, a period during which the US dollar gained strength as a reserve currency.
It followed the European Central Bank’s announcement of new quantitative easing measures and a drop in the euro and sterling’s weakness in the face of the Scottish vote for independence.
A strong dollar has historically been negative for commodities but such a dramatic fall in the prices of industrial metals as well as oil appears overdone.
Performance of index over 3 months
Source: FE Analytics
Demand for iron ore, copper and other industrial commodities has, in the last 20 years, been dominated by Chinese growth.
As China transformed its economy with a rapid industrialisation and urbanisation, its demand for base resources was voracious.
During this period China became the largest importer of oil in the world.
With recent indications that Chinese economic growth has slowed to between 6-7 per cent per annum, after decades of 9-10 per cent growth rates, the market became concerned that the super-cycle of commodities demand might have ended.
I believe that the current demand picture points to a short-term adjustment process. With an over-heated property market and shadow lending based on commodities as collateral, the Chinese authorities have been tightening regulation.
This is likely to have resulted in a rapid draw-down of inventories, reducing new orders thus putting short-term prices under pressure.
After decades of consistently rapid growth, the Chinese economy is more than double its size it was at the turn of the century. More importantly, it has developed its own affluent middle class that demands a higher standard of living.
According to the IMF, China is now the major driver of global economic growth. It also continues to develop its infrastructure to support urbanisation and it is likely to demand more base commodities and energy well into the next decade.
Once we get comfortable with the longer-term picture for demand of oil and discount the recent drop in price as a short-term situation, we cannot ignore the state of the equities market.
Oil and gas explorers and producers have been decimated in the last three months.
Smaller companies shares have been sold-off regardless of fundamentals and the AIM Oil & Gas index, comprising 114 constituents, now trades over 55 per cent lower than its peak in April 2011.
In our analysis of average multiples in price to cash flow and price to NAV, the smaller sector now trades at the lowest levels seen over the last eight years except during the financial crisis of 2008. We must therefore look for the best medium-term value.
We believe that such outstanding value exists among smaller companies with a) discovered, economically viable resources in safe political territories; b) rapid production growth expectations; c) experienced and successful management teams able to control development costs; and d) balance sheet strength providing stability during prolonged weakness in the capital markets.
Among the core holdings in the Junior Oils Trust, which I advise, I would single out three as outstanding opportunities in the current market:
1. Parkmead Group, headed by Tom Cross, is probably among the most under-valued in the London market.
At a market capitalisation of about £150m, its investors get about £50m in cash, just under 2,000 barrels per day of oil production and a strong portfolio of development prospects in the North Sea.
The company is likely to enter into commercial agreements with other operators for drilling its prospects efficiently and its management specialise on taking advantage of distressed sales in the sector.
The current market conditions are likely to offer very attractive deals that will be highly accretive in the future.
2. Caza Oil & Gas, a long-term holding of ours, has been delivering excellent results from its Bone Spring operations in New Mexico.
Its annual production has now grown to about 2,000 barrels per day, a level believed to be attractive to larger oil companies.
Caza’s acreage has the potential to drill over 300 wells with relatively low development risk.
A larger company with access to capital resources is likely to find this attractive and the deals executed in similar situations would justify a large premium on the current share price.
With recent re-financing of its facilities and a capital raise, Caza is well positioned to continue its growth in production and cashflow.
3. Circle Oil, also a large holding in JOT. Its recent discovery of oil in the Mahdia permit offshore Tunisia was possibly misunderstood by the market. The well confirmed the presence of a large petroleum system.
Technical problems prevented a precise assessment of likely volumes but the early indication of approximately 100 million barrels is very material for the company.
Positive appraisal could determine the field as the most important discovery in Tunisia and the company is wisely looking to farm-out this development risk to larger players.
Circle Oil benefits from approximately 4,600 barrels of oil production from its Egyptian operations where the receivables from the Egyptian National Oil Company have been improving steadily.
In Morocco, production has grown to between 6-7 million cubic feet of gas per day and the on-going drilling performance has been exceptional.
In Oman, there is attractive potential for a farm-out deal as well as new license awards.
Despite the unrest in North Africa during the last three years, Circle Oil’s operations have not been disrupted.
Angelos Damaskos is an investment adviser on Junior Oils Trust. The views expressed above are his own.
