Small-cap oil stocks offer better prospects than their large-cap counterparts and can be less risky than many investors think, according to Paul Mumford, manager of the TM Cavendish Opportunities fund.
The veteran fund manager remains optimistic on the prospects of oil stocks despite a sharp decline in the price of Brent crude over the past five years caused by oversupply issues and lower demand due to technological advances.
Indeed, as the below shows, the Brent crude oil price slumped in 2014 and, despite a bounce-back throughout 2016, remains 53.63 per cent lower than five years ago.
Performance of oil over 5yrs
Source: FE Analytics
But Mumford remains positive and suggests oversupply issues could be a net-positive for some of the UK oil minnows he invests in.
“The big advantage of the drop in oil prices is that the costs will also decrease so consequently a lot of the smaller oil companies have brought their production costs down to $23 per barrel and even at $50 per barrel they are making decent returns from production,” he said.
“At the moment I think if you get the overproduction pushing the oil price down that is actually quite bullish on the basis that I think OPEC (Organisation of the Petroleum Exporting countries) may be forced to cut production once more; it is also in the interest of the Saudis to get the state oil company away and they won’t want to do that with a falling oil price.”
He added: “Over the longer term I think prices will move higher and I take a five- or 10-year view.
“The idea with value is to buy into these things when they’re cheap and sell them when they get expensive and I think there are some great bargains around the place.”
He said investors looking to buy into the space have four options. The first option includes out-and-out explorers which have no production and are banking on making a transformative find.
The next segment includes US shale companies which are focused mainly on cashflow: the more holes they can drill the more production increases and the more income they can earn.
Mumford (pictured) said: “Then you’ve got the exploration companies with production which are the ones I am quite keen on where the production cashflow generally helps to finance operations. 
“The reason I quite like those is if you get one reasonably-sized find it can be completely transformational to a company of that size.”
The fourth type of company is large caps, such as BP and Shell, which he says are suitable for larger funds that are unable to invest in smaller companies, particularly those with an income bias.
He said: “Now BP and Shell in a portfolio is probably not a bad thing if the share price doesn’t do much because the income yield will probably pay for some part of the performance.
“If you are buying them on a 5 or 6 per cent yield or whatever it is and the price doesn’t move then at least you have that amount of performance in the portfolio. However, you are unlikely to find the ‘tenbaggers’ which is where I’m sort of looking.”
Tenbaggers is a term used for those companies that investors can make returns of more than 10 times over the course of their investment.
The manager said: “One of the reasons for this is because you would need to have a very significant find in order to make a difference to a large oil company and they also have to find significant amounts of oil on the basis that they are using up reserves so quickly so they have to replenish them.
“You are almost on a treadmill looking for the major finds and then you get into the more expensive areas like deep water.”
Meanwhile, smaller companies with some cashflow are in a good position as they have cash on the balance sheet while also only needing one big discovery to be transformational to the business.
However, this is not fool-proof, with the manger noting that last year he had a couple of companies in the portfolio go “belly-up”.
“Some of these have got quite highly geared in the past and I’ve had a couple that have gone belly-up and I’m not afraid to admit it,” he said.
“I think a portfolio should have a big spread of stocks and if I were gambling on a few 5 per cent holdings and one or two of those went wrong then I would suffer in terms of performance.”
Both companies – Circle Oil and Xcite Energy – fell into issues with their debtholders, though Mumford said this should never have happened, with the low oil price likely affecting their decision.
“Circle Oil, which had production, had the loans in due and could pay the interest but the loan stockholders wanted their capital back,” he said.
“Xcite owned the Bentley field in the North Sea which was quite an attractive proposition but they couldn’t refinance their loans and consequently the loanholders pulled the plug.”
Yet, Mumford remains undeterred.
“I think personally that where you’re in oil & gas and you have hopefully a cashflow from some of these companies then it is a much less risky area than something like biotech which is another areas where you can get tenbaggers but you are likely to get many more mistakes,” he said.
He noted that conditions this year have improved as the oil price has rebounded from its very low levels, giving hope for a new run in the sector.
Mumford invests mainly in the North Sea, as he said “there is less political risk and the sector is completely unloved because the oil price hasn’t looked good”.
His £151m Cavendish Opportunities fund is 12.4 per cent invested in the energy sector, with EnQuest his largest holdings at 3.3 per cent.
“EnQuest is a highly geared oil company but has a couple of fields which will give it a big boost in production that will reduce the borrowing costs quite significantly,” he said.
Performance of oil stocks over 1yr
Source: FE Analytics
He also owns two “well-funded companies” that have net cash in the balance sheet in Faroe Petroleum and Cairn Energy.
Mumford said: “Faroe Petroleum is one of the largest licence-holders in the Norwegian part of the North Sea and the great thing about this is that 80 per cent of the drilling costs are paid by government once the wells have been drilled.
“It is very difficult to get licences because of this government rebate that you are getting and you have to be on the approved list so once you’re there you can farm out other oil companies and you’re drilling costs are greatly reduced.”
Meanwhile, Cairn Energy, which is larger than the other two companies, is also based in the North Sea and has a “very strong balance sheet”, the manager said.
His fund has been a top quartile performer over five and 10 years, returning 133.68 per cent over the last decade.
Performance of fund vs sector and benchmark over 10yrs
Source: FE Analytics
The fund has a yield of 1.4 per cent and a clean ongoing charges figure of 0.81 per cent.