Positives of The Last Frontier

EXPLORATION has its risks but can also bring great rewards, a fact which not only drives the oil industry but also seems to Slugcatcher to have been overlooked by most investment bank analysts in their initial reaction to the Alaskan adventure of Oil Search.

    • Slugcatcher
    • 06 November 2017
    • 07:30
    • News
Positives of The Last Frontier

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A bold move it certainly is, but not the bad one which some analysts think it is with Citi's team leading the negative sentiment, cutting its share price forecast for Oil Search from $5.84 to $5.79 while maintaining a sell tip.
 
Most other analysts, including those at Credit Suisse, Morgan Stanley and UBS, have their doubts and retain neutral ratings on Oil Search. Only Deutsche Bank has kept its buy tip and a price forecast of $8.05, a whopping $2.21 higher than Citi.
 
So, what is it that caused most of the money-men sitting on the sidelines of the oil industry to be so concerned about what Oil Search is doing with a $US400 million plunge into the snow-covered slopes of Alaska?
 
The answer to that question boils down to a mix of "new-country" risk, past failures by Oil Search to expand outside its backyard of Papua New Guinea, and a preference for the certainly of investing in LNG expansion versus the challenge of Alaskan oil.
 
There are answers to each of those points but for a newcomer to the deal which was announced last Thursday here's a snapshot.
 
For its $US400 million Oil Search gets a 25.5% interest in the Pikka Unit and a 37.5% interest in the Horseshoe Block, leases on the North Slope of Alaska which are estimated to contain 500 million barrels of oil, and perhaps a lot more.
 
There is also an option to acquire another 25.5% and 37.5% respectively of the Pikka and Horseshoe areas, and an option to acquire similar stakes in adjacent exploration acreage.
 
Other important aspects of the deal include Oil Search funding the 2018-19 appraisal work on the discovery, at a cost of between $25 million and $30 million, as well as assuming the position of project operator from June 1, next year.
 
What it might reasonably asked could go wrong with a deal that has the potential to elevate Oil Search into the ranks of oil producer in a first-world country with what looks to be a tier one asset, neatly complementing the company's gas assets in PNG.
 
Citi, the doubter-in-chief, reckons the deal is "value decretive", as was reported here on Friday. Macquarie is cautious. UBS said it might take time for investors to "warm to the transaction", and Credit Suisse described it as a "surprising strategic move".
 
Understanding where the banks are coming from is actually quite easy because there seems little doubt that they were caught by surprise, and bankers as a breed do not like surprises.
 
A second aspect which helps explain the criticism is that the banks are sticking to their gloomy oil forecasts. Citi, for example, is using a long-term oil price of $US55 a barrel whereas the price has been trending up quite nicely since mid-year with Brent quality crude currently around $62/bbl.
 
A third point is that by launching an Alaskan oil adventure Oil Search has upset the banker's neat spreadsheets which are based on known LNG production volumes, largely understood pricing, and a clear assumption that the PNG LNG project will be expanded because it is performing so well.
 
Then there's a fourth point which even the bank's analysts have to admit is a fact and that's the strong management of Oil Search under its long-term chief executive Peter Botten, an oil man who has got a lot more right, than he has got wrong, and that's quite an achievement in the volatile world of oil, and the sometimes-volatile country of PNG.
 
Rather than taking on more risk for Oil Search what Botten and his management team have done is vary the risk, and possibly lower the risk of the company which is so obviously too dependent on PNG and too dependent on gas.
 
Alaska might be cold but it is a far more predictable location than PNG. Oil too might be more volatile than gas, but it can also be much more profitable.
 
Deutsche Bank, the only major investment bank to like the deal (along with Ord Minnett a Sydney stockbroking firm), reckons the price being paid is fair and while there are risks associated with field development the acquisition, telling clients that the Alaskan investment: "Offers Oil Search diversified development and exploration optionality at an attractive point in the (oil-price) cycle."
 
In a nutshell, that's what is so good about the Alaskan investment. It is at a perfect time in the cycle and it does provide options that Oil Search did not have a few days ago.
 
In time, even the surprised bankers will warm to Alaska.
 

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