There have been a couple of interesting posts in the pub over the past few days which have suggested that oil shares are a “bandwagon” or “bubble” from which “sensible” investors should steer clear. No evidence is actually cited for this “bubble” save that on TMF, there are a number of people who specialise in that sector and some of the shares in the sector have risen over the last year or so. I want to make the argument that far from there being a bubble in this sector, that we are witnessing only the very early stages in a growth period in oil shares. This post is for paulypilot and others (yes you Kevin) who might be interested in broadening their knowledge a little.

My interest in oil is relatively recent and I should say that there are many more knowledgeable posters than me out there. However, it might be that my lack of deep understanding is a positive bonus because if I can explain in a basic way why I am interested in oil, perhaps that might motivate others to take the reasonably small amount of trouble to get to know the basics of the industry.

Ask yourself, what will be the next boom sector? Where is there increasing demand?

I first became interested in shares in latter stages of the 90s, around about the time that Alan Greenspan said that there was “irrational exuberance” in the market. I remember lamenting to a friend of mine who was a share expert that I had “missed the boat” on tech shares. He strongly disagreed with me but I didn't listen to him and to this day I have never bought a “tech” share. In my view, many investors adopt a “rear-view mirror” investing approach whereby they constantly look at the last bubble and try to invest in stocks which are past their peak rather than taking the time and trouble to think what might be the next boom sector. Its harder to think ahead than look back and many people don't bother.

So why do I think that oil (and commodities in general) are likely to be the next boom sector. Well without being too macro, China and India are growing strongly and I regard that process as irreversible and accelerating. Oil is the lifeblood of any growth in an economy and this growth coupled with undiminishing demand in the Western world will create a constant market for oil indefinitely.

And diminishing supply?

Oil is becoming harder and harder to find. Massive oil finds from the 60s and 70s are starting to look a little shaky (see Simmonds recent book on how the Saudis are having to work harder and harder to get oil out of their fields) and as oil fields across the world start to slow down, the replacement rates alone are causing real headaches for oil executives across the world. I am sure you all remember the Shell scandal recently. Huge oil companies are having to work more and more to replace the oil they are drilling and having to go to further and further extremes to get new oil. Even if you project zero growth in oil demand over the next few decades (which is bonkers), there will serious oil supply difficulties in the next twenty years. This was recently confirmed by the Saudi Oil Minister. If you are interested in this, check this post by our resident genius Halluciagenia: http://boards.fool.co.uk/Message.asp?mid=9228949

Suffice to say that whilst there are billions and billions of barrels of oil left, the decades of incredibly easy discoveries and supply are nearing the end and in future oil will be difficult, expensive and slow to extract. That obviously means higher oil prices in the long term.

(Imaginary sceptical investor speaking) “So why haven't Shell and BP tripled over the last few years? I've checked the oil & gas sector in the FT, and it's not doing much”

That's because Shell and BP not only get oil out of the ground, they also sell it to retail customers. That means that for every pound extra they make in exploration and production (“E&P”), they lose in margins selling it at retail. And since these two companies totally dominate the sector, the graph for the E&P sector is very misleading.

“So what, I am too late, we are clearly in an unsustainable boom and if I get on the bandwagon now I am bound to get burned. Look what happened in the Tech crash.

Bull markets climb a wall of worry. In the 1920s, the Wall Street Times called the top of the bubble over 25 times and when it was finally right, it was more resigned than exultant. So ask yourself, are you hearing about the oil sector boom at dinner parties? Is your taxi driver nodding knowingly to you about “Peak Oil” and how the world's energy policy needs to be urgently rethought? Are the newspapers covered in stories about how oil equity valuations are being affected by the fluctuating spot price in oil? Are all the medium size exploration companies household names? Are there pretty 20 something Chief Executives of companies like “LastminuteOil” splashing over all the inside pages a la Martha Lane Fox?

No?

Hmmmm.

When the oil price moves, the only thing the media talk about are petrol pump prices. Few people outside the Fool have even heard of Cairn (the largest E&P if you disregard Shell and BP for the reasons given above), never mind Dana, Tullow, Dragon etc. Most of these companies are bigger than Lastminute was at its peak. And they've got real producing assets. The only exception to this was Regal but its not every day that a drug dealing Chief Executive manages to destroy the reputation of an entire sector.

When you get mug punter retail investors multiplying fictional numbers of billions of barrels of oil by a number above the current spot price (taking no account of extraction costs) to get a “valuation”, then I might take the “bubble” idea seriously. When the billboards around town are covered in “Oil Fund Management” investment funds sucking in retail punters with graphs showing oil stocks moving vertically for years with promises of their fund investing in a range of oil companies “to lower the risk”, then we might be seeing a bubble. But ask yourself, seriously, is it really reasonable to glibly dismiss the oil sector as a “bubble” because a few tens of Fools are taking an interest in oil stocks? Are you missing the wood for the trees?

And anyway, I don't understand the valuations for these stocks, its all voodoo.”

When I first started reading the Oil & Gas Board on the Motley Fool I could not make head nor tail of it. All that stuff about 2P, OOIP, risked NAV, Declarations of Commerciality, tanker costs, pipeline costs, fracture zones, 3D seismic etc. Well its not all gibberish and it is possible to get a sufficient handle on this stuff with a little patience. And there are some very helpful Fools out there who will chip in if you ask nicely. I am wondering whether we should have a “Basic Oil & Gas Questions” board so that people can read up on the sector from scratch in a less pressured environment. Does that sound interesting?

There are two types of oil company although many of them shade together. Some focus more on exploration and others focus on production.

Production companies

Production companies can be valued by the oil they sell every year. One quick example. Dana is due to be producing around 25,000 barrels of oil or equivalent (this is written as 25k boepd for short) per day by the end of the year. Current spot price for oil is about $55 which is roughly £30. That means it will turn over 25,000*30*365= £275m next year. Tax is 50% and costs are say 25% which means it has Profit After Tax of £70m. Dana's market cap is about £500m so it is on a forward PER of 7x (without even looking at its exploration potential). Hardly bubble territory is it?

Exploration companies

Explo cos can be valued by their oil in the ground. Now this is at times controversial so if you want to be very conservative (and fund managers are very conservative for example), you only value reserves which are booked in the Annual Report and where there has been a “Declaration of Commerciality” which means that the field is viable and going to be a production field in the short to medium term. However, what the Motley Fool O&G Board has specialised in is trying to spot companies where the booked reserves of an explo company are much less than the actual reserves which get reported to the market but then go through a long process of verification and approval before being “booked”. This inevitable time lag can create valuation anomalies which fund managers avoid for safety reasons but Foolish investors can exploit.

Secondly, the Oil industry has been severely traumatised by the 1990s when oil prices were at $10 a barrel and it is an accepted mantra that oil prices are cyclical and are bound to plummet soon. This means that when oil was stuck for years in the $20-30 range, oil in the ground was priced at $3-5 allowing $15 for infrastructure and production costs and a little bit over for profit. That $3-5 price has stuck to this day because much of the industry has been understandably reluctant to budget and plan based on higher oil prices in case they plummet again and a lot of projects will collapse at vast cost and embarrassment. It is literally only in the last 6 months that analysts are starting to rejig their models for higher oil prices. Shell recently made some noises about a $40 floor and Saudi Arabia/ OPEC are starting to hint at permanently higher prices.

I was just about to do a quick valuation summary but then Simon54 provided a link to a post by SirLurkalot on how to value explo companies. I cannot improve on it for an explanation as to why the Spot Price of $60 has had no impact on the share prices of small explo E&P's over recent years. Oil E&Ps are lagging behind. It sounds extraordinary I know that the market could be behind the curve but sometimes it happens. And it happens for the same reason you are not interested in oil – because it is “difficult” and “specialised” – traders and fund managers are human too and they don't want to have to mug up on new stuff when they've been trained on PER, P/Sales, EBIT, EBITDA etc.

http://boards.fool.co.uk/Message.asp?mid=8818233&sort=recommendations

Put simply, if Drillalot has a discovery which it thinks has 250m barrels of oil in it with a good chance of being extracted (known as 2P, I'll explain shortly) then you can value that company at 250*$3=$750m = £400m. And that's it. Frequently of course, the company doesn't own the whole field so you divide by the ownership percentage. Also, if a field is not yet drilled but seismic suggests say 250m barrels then it is accepted practice to discount the value by a percentage to take into account the “Chance of Success”. So for example Soco is due to be announcing the result of a well in Vietnam in the next few days. The company have said there is a 40% chance of success. If it is successful then the percentage will rise to about 60% or more (not 100% because of there are still potential difficulties in getting it out etc).

Oil in the ground

No extraction process can possibly remove all the oil in the ground. This is known as Original Oil In Place (OOIP) and is irrelevant for valuation purposes. Then we come to “Proven, Probable and Possible”. 1P is “Proven” – this is defined as oil which has a 90% chance of being extracted. 2P is “Proven and Probable” – this is defined as oil with a 50% chance of being extracted. 3P is “Proven, Probable and Possible” and is defined as oil with a 10% chance of being extracted. Naturally 3P contains all of 2P and 1P. 2P contains all of 1P. It is accepted practice that valuation of an oil field is done by multiplying the 2P figure (i.e. oil with a 50% chance of being produced) by $3-$5. See, that wasn't hard was it?

Let me give you a practical example.

Soco discovered extra oil in Yemen recently in its “Kharir” field (known as KHA). It was the fifth well drilled there and the fourth drilling programme so the well is known as KHA-405 (not rocket science this is it?). It took a bit of work to get an estimate of the increase in size attributable but it was about 130m barrels 2P. If we price that at $9 (because Yemen already has excellent production facilities), that is worth $1170m=£650m, roughly. Soco owns 16% of the field so that's roughly £100m. Soco has 75m shares so the share price rise should be up about £1.30 on announcement which is roughly what happened.

I hope this post is helpful and sparks some discussion. I am sure more knowledgeable Fools will be around to answer questions and correct any errors.

KoD