The oil and gas industry’s tumultuous 2021: what does it mean for small caps?
“…Brent crude has reached its highest level in two years, with some leading commodity traders suggesting prices might persist above $100 a barrel for the next few years if current capacity struggles to keep up with demand…”
2021 has been another turbulent year for the oil and gas industry. Governments, climate change campaigners, analysts – and investors themselves – have continued to shine an ever harsher light on the industry’s prospects through a cascade of policies, executive orders, forecasts, courtroom and boardroom battles.
And yet, as increasing post-pandemic demand for hydrocarbons collides with a possible supply shortage, some commentators are predicting that oil prices could soon touch $100 a barrel. In this article we try to step back from the daily rush of news and assess what this years major developments mean for investors in oil and gas small caps.
Companies covered include : #BLOE #ECHO #ECO #NTOG #PXEN #ZPHR
Governments getting tougher
Although not moving at the pace that green lobbyists might wish for, governments are painstakingly piecing together an ever tougher regulatory environment for fossil fuel explorers and producers.
The Biden administration continues to pursue a broad range of initiatives in pursuit of its target of halving greenhouse gas emissions by 2030. The construction of the controversial $8bn Keystone XL pipeline that would have carried bitumen from the oil sands of northern Alberta to Gulf Coast refineries was officially terminated this month after the President withdrew permission for the project partners to build on US soil. The future of another major pipeline that would transport oil from the Bakken shale patch in North Dakota to the rest of the US is currently under judicial review. The administration has also suspended Arctic oil drilling rights sold in the last days of Donald Trump’s presidency, is currently engaged in a court battle to end fossil fuel development on public lands, and is exploring options for stringent action to curb methane emissions.
On this side of the Atlantic, Denmark, the EU’s largest oil and gas producer, set a bold precedent for other states by cancelling all future North Sea exploration and production licensing rounds with a view to phasing out the country’s fossil fuel extraction by 2050. And new climate change measures announced at this month’s G7 summit included a commitment to end funding for coal generation in developing countries.
Breakthroughs for activist and investor pressure
But perhaps the most striking blows this year against the industry have not been struck by governments, but by environmental groups and investors working within the courts and shareholder meetings.
Last month a court in The Hague issued a groundbreaking ruling against Shell, ordering the supermajor to accelerate its net zero strategy by cutting carbon emissions by 45pc rather than 20pc over the coming decade, and taking absolute units of carbon rather than carbon intensity – a less stringent requirement – as a measure. The order, which applies across the corporation’s global business, was brought by Friends of the Earth on the basis that the Dutch civil code placed a human rights obligation on fossil fuel corporations to take more radical action to reduce emissions.
Although Shell plans to appeal the ruling the company has indicated it is now reviewing its strategy in accordance with the order. Lawyers, academics, investors and energy analysts believe the verdict will be just the first of many future human rights cases to target corporate strategies – previous environmental litigation has focused on companies’ past rather than future behaviour. The Hague ruling supplies a precedent and legal template for well funded and legally skilled environmental groups to bring similar actions not just against against carbon producers but any company investing, insuring or extending finance to them.
Legal action is being pursued against states as well as companies. A case has been brought to a European court on the grounds that Norway’s plans to drill for oil in the Arctic breaches future generations’ human rights. And campaigners are seeking to bring a case before the British High Court to challenge the UK government’s support for continued North Sea oil and gas production, arguing that the statutory objective of the Oil & Gas Authority (OGA) to maximise recovery of the country’s reserves of hydrocarbons is ‘irrational’ in light of the UK’s legally binding 2050 net zero emissions.
Campaigners are also starting to make breakthroughs in taking their demands direct to corporate boardrooms. During ExxonMobil’s annual meeting last month activist hedge fund Engine No 1 succeeded in placing representatives on the corporation’s board, convincing a majority of shareholders that the group’s strategy to continue to focus on fossil fuel exploration had put it at ‘existential risk’. The language is significant, reflecting concern that the company’s programme is commercially as well as environmentally misguided. Exxon’s shares actually rose after the vote.
Shareholders passed a similar resolution at Chevron’s annual meeting, nearly two-thirds voting for a proposal requiring the company to ‘substantially reduce’ the greenhouse gas emissions created by its products, with a specific requirement to take greater note of ‘Scope 3’ emissions, those produced by the use of a company’s products and services, not just the Scope 1 and 2 emissions produced within the organisation itself, making for a much tougher benchmark.
The IEA’s dramatic turnaround
On top of everything else, the industry has been taken by surprise by a bombshell International Energy Agency (IEA) report arguing that all new oil, gas and coal exploration must stop if the Paris agreement’s 2050 net zero emissions targets are to be met. Arguing that the sector’s existing oil and gas resources are sufficient to meet the world’s future fossil fuel requirements, the report envisages oil and gas demand falling respectively by 75pc and 55pc over the next 30 years, while solar and wind power capacity increase by 20- and 11-fold.
The Japanese, Australian, and Norwegian governments, together with the World Coal Association and the International Gas Union were among those to immediately push back against the report, but what the IEA says matters. Governments, oil companies and investors continue to rely on the Agency – founded during the 1970s OPEC crisis to work for the secure supply of oil and gas to the western world – for authoritative analysis and forecasts used as the basis for the planning of policy, corporate and investment strategies.
The IEA report follows a somewhat less well publicised but no less compelling study by the Carbon Tracker energy research institute, which noted the extent to which oil and gas producers will have to up their game to continue to secure investor confidence.
The report found that fossil fuel producing and related companies underperformed the MSCI All Country World Index by 52pc from 2012 to 2020, with exploration and production companies delivering the worst performance, trailing the Index by up to 80pc. Although fossil fuel stocks continued to attract much more capital than clean energy over the period, oil and gas annual equity offerings have fallen sharply in the past two years. Clean energy IPOs overtook carbon-heavy flotations worldwide for the first time last year, raising a record $11bn from public equity offerings in 2020 alone, with the value of fossil fuel listings falling 85pc from $70bn to $10bn.
$100 a barrel?
But although the industry is being battered by waves of new challenges, its economic performance has picked up sharply in recent weeks and months, with some forecasts indicating the oil and gas sector may be set for a sustained period of high demand and rising oil prices.
New figures – produced by the IEA itself – predict that demand for oil will exceed pre-coronavirus levels by the end of 2022, with consumption expected to rebound by 5.4 million per day this year after falling by a record 8.6 million barrels a day last year. Indeed 2021 may exceed the record 160 million barrels sold in 2019. Though standing by its report calling for an end to new exploration, the IEA said that OPEC and its allies needs to ‘open the taps’ to boost oil production and keep the world well supplied – the cartel is expected to increase daily production by at least two million barrels when it next meets.
Brent crude has reached its highest level in two years, moving above $73 a barrel, with some leading commodity traders suggesting prices might persist above $100 a barrel for the next few years if current capacity struggles to keep up with demand in the period before green alternatives can take up the slack. Speaking at an FT Commodities Global Summit earlier this month, Jeremy Weir, executive chair of Trafigura, argued that the ‘issue for oil is not demand … the supply situation is quite concerning. We’ve gone from 15 years of reserves to 10 years. We’ve seen capital expenditure go from five years ago at $400bn a year to just $100bn a year.’ Jeff Currie of Goldman Sachs argued that huge state investment in green infrastructure programmes will drive sustained demand, saying that ‘every $2tn of green capex spend is worth about 200,000 barrels per day of oil demand’.
Oil and gas stocks have been trending higher as price rises return companies to profitability. BP, for example recorded a sharp return to profit in Q1, stating a $4.7bn gain against a loss of $4.4bn 12 months ago. The company’s net debt fell from $38.9bn at the end of 2020 to $33.3bn in the first quarter, beating its target of $35bn, figures that emboldened it to commit to buy back shares later this year.
Looking at the wider picture
With so much to digest, it’s important to stand back from daily flow of news and try to look at the wider picture. According to analysis by energy consultancy Wood Mackenzie for example, the sober truth is that the world will still need oil and gas supply for decades to come, even as the energy transition gradually erodes fossil fuel demand. But it will be tougher than ever for producers to convince investors to entrust them with capital.
Like the IEA, Wood Mackenzie believes existing discoveries offer enough oil to meet future demand. But the consultancy suggests that new exploration may actually help the industry meet its net zero obligations, discovering new resources that make possible less expensive and carbon-intensive extraction than existing deposits. It estimates that oil demand will peak before 2025 and fall towards 35 million barrels per day by 2050, 70pc below peak levels, and that by 2030 the price of Brent will average $40 per barrel and continue to decline thereafter. But demand for gas, a less carbon-intensive fuel, will continue to grow into and through the 2030s, before declining very gradually as renewables eventually take over.
Whatever the exact future mix between oil and gas, delivery and discipline will become even more important as producers seek to prove themselves to prospective investors. In the consultancy’s words, the industry’s historic ‘affinity for complex, long-life developments with thin margins has to end, as does its propensity for exuberant spending when prices rise’. With little demand for long-term greenfield spending projects with shorter payback periods will be prioritised. Carbon capture, both utilisation and storage (CCUS/CCS) represents a huge growth opportunity for those companies willing to invest in it: CCUS/CCS capacity simply has to rise from a wholly inadequate 40 million tonnes per annum today to 4 to 8 billion tonnes per annum by 2050 if the world is to achieve its net-zero carbon ambitions.
As energy companies shift to renewables national oil producers (NOCs) will gain even more market share, especially OPEC countries, which have the lowest-cost, lowest-carbon barrels and cheap finance, making them more resilient to change. But there is scope for the best independents to thrive, especially those able to serve niche markets, or with specialist expertise in mature asset rejuvenation and the harvesting and retirement of assets.
These are all tough challenges, but chastened by oil price crash of 2015 and corona Wood Mackenzie believes the industry is in good shape to meet them. Having shifted its focus to short-cycle, quicker-payback prospects, the sector is now able to generate as much cash flow at $60 barrels per day as it did at $100 prior to the price crash.
Prospects for the North Sea
Zooming in on the UK the prospects for North Sea operators look decent (subject of course to possible court cases) with Westminster and the Scottish Parliament continuing to affirm the sector’s ‘social licence to operate’. Last May the OGA set out of the principles of a net zero strategy proposing that that maximising economic recovery of oil and gas need not be in conflict with the transition to net zero. Declaring that ‘oil and gas will remain a vital part of the UK’s energy mix as we move towards net zero’, the strategy backed the industry to provide the skills, technology and capital to help unlock solutions required to help the UK achieve the net zero target, while securing ‘the maximum value of economically recoverable petroleum’ from the strata beneath relevant UK waters.
In March the Department for Business, Energy & Industrial Strategy set out a North Sea Transition Deal between the UK government and hydrocarbons producers that recognised ‘oil and gas is still vital to the production of many everyday essentials like medicines, plastics, cosmetics and household appliances’ and will continue to be ‘over the coming decades as the UK transitions to low carbon solutions’. The Deal, which is committed to emissions cuts of 50pc by 2030, will introduce a new Climate Compatibility Checkpoint before each future oil and gas licensing round to ensure licences awarded are aligned with climate objectives. Up to £16bn will be invested over the next decade to replace fossil fuel-based power supplies on oil and gas platforms with renewable energy, and to develop CCUS and hydrogen production.
Earlier this year another energy research group, Rystad Energy, argued that the UK offers the world’s most favourable fiscal regime for offshore development, facilitating a net present value (NPV) of $11.1 per barrel of oil equivalent (boe) at a flat oil price of $70 per barrel, ahead of Kuwait ($11 per boe), Canada ($8.9 per boe), and the US ($8 per boe). Rystad issued a report the following month showing that private equity continues to have faith in the North Sea, with private companies’ share of UK oil and gas production reached nearly a third last year – up from just 8pc a decade ago. Producing fields in the North Sea still generate a lot of cash at stable oil prices, making them attractive to private investors that do not face the same pressures as majors to divert spending to cleaner energy technologies such as offshore wind.
The evidence, then, is that there is still scope for the best independents to explore and produce defined fields and markets in the North Sea and beyond. Here, in alphabetical order, are a few small caps to look out for, most of which have been discussed before by TMS.
Block Energy
Block Energy (AIM:BLOE), an oil and gas production and development company focused on the country of Georgia, looks set for a busy summer and autumn after quiet progress over the past year.
Block listed nearly three years ago with a cluster of assets a few miles south east of Georgia’s capital city Tbilisi. The company’s founding premise was to bring contemporary drilling technology to proven Georgian fields that might have much more to offer, the immediate objective being to open up the West Rustavi field’s contingent resources of 38 MMbbls oil and 608 BCF gas in the Middle, Upper and Lower Eocene formations.
Last March Block acquired two neighbouring fields from Schlumberger, a potentially transformative acquisition that increases Block’s acreage more than 30 times, from 82 km2 to 2,622 km2, opening several new development opportunities. One of them, Block XIB, has produced more than 180 million bbls of oil from the Middle Eocene, rates peaking in the 1980s at 67,000 bopd. The new assets increased the company’s 2P reserves of oil and gas by 64 million boe, its 2C contingent resources by 29 million boe, and its prospective resources by 245 million boe. In February Block announced its first gas sales from an Early Production Facility (EPF) at West Rustavi.
This year Block is drilling two new wells, both at West Rustavi, both targeting initial production of 600 boepd. The first, WR-BA, will be the first new horizontal well identified by a $1m 3D seismic survey undertaken in 2019. The well, which will target the top of the Middle Eocene reservoir, is close to the field’s EPF. If successful a second well, WR-BB, will be drilled targeting the same formation. Locations for further drilling in this area have been worked up. Block is currently producing at a (30-day average) production rate across all its licences of 555 boepd.
Last week Block signed a Memorandum of Understanding with Baker Hughes to enhance its drilling operations. The oil services giant will assist Block’s horizontal drilling at WR-BA.
Echo Energy
Echo Energy Plc (AIM:ECHO), has assembled a set of full-cycle oil and gas assets carefully balanced between exploration and production in South America.
The company holds a 19pc interest in the Tapi Aike exploratory licence, a cluster of gas discoveries left undeveloped since the 1970s, and a 70pc interest in the Santa Cruz Sur licence, which has 12 producing oil and gas fields. Last year Echo increased its revenue fourfold to $11.1m (2019: $2.6m), producing a cumulative 0.72 MMboe and 3,750 mmscf of natural gas.
Crucially, the company also completed a successful restructuring of the debt that had cast a cloud on its future, deferring maturity on a debt facility until Q2 2025, with no cash payments due till the maturity date, allowing for the reinvestment of cashflow into the business.
Recent progress has included the securing of new gas sales contracts at premium rates to the prevailing spot markets; a cooperation agreement with GTL International to seek future opportunities in Bolivia; and the drilling of an exploration well on the Palermo Aike concession.
Eco (Atlantic) Oil & Gas
With significant interests in the giant discoveries off the coasts of Guyana and Namibia, Eco (Atlantic) Oil & Gas (AIM:ECO) is arguably one of the more undervalued hydrocarbons stocks.
Eco has a 15pc stake in the Orinduik licence offshore Guyana, in which Total and Tullow Oil also have interests. A February CPR estimated Orinduik may hold 5.14bn barrels of oil, a net 771 million due to Eco. The Orinduik Block is adjacent and updip to ExxonMobil Operated Stabroek Block, on which twenty discoveries have been announced and over 10 Billion BOE of oil equivalent recoverable resources are estimated.
The company continues to recover from a set back last November when analysis indicated the reservoir to have a heavier grade than expected, with high levels of sulphur, which the markets greeted with some disappointment, rudely arresting the progress of Eco’s hitherto soaring share price. Eco has argued that the market overreacted, noting the crude tested to date appears not dissimilar to the commercial heavy crudes currently in production in the North Sea, the Gulf of Mexico, Brazil, Venezuela and Angola.
Eco also has substantial working interests in four licences in the Walvis Basin off the Namibian coast. Collectively, the licences cover more than 28,500km2 with the potential for over 2.36bn boe of prospective P50 resources, making Eco the second largest operator in Basin after ExxonMobil. Other majors including Total and Shell are moving into this giant Cretaceous play, which offers a potential two billion barrels of oil.
Eco and its partners are confident of progression towards target selection at Orinduik selection in Q3 this year, with a view to drilling next year.
Nostra Terra Oil and Gas Company
Nostra Terra Oil and Gas Company Plc (AIM:NTOG) is an exploration and production company with assets in the Permian Basin and East Texas. Its core asset is a 100pc working interest in the Mesquite asset located on the Eastern Shelf of the Permian Basin, which has estimated recoverable reserves of 2.4 mmbbls. Nostra also has 100pc interests in Pine Mills, a 2,400-acre producing oil field located in Wood County, eastern Texas, and the Caballos Creek oil field in South Texas.
The oil price crash had an upside for Nostra, giving the company opportunities to pursue its strategy of expanding its low-cost, low-risk production portfolio during a time of lower asset valuations. The company negotiated a farm-in according to which a third party will fund a new well at Pine Mills, with Nostra taking a 32.5pc working interest. The well was successfully drilled in Q4 2021, completed and subsequently put into production with an IP rate of 100 bopd.
The company also has a farm-in agreement with a consortium of local producers for three additional leases in the Permian Basin. There is significant upside opportunity through a combination of re-completions, workovers, and new wells. The asset is in a proven area, adjacent to other leases Nostra Terra owns in the basin. Work is expected to begin later this year.
The combination of reduced overheads, increased production, improved operational efficiency and steadily increasing oil prices allowed the company to go cashflow positive early this year. In April 2021 Nostra said it is working towards securing an interest in an oil and gas property in Tunisia, reducing its dependence on its Texan acreage.
Prospex Energy
Prospex Energy Plc (AIM:PXEN) – renamed this year from Prospex Oil and Gas Plc – looks like a solid low-cost bet for investors seeking exposure to continental Europe’s oil and gas sector. The company looks for low capex European investment opportunities with ‘a particular preference for late stage, drill-ready exploration; reworking of existing fields; or failed exploration targets where new ideas and the latest technology can be applied’.
Prospex currently holds a portfolio of three projects: the Podere Gallina Permit in Italy where first gas at the Selva field is targeted for 2021; the El Romeral gas and power project in Spain which includes three producing wells that supply gas to a 100% project-owned 8.1MW power plant; and the large scale Tesorillo gas project in southern Spain which has the potential to hold gross un-risked prospective resources of 830 Bcf of gas, with upside in excess of 2 Tcf. The company’s strategy is to rapidly scale up gas production in the short term to generate internal revenues that can then be deployed to develop the asset base and increase production further.
Prospex has secured full environmental approval for the development of the Selva field, paving the way for the grant of a full production licence from Italy’s Economic Development Ministry. In tandem with the production licence application process, development and preliminary work has now commenced to prepare the field – which has gross gas reserves of 13.3bcf (2P) – for production in mid-2022. Under the first phase of the development plan, a fully automated gas plant will be installed along with a one-kilometre long pipeline to connect the well with the nearby Italian National Gas Grid.
With a planned maximum production rate of up to 150,000 cubic metres/day, Selva has the capacity to generate annualised revenues several times greater than the company’s historic annual corporate costs, which would allow it to pursue additional low risk exploration and development opportunities both at Podere Gallina and its Spanish projects.
Zephyr Energy
Zephyr Energy (AIM: ZPHR), formerly known as Rose Petroleum Plc, invests in oil and gas interests in the Rocky Mountains, a prospective region of the US with less competition and lower acreage costs than the larger and better known Permian Basin, Eagle Ford and Bakken plays.
Zephyr’s principal asset is a 75pc working interest in a 20,000 acre leaseholding at Paradox Basin, Utah, a licence carried over from Rose Petroleum. The field’s first well was spudded ahead of schedule, with the objective of acquiring up to 100 feet of continuous core from its Cane Creek reservoir, and running a comprehensive well log suite across the entire Paradox formation, which includes at least five other potential reservoir zones.
The company’s other interest is an option for an initial transaction in the Denver-Julesburg Basin spanning Colorado and Wyoming, a region of increasing interest to operators employing horizontal drilling techniques. Zephyr would gain participation, as a non-operated working interest owner, in a two-mile lateral development project operated by Great Western Operating Company.
Zephyr expects to accumulate substantial cash flows over the next twelve months from recently acquired non-operated assets in the Williston Basin, North Dakota, and is poised for significant near-term organic growth as it plans to drill and target first production from its flagship appraisal project at Paradox. The company expects all of it acquired wells in the Williston Basin to be online and generating significant near-term cash flow soon.
