Taking stock of oil shares

SHARES in oil exploration companies have gone through the roof this year. But investors who missed out on the initial rises will be pleased to hear that fund managers see no signs of the City‘s enthusiasm for the sector waning in the short term.

Brent Crude is currently trading at around $45 a barrel, and has been as high as $50 in the last month but the fund managers‘ investment rationale has less to do with continuing high oil prices and more to do with specific company news.

James Dodd, manager of the UK smaller companies fund at Artemis, said: 'These companies' share prices are driven by stock specific newsflow. The effects of the oil price are only indirect.'

Several Artemis funds have stakes in companies such as Cairn Energy (up 275% since December) Regal Petroleum (260%), JKX (175%), Burren Energy and (160%). Dodd says the funds will hold them at least until the end of the year.

Nigel Thomas, Framlington's award-winning fund manager, also still has 4.5% of his fund invested in Cairn.

All agree that for these stocks, the oil price is largely irrelevant. Oil exploration companies assume a longer-term oil price of around $25 a barrel in their calculations, as do the analysts forecasting their earnings.

When the oil price is high, however, the companies' existing oil production divisions generate a lot more cash. This enables them to finance more exploration activity.

Fund managers such as Derek Mitchell at ISIS, warn that a high level of exploration spend does not necessarily translate into more finds. 'It‘s all about stock-picking. You have to trust the management to deliver on what they say they can do.'

Cairn's five major discoveries this year in Rajasthan, India have swelled its reserves by an estimated 2bn barrels. Investors can look forward to drilling reports from Nepal, where it has recently signed exploration agreements.

Regal Petroleum has exceeded its own expectations for recovery rates in its Ukrainian operations. Burren Energy surprised the market in August with a sharp increase in the level of estimated reserves in the Congo.

JKX, which is also focusing on the Ukraine is drilling a third new well this year, and a further three next year.

All have plenty of potential for positive news still to come, and issued upbeat outlook statements with their last results.

Despite some successes in the sector however, investors elsewhere have had their fingers badly burned.

Since January, Ramco Energy‘s shares have fallen from 400p to 27.5p (down 93%) due to production complications at its Seven Heads field. The ensuing £93m write-down of assets in May left it struggling to manage £63m of debt.

Aminex‘s share price in the early 1990s, however, was close to 100p, before exploration problems in Russia and Tanzania drove it down to as low as 8p (a fall of 92%) in July. Although the shares have recovered slightly with news of a development agreement in North Korea, Aminex announced widening interim losses of £1.15m this week.

Dodd at Artemis reminds investors that even Cairn 'has faced bankruptcy' three times in its history.

The message to investors, therefore, is clear - while the sector has not run out of breath yet, it pays to be selective.