I appreciate it is a "bottom drawer" stock and am happy to wait....

I appreciate it is a "bottom drawer" stock and am happy to wait. I got in on Intelligent Investor advice (see below for full report) at 3.71and then it dropped as we saw. I was interested in reaction to the what the II said - is it wrong in any major sense - or is there issues it is not considering??


Company: Roc Oil Company Limited
ASX code: ROC
Recommendation: Buy
Price at Review: $3.34
Current Price: $3.48

Change Since Review: +0.14
Category: SECOND LINE RESOURCES
Issue: 208
Date: 13 Sep 06


Fundamental risk
Share price risk





This oil company boasts attractive producing assets, with some exciting exploration potential thrown in.
‘I am becoming sick and tired about lying about the extent of our reserves’ said an email from Walter van de Vijver, also known as The Tall Angry Dutchman. Van de Vijver, then head of exploration at Royal Dutch Shell, wrote that fateful email to Sir Phillip Watts, Shell’s chairman, in November 2003. It ended up as part of one of the most sensational scandals in the oil business in recent years—that Royal Dutch Shell had been overstating its reserves for years to placate investors and support its share price.


It’s a great example of how important it is to be able to rely on the management teams you back. And we’d bet (in fact, we have bet) a substantial amount on the fact that no such email exchange would ever take place between Wes Jamieson and John Doran, exploration manager and chief executive, respectively, of Roc Oil.



The quality of its management has been a major factor in our support of Roc Oil, which extends all the way back to our Opportunities in Oil special report in June 2003, when the stock was changing hands at $1.13. With the share price almost tripling since then, it might seem surprising that stingy value investors such as ourselves are still keen to buy more shares.



Our brand of investing involves constantly weighing a stock’s value against its market price. And, on that measure, we still see a gap in favour of today’s buyer of Roc shares. In this review we’ll examine the company’s assets and explain our case. Firstly, though, it’s important to understand the risks and vagaries involved in assessing oil and gas companies.



Can of worms



Oil company accounts do a remarkably good job of misrepresenting the likely future economic benefit flowing to shareholders. For example, one popular metric is to compare enterprise value (a company’s market capitalisation plus its outstanding net debt) with operating cash flow (minus corporate tax and the often barbarous resource rent taxes). But this approach ignores the quality and trajectory of a company’s reserves, as well as a host of other variables.



To get closer to the true situation, there’s no option but to examine reserves of oil and gas, but this also opens up a can of worms. Hydrocarbon reserve estimation means combining a long list of factors that are notoriously hard to pin down. The list includes such things as recovery, pay volume, porosity, saturation and volume factor. Highly schooled petroleum engineers express such factors in arcane mathematical formulae, but we’ll spare you the headache here.



Once the above variables have been assessed, a recovery probability factor can be allocated. This is where the reserve-related terms ‘proven’, ‘probable’ and ‘possible’ come from. Proven reserves are held to have a recovery confidence of at least 90%. Simply put, there’s a 90% chance that at least that number of barrels will be recovered. Probable reserves have a recovery confidence of 50%, and possible reserves a recovery confidence of only 10%.



The combination of proven and probable reserves, or ‘2P reserves’, is an important measure for an oil company but, as you can see, the efforts to conform to a formula are already beginning to cloud reality. Our preference is for what’s known in the trade as a ‘deterministic approach’—or a ‘best estimate’ in everyday language.



Current projects



Roc currently has four projects either producing or nearing production. They are located in Western Australia, Mauritania, China and the United Kingdom. Their published 2P numbers are shown in the table on the page opposite (we’ve lopped a little off the Mauritania total due to a likely reserve downgrade).



Given past experience and the chance of further successful exploration, though, our own ‘best estimate’ reserve numbers are higher than those currently booked as 2P. For example, Cliff Head is currently doing quite remarkable things compared to original expectations. We have few doubts that Roc, as operator, was conservative in its assumptions—further evidence of management’s prudence.



There’s every chance that Cliff Head could be worth another 2–3m barrels to Roc above the 5.5m already booked. And such additions shouldn’t require vast sums to be spent. In fact, we think there could be even more than this, but we’ve put 8m in the table as our ‘best estimate’.



As our nine-part Investor’s College series on the fundamentals of value investing explained, starting in issue 197/Apr 06, the value of an asset is the value of all its future cash flows, brought back to today’s dollars. So what does our 8m barrel best estimate for Cliff Head boil down to for Roc shareholders?



Variables include the costs of extraction and any further development, the quality of the oil, the timing of the oil flows, the rate at which we would discount the expected cash flows, any taxes payable, the oil price itself and the exchange rate. As you can see, it’s a bit of a dog’s breakfast.



To keep things simple and stay on the safe side, we’re going to assume a profit in today’s dollars of $35 (that’s Australian dollars) for each barrel of oil coming out of Cliff Head. So, multiplying our 8m best estimate of Roc’s reserves at Cliff Head by $35 gives an estimated value of $280m, or $1.29 per share.



Teenager



Roc bought Zhao Dong, off the coast of China, from Apache Corporation earlier in the year for US$260m, acquiring some 15m barrels of 2P reserves. Doran has described the area as a ‘mere teenager’ and, like a teenager, there’s reason to believe it will keep growing, or at least producing without shrinking a lot.



Our best estimate of Zhao Dong’s reserves is 20m barrels. With production already flowing, our estimate of $35 profit per barrel is the same as Cliff Head and should prove conservative. Multiplying it out we arrive at a valuation of $700m, or $3.23 per Roc share. Roc borrowed money to finance the Zhao Dong purchase, but we’ll subtract that at the end of the exercise.



Next let’s take a trip to Africa, where Chinguetti (off the coast of Mauritania) currently has some 4m barrels of 2P reserves attributed to it. However, in the short term at least, this is heading for a downgrade. In the table we’ve popped it in at 2m barrels of 2P, with the same number as our best estimate. Applying a slightly lower profit per barrel of $30, Chinguetti works out at $60m, or 28 cents per Roc share on these numbers. Again, our $30 profit per barrel should prove on the low side. While Chinguetti is having a few problems, the vast bulk of development spending is behind it.



Blane in the North Sea has total 2P of 32m barrels, of which Roc’s 12.5% share is booked at 4m. Enoch, also in the North Sea, is worth a net 2m 2P to Roc. The history of the area is pretty good and it’s well understood. We’re inclined to think that actual production will end up some 50% above the currently booked numbers. We also respect the operator, Calgary-based Talisman Energy, which adds to our confidence.



There’s more money to be spent on development at both Blane and Enoch, but we’re comfortable applying our $30 per barrel profit to these projects. Doing so gives us $180m for Blane and $90m for Enoch, or 83 cents and 42 cents per share respectively.



Exciting discovery



Totalling up these producing or near-producing assets, we arrive at a value of $6.05 per share. But we also need to subtract the Zhao Dong-related debt and also account for the exciting Wei 6–12S discovery Roc made in the South China Sea back in May. In issue 200/May 06 (Buy—$3.64), we wrote that ‘the project could be worth several to many hundreds of millions of dollars to Roc’.



The pre-drill estimate here was 30–40m barrels in situ. The final outcome will not be known for months or probably years, but the results look good and the area is proven and close to infrastructure (making potential production more profitable). It looks to us like the magnitude will be many tens of millions of barrels. Given Roc’s 19.6% effective economic stake, we think the outcome for Roc will be bigger than Cliff Head, and very comfortably above 10m barrels. But it’s early days, so we’ll peg this discovery at $250m ($25 for each of 10m barrels), or $1.16 per Roc share.



Adding up those individual amounts, we end up with a valuation north of $1.5bn before subtracting Roc’s net debt, which we estimate at $300m. We’re left with a valuation of around $5.82 per share. But on top of all this, Roc also has some exciting exploration acreage.



Bought for a song



Top of the list is Angola. Management bought into the area in 2001, amid a civil war, and paid an absolute song as a result. About a year later, the country emerged from the funk of its 27-year old civil war and Roc was left in a prime position to explore this very prospective territory.



The company has already spent tens of millions gathering data (and clearing the civil war’s leftover landmines), and will spend plenty more. Drilling is pencilled in for late this year, and we’re fully expecting some interesting finds. If we’re right, this could put some very creamy icing on the already delicious Roc cake.



We’re not going to assign a precise numerical value here, because we have no idea, but it could range from nothing to many dollars per share. We like the fact that this is great oil territory, and Doran and his team are excited in the extreme—that says a great deal in itself.



Other prospects in the exploration and appraisal boxes include Tevet and Tiof (and others) in Mauritania and acreage in Equatorial Guinea. Then there are several prospects in Australia as well. Playing the averages, we’d expect at least one or two more Cliff Heads, Blanes or Wei 6–12Ss lurking in that lot.



The most important thing is that the base case is a good one, and anything above that could make it a great one. The risks are numerous, including the oil price, political instability and the usual operational risks involved in the oil and gas game, which is why we need a decent margin of safety. And we’re getting it at the current price. The stock is down 20% since issue 204/Jul 06 (Buy—$4.15) and it remains at the top of our BUY list for up to 8% of your portfolio.



Disclosure: The author, Tom Elder, and staff members own shares in Roc Oil.