Record levels of resource to drive a phase of lower risk growth
Material growth in the underlying resource base continues to be at odds with
sector performance. We estimate the peer group holds an unprecedented ~7bn
boe of 2P+2C resource, triple the level of 5 years ago, presenting significant
opportunity for lower-risk growth through appraisal, near-field exploration and
project de-risking. Despite balance sheet strength and attractive debt
financing, a 45% increase in development capex to 2016 outstrips OCF and
appears a stretch. In our view, asset disposals are increasingly likely to unlock
valuation discounts, accelerate free cash and support shareholder returns. Our
preferred names are Genel (Buy 1400p) and Salamander (Buy 175p).
Outlook for frontier exploration likely to remain challenged
Recycling cash into exploration and taking subsurface risk remains a core
source of value creation and differentiation for E&Ps. However, we believe a
supportive oil price has increased industry competition and put pressure on the
quality and depth of the group’s exploration portfolios. While upcoming
campaigns in Morocco, Kenya and Gabon offer material upside, the overall
opportunity set over the next 12 months appears more limited.
Genel and Salamander are our top sector picks
Our bias towards asset-backed growth drives a preference for E&Ps with a
diversified strategy. At Genel (Buy, 1400p ), the growth potential of a ~1.3bn
boe 2P/2C resource base is yet to be fully reflected in the shares and could
support a 4x increase in production over the next three years. Start-up of oil
exports by pipeline in Kurdistan could support a re-rating, while sanctioning a
second wave of gas projects could increase the scope for disposals and
shareholder returns. For Salamander (Buy, 175p), a strong outlook for growth
from discovered resource, centered on the flagship Bualuang oil field, provides
a platform for exposure to low cost exploration. With the shares trading close
to a tangible asset value of ~120p/sh we see risk/reward favourably positioned.
Growth potential of Premier Oil’s resource base remains underappreciated
Premier (Buy 520p) trades around core NAV of ~310p and materially
undervalues a project pipeline that we believe can deliver production growth of
10% p.a. over the next 5 years, excluding Sea Lion. Of the higher risk frontier
exploration names, underperformance at Ophir (Buy, 400p) offers an attractive
entry point ahead of drilling offshore Gabon. While intense drilling activity
onshore Kenya/Ethiopia could yield further success for Africa Oil (Buy, SEK75).
Sector large caps Tullow and Lundin on hold, Afren least preferred
Despite substantially lower expectations at Tullow (Hold, 975p), a tangible
asset value of ~700p suggests the shares discount 2-3 years of exploration
success, which we argue is a fair reflection of Tullow’s impressive track. Longterm
growth at Lundin (Hold, SEK140) remains attractive, but we expect a
period of planning at Johan Sverdrup and development at Edvard Grieg ahead
of more material growth in 2015. At Afren (Hold, 180p), free cash flow
generation differentiates but with the shares at 2 ½ year highs, we argue
valuation on NAV metrics appears stretched. Lastly, risk/reward into frontier
drilling at Cairn (Hold, 345p) remains attractive but we see a higher potential
for transformational exploration upside elsewhere in the sector.