Aiming high: Drilling down for value in the AIM OIL & Gas Index

As discussed here in several prior blogs and mag articles, it’s fair to say that it has been a tough couple of years for stocks in the mineral resource sectors and none more so than for the components of the AIM Oil & Gas index, where large number of UK listed junior exploration and production companies reside.

The oil and gas index  is one of the most populous subsets of the AIM market, with well over a 100  members. Not all of these are in the business of prospecting or production, as there are junior oil services and support companies present as well. However, it is the large number of E&P companies in the index that provide its characteristic volatility – private investors love/hate relationship! It’s also true to say that the majority of the index constituents are relatively small in market caps terms, although there are a number of heavyweight names amongst them, for instance Indus Gas, Gulf Keystone and Costal Energy – all having capitalisations of more than £1 billion.

The last year has been a particularly tough time for the AIM Oil & Gas index, as the chart below testifies. This chart shows the performance of the index versus that which is comprised of the top 50 companies from all sectors on AIM, over a three year period.  The light blue line is the Oil and Gas index and the darker line the AIM top 50.

What we can clearly see is that we have undergone a period of sharp divergence over the last 12 months as the Oil and Gas index retreated from its recent peaks in May 2012 to cross down and through the composite of the top 50 stocks through August and September 2012. At the same time, the AIM top 50 index has moved progressively higher – mirroring the rise in the broader equity markets.

AIM Oil & Gas index v AIM 50 three year chart 

But what were the factors behind this fall?

We have already noted that the mineral resource sector has been “under the cosh” for the last twenty four months but the Aim Oil & Gas index has suffered additionally as investor confidence has ebbed away from smaller companies in general and in particular stocks that many investors perceive to be speculative and highly risky i.e. exploration companies.

Good quality quantitative data on the AIM Oil & Gas index is as difficult to find and extract as the fossil fuels that many of its members are searching for. However global accountancy and management consultancy EY has been tracking the top 20 companies within the AIM Oil & Gas index for many years. Providing an excellent proxy for the wider sector index by virtue of the weighting (market caps) of these 20 names compared to the rest of the field. Their (EY’s) quarterly data provides some very interesting insights, for example on fund raising in the sector Q2 2013 at both a primary and secondary level

Q2 Primary fund raising totalled just £32.1 million, whilst secondary issues raised just £42.1 million -sharply down on both counts from Q1 numbers of £107.4 million and £173.9 million respectively.  EY noted that “this represents the lowest total of Oil and Gas funds raised in a single quarter in four years and that just 10% of the Aim listed Oil and Gas companies successfully raised capital in Q2 2013.”

EY also highlight the volatile nature of the sector, noting that “the top 20 companies in the AIM Oil and Gas index have failed to produce two consecutive positive quarters in terms of performance since 2009” and “that over Q2 2013 these names fell by 12% which was the largest fall registered over the prior 12 months and that fall erased modest gains made in Q1 2013”. (Note that the AIM All Share index fell by just 5% over the quarter to the end of June 2013). These sort of levels of underperformance, certainly when backed with solid fundamentals usually get our noses twitching.

EY research also highlights some home truths about the junior companies. Firstly that the actual companies and attitudes towards them are often quite binary. Investors will often draw a clear distinction between the larger and smaller elements in the index and even in the upper echelons of the sector there was sharp divergence. For instance, stocks that performed well in Q2 rose by a combined 78%, whilst the those that fell, fell hard with the worst performers falling by some 70%.

This sharp directional performance was almost entirely driven (as we might have expected) by drilling results with investors flocking to names that produce positive results and exiting or shorting those that did not.

Size matters and it’s not all bad news

We underlined the word successfully above in relation to fund raising in the sector as this is another element of the binary nature of the oil & gas arena. That is that larger companies will have easier access to capital going forwards whilst the minnows will need to find alternative  funding solutions – something that has weighed on the prices of stocks such as Xcite Energy with continual equity dilutions – sometimes at very high cost. This is polarisation in access to capital is driven by a combination of investor confidence in size alongside an aversion to smaller riskier names and regulatory constraints which, have made it harder, if not impossible, for larger fund managers to make allocations to smaller companies, where they may not be able to acquire sufficient stock ,or feel confident about liquidity and their ability to exit a position.  Of course, this lack of fund management participation just may produce opportunity.

The current set of circumstances leaves the door open for larger names to consolidate the sector via acquisitions and strategic deals, and we expect to see further evidence of this process into the end of 2013 and beyond. Nor will the M&A be confined to AIM as the cash rich Oil majors will also be looking to add additional resources to their portfolios as oil prices remain above $100 per barrel.

Global geopolitical issues have always played a key part in Oil exploration and production but, with tensions mounting in anticipation of a US led “punishment “strike against Syria and the real possibility of an escalating conflict thereafter, it seems the supply-side of the Oil price equation will potentially be out of kilter in the near term and prices may well rise further as and when the US takes action.

Such has been the  poor performance  of the  sector and its constituents  that many  of the smaller names in the sector are  being  priced around their cash  balances  with little or no premium placed on the enterprise itself or the possibility of a successful/ commercial find. Regular readers will no doubt be aware of our stance on the natural resources and gold mining sectors in recent months and our positioning long here in the expectation of a sharp rally.

Well, the last 8 weeks have seen some stock prices increase by 50-150% – AVM, ABG, AMA etc to name a few. Our traders nose, and the same type of asymmetric risk profile tells us that the same could potentially happen here. Difference is there is “duster” risk with a lot of the minnows and we would advocate building a portfolio of mid tier and small cap stocks with a mixture of proven reserves, low EV/2P’s and some speculative drillers. In our Titan Natural Resources fund are positioning ourselves in selected companies, precisely on the basis of this having reaped handsome rewards from the gold miners in the recent weeks.

Yes of course there will be dusters, dry wells and failures along the way but it strikes us that the time has come for the divergence and under performance of the Oil and Gas index to stop and indeed reverse direction.

In the chart below  I have drawn a downtrend in red  for the Oil and Gas sector  (I make no apologies for  drawing the line  through and cutting  off the spring 2012 spike though this may offend a some chart purists like our editor Zak!). It is our contention that the sector is now finding horizontal support, is rebounding and testing back to the  downtrend line, which it has followed for the vast majority of the time since early 2011. Breaking above this line will the first stage in a process of normalisation which should see the sharp discount between this index and the AIM 50 peer group narrow considerably.  

AIM Oil & Gas index Versus the AIM 50 index over five years 

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R Jennings, CFA. Titan Inv Partners.