Sterling Energy is James Faulkner’s Small Cap of the Week

Spreadbet Mag and t1ps.com are both of the opinion that the resources sector currently offers value in a market where value is hard to come by. With this in mind, t1ps.com has uncovered what we believe looks like a very interesting situation indeed…

The market just does not want to know about oil explorers at the moment, certainly not ones with a recent history such as Sterling Energy’s. Sentiment hit rock bottom when the firm’s Bamboo-1 well in Cameroon was plugged and abandoned after it failed to find a commercial discovery. Given that this came on top of an abortive foray into Kurdistan, it is perhaps understandable (but not justifiable?) that the market has lost interest.

As at 30th June 2014, Sterling Energy was sitting on cash of $110.9 million (c.£68 million) and had no debt. The current market capitalisation of Sterling Energy is just over £58 million.

Obviously the market is taking a very dim view of the firm’s prospects given the poor track record, but we believe market pessimism has gone too far. Sterling already has a production base, albeit a small one, in Mauritania. In FY14, Sterling’s 8% share of production from the Chinguetti field netted Sterling 436 bopd (barrels of oil per day), enabling it to report a profit after tax of $1.7 million on turnover of $9.1 million.

This also means that Sterling is cash generative at the operating level (+$3.2 million in FY14), so barring any acquisitions, farm-ins or exploration activity, we believe the firm should be able to maintain and possibly even grow the cash position.

We also believe it is too early to write Sterling off as an exploration play. Sterling holds interests in a large acreage position in northwest Madagascar in the Ampasindava and Ambilobe Blocks. These blocks are located in one of the largest, undrilled, deep water provinces offshore East Africa, spanning the Majunga and Ambilobe basins. Exploration activities on both blocks were suspended in 2009 due to an uncertain political situation in Madagascar; however democratic elections in December 2013 resulted in the election of Hery Rajaonarimampianina as the new President and his government is now in place.

Experts believe that Madagascar could be sitting on as much as 20 billion in untapped oil reserves, and the change in political climate could be the catalyst to see it begin to be exploited.

The most likely candidate for near-term newsflow is the Ambilobe PSC (Sterling: 50%), where Sterling is carried for the acquisition of a 3D seismic programme, up to a maximum of $15 million, by partner Pura Vida. The PSC covers approximately 17,650 km2 of the Ambilobe Basin, a large under-explored area where both Cretaceous and Tertiary leads have been identified. There are no outstanding work commitments in the current phase, but 3D seismic expected to be acquired in Q4 2014 aims to mature the best leads to one or more drill ready prospects prior to the expiry of Phase 2 (September 2015) as Phase 3, if entered, has a commitment to drill an exploration well.

Next up is the firm’s 30% non-operated working interest in the Ampasindava licence, where the firm sits alongside Exxon Mobil, the world’s largest listed oil company. Ampasindava contains the Sifaka prospect, which is independently assessed to potentially hold gross best estimate prospective resources of 1.2 billion barrels, but is considered to be a very high-risk target. Again, Sterling’s costs here are carried up to a fixed amount, but Sterling has indicated that it would seek to farm-out its share in the event of drilling due to the significant costs involved. In any case, success here could be truly transformational for Sterling given the size of the prospect.

Moving on, but staying in East Africa, we have the Odewayne PSC (Sterling: 40%), which comprises an area of 22,840 km2, onshore Somaliland. During 2013, an aero-magnetic and gravity survey confirmed the geometry of a broad basin over the Odewayne block believed to be of Jurassic to Cretaceous origin, analogous to productive basins in Yemen. Fieldwork in the block has highlighted the presence of numerous seeps giving encouragement that a working hydrocarbon system is present in this undrilled basin. Here, Sterling is carried by operator Genel for the costs of all exploration activities during the Third and Fourth Periods of the PSC, which expire May 2018. Clearly, this is a very early stage prospect, and operations have currently been delayed until the government can provide the level of security required by the in-country operators so that future seismic and drilling operations can be conducted safely. An Oilfield Protection Unit is expected to be operational in 2015.

Also of note is that the Bamboo-1 failure didn’t end the firm’s Cameroon operations. In fact, it has provided significant new geological information in what remains a lightly explored area. The data from the well continues to be analysed and the results are being used to assess the remaining prospectivity of this large deep-water block which covers some 2,319 km2. The current phase of the Ntem concession (Sterling: 50%) runs to April 2015 with no outstanding work commitments and an option to extend it by a further two years.

What’s it worth?

At the current price of 26.5p, we believe shares in Sterling Energy represent an asymmetrical risk/reward trade. In our view, the current valuation is more than accounted for by the net cash position and existing production base, which offers investors ‘option value’ over the potential success of any one of the firm’s exploration plays.

Interestingly, Bamboo was a 450 million boe prospect and accounted for 105p (risked) of broker Westhouse’s 141p valuation for Sterling (prior to the drilling of Bamboo-1). Westhouse’s current target price for the shares is 35p, which currently attaches no value to the firm’s 30% stake in Ampasindava (a 1.2 billion barrel prospect) given that “there is no clarity on when a well might be spudded”.

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