Drillsearch's positive energy flow

The oil and gas producer is well placed to serve our growing energy market.

Summary: Australia’s East Coast is facing a gas shortage, and those companies able to fill the void will do well. Enter Drillsearch, an oil and gas producer and explorer that is set to ramp up output from its substantial energy reserves in Central Australia’s  Cooper Basin.
Key take-out: Analysts cite Drillsearch’s large energy resources, growing cash flows, and its potential as a takeover target.
Key beneficiaries: General investors. Category: Shares.
Recommendation: Outperform (under review).

Australia’s looming East Coast gas shortage is bad news for gas users, but excellent news for investors with an eye for companies set to profit from the problem. This is why Drillsearch (DLS) earns an outperform rating.

One of the smaller participants in the central Australian oil and gas province of the Cooper Basin, Drillsearch has been quietly lifting production, boosting profits and expanding its exploration footprint.

Success in the field, including more oil and gas produced in the September quarter than in the whole of the previous financial year, is being matched by rising profits and growing recognition by big-name investment banks that Drillsearch is a small company destined to become much bigger.

The current driving force in the stock is oil, particularly from an area of the Cooper known as the western flank. Also, a series of relatively small fields are collectively enabling Drillsearch to lift production to its forecast production rate of 2.3 to 2.5 million barrels of oil equivalent, and some analysts are tipping the annual rate will hit 2.7 million barrels this financial year.

More gas, in a variety of forms and from different layers of the Cooper’s hydrocarbon-soaked geology, will be the future of the stock. The gas will come from conventional structures, or from the potentially world-class unconventional structures (shale gas).

Production pecking order

Maximising the volume of liquids, the most valuable form of petroleum, is the challenge for Drillsearch. This is why its exploration and production pecking order is oil first, wet gas (gas rich in liquids) second, and dry gas third.

It is the multiple types and multiple sources of raw material, plus ongoing exploration success and a market showing signs of desperation for supply, which have combined to see Drillsearch added to the “conviction buy” list of the international investment bank Goldman Sachs. This is despite the stock having a modest market value of $550 million.

What analysts see in Drillsearch is a company at the start of a period of rapid growth, thanks to it being in the right place, at the right time, producing products that are in demand.

Strong rates of production are flowing directly into Drillsearch’s accounts, with last year’s pre-tax profit of $37 million expected by Macquarie Bank to rise more than four-fold this year to around $150 million.

No dividends are expected over the next three years, with the company re-investing every dollar in a busy drilling schedule that should set the business up for a time when East Coast gas prices rise from their current $7 a gigajoule to closer to $10 a gigajoule.

The East Coast opportunity

Drillsearch chief executive, Brad Lingo, calls the current situation as a “once in a generation opportunity” with the company having its foot on an expanding base of oil and gas reserves that are ideally placed to serve a thirsty and growing market.

“As a pure Cooper Basin producer and explorer, we are well placed to capitalise on the near-future opportunities from east Australian gas market fundamentals,” he said.

Lingo lists four points as the keys to Drillsearch’s immediate future: substantial wet gas reserves, access to established Cooper Basin infrastructure, commercialisation partnerships in place with much bigger oil companies (Santos and BG), and a proven ability to deliver on its promises.

In the western flank area, Drillsearch has identified more than 100 potential exploration targets and has enjoyed stronger-than-expected oil flows from recent discoveries such as the Bauer field.

While consistent cash flows can be expected from oil and conventional gas production, the future could be dominated by unconventional gas, which is trapped in structures yet to be proven as commercially viable in Australian conditions.

In theory, but yet to be proven by drilling, Drillsearch has a target of outlining 1-2 trillion cubic feet of unconventional gas by the end of next year, with up to another 2tcf of unconventional gas by the end of 2015.

It is the unconventional gas potential of the Cooper Basin that has attracted international oil majors such as Chevron to the region, hoping the conditions are similar to those found in the US. Unconventional oil and gas discoveries have transformed that country’s economy through the production of large amounts of low-priced gas.

Macquarie is a fan of Drillsearch, rating the stock as outperform, with a 12-month share price target of $1.60, around 27% higher than its recent sales at $1.27.

In its latest research report on the stock (November 20) the bank upgraded Drillsearch from neutral to outperform, thanks to rising oil production and growing interest in its exploration program on its western flank tenements.

“With Drillsearch participating in 22 oil wells over the 2014 financial year, drilling results are likely to confirm the growing crude oil production and exploration potential,” Macquarie said.

Goldman Sachs has also upgraded Drillsearch to a buy recommendation, noting its stronger-than-expected rate of oil production, improving balance sheet position as cash flow rises, and the potential strategic appeal of the stock as a takeover target in the event of consolidation of Cooper Basin assets.

Of interest to investors with an appetite for the risks associated with punting on a potential takeover, Goldman Sachs said it believed Beach Energy is sitting on a 4.9% stake in Drillsearch.

“We note that Beach has become more aggressive in taking equity stakes in smaller western flank players in which it has joint ventures,” Goldman Sachs said.

Deutsche Bank, UBS and J.P. Morgan echo the views of Macquarie and Goldman Sachs that Drillsearch deserves an outperform recommendation, with Deutsche winning the prize for the most optimistic 12-month price target of $1.90 while J.P. Morgan is the most conservative at $1.44.