Oil stock goes with the flow

Drillsearch shares have eased off, but higher oil production will boost returns.

Summary: Copper Basin oil and gas producer Drillsearch Energy continues to excel, despite its shares having slipped back from a 12-month reached last week. Some analysts say higher oil output has been priced into the company’s shares, but the market is expecting more good news ahead.
Key take-out: Drillsearch’s production this year should be around triple what it was last financial year, and analysts are tipping further reserve upgrades across the company’s Cooper Basin tenements.
Key beneficiaries: General investors. Category: Shares.
Recommendation: Outperform (under review).

Drillsearch Energy (DLS) was a good stock nine weeks ago when I recommended the company as an oil and gas producer that would outperform, and it’s an even better stock today – which is why the outperform tip sticks.

Back on December 4, the Cooper Basin focussed stock closed for the day at $1.29. Last Wednesday it hit a 12-month high of $1.63, causing some investment banks to tell clients it was time to take profits.

That advice was heeded because, over the past few days, Drillsearch has slipped back to $1.46. However, over the next few months it should become clear that the good news from Drillsearch’s central Australian oilfields will continue to flow as production rises and the company starts to build a handsome cash pile.

A glimpse of the future came last week when Drillsearch surprised the market with a significant production guidance upgrade.

Rather than producing between 2.3 million and 2.5 million barrels of oil in the 2014 financial year, management now expects production of between 3 million and 3.3 million barrels.

To put that updated output forecast into perspective, Drillsearch’s production this year should be around triple what it was last financial year.

The increase is largely due to better-than-expected flows from the partly-owned Bauer oilfield, which delivered 13% more oil than forecast and 29% more revenue at $111 million.

Drillsearch managing director, Brad Lingo, said he was confident the strong production rates could be maintained from the permit containing the Bauer field, PEL 91.

“The Bauer field has been a prolific performer since it started up in 2012, and with a number of new fields still to be tied in … we’re confident that we can sustain production from the block into the future,” he said.

It was that promise of more oil and more cash that lifted Drillsearch to its 12-month share price high, a performance which caused some analysts to say that the stock has done its best work for now.

Macquarie, UBS, J.P. Morgan argue that the oil (and cash) flow from the Bauer field is “in the price” of Drillsearch, rating the stock as neutral.

Deutsche Bank does not agree. It argues that the upgraded production guidance deserves an upgraded target price forecast, with $2.05 seen as the next stop for Drillsearch.

Reserve upgrades in Cooper Basin

The problem for anyone trying to analyse the future profit performance of a small oil and gas stock is that there are multiple risks, not least being geological risk (oil flow slows) and price risk (the oil price tumbles).

Macquarie, despite its note of caution, acknowledges that the latest production guidance for the 2014 financial year “could again prove conservative.”

It has gone a step further than Drillsearch’s management, forecasting oil output this year of 3.5 million barrels, plus the bonus of a reserve upgrade across the company’s extensive exposure to Cooper Basin tenements.

Macquarie said the reserve upgrade could see the estimated size of the Bauer field increase beyond the 10 million barrels previously reported by Drillsearch’s partner in the project, Beach Energy.

J.P. Morgan, which last week downgraded Drillsearch from overweight to neutral, told clients it continues to like the company’s strategy and asset mix but believes there are better options for exposure to the Cooper Basin, including Senex Energy.

“It could be time for the share price to take a breather at its 12-month trading high,” J.P. Morgan said.

As a prediction, that observation was spot on. Drillsearch has pulled back and should now be ready for the next upward move, which will be driven by a combination of rising rates of oil production, an increase in reserves, substantially higher revenue and strong earnings.

Deutsche Bank reckons oil production from the Bauer and other Cooper Basin fields in which Drillsearch has an interest will boost the company’s revenue from $102 million last financial year to $340 million this year.

Much of that revenue will stay with Drillsearch as profit, with earnings before tax and other charges expected to come it at around $231 million and net profit at $115 million, which is the equivalent of 26c a share.

None of the investment banks following the stock predict a dividend over the next three years, with cash being reinvested in expanding production.

Drillsearch

2013-14

2014-15

Earnings/share (adj)

26.6c

21.6 cents

Dividend/share

-

-

EPS growth (adj)

151.8%

19%

DPS growth

-

-

Price/Earnings

5.2 times

6.4 times

Dividend Yield

-

-

Source: Bloomberg

Prospects for additional discoveries

Another factor not featuring in analysis of the stock is geological upside, or the potential for additional discoveries as a busy drilling program tests fresh targets on the company’s tenements. This is especially so around the hottest Cooper Basin address in its re-birth as an important source of oil and gas – a region known as the western flank.

Early stage exploration such as seismic surveys has identified more than 100 potential targets for future drilling in the western flank area, containing an estimated 44 million barrels of oil.

Further into the future there is the untested potential for large reservoirs of unconventional oil and gas – the so-called shale-gas deposits which have revolutionised the US oil and gas sector – which is yet to capture the attention of Australian investors.

Over the next few years the Cooper Basin’s unconventional gas resources will become important for both domestic consumers and possibly as an additional source of supply for the LNG export projects being developed in Queensland.

It is the prospect of an immediate increase in oil production and the lure of future discoveries and development that makes Drillsearch a stock which should continue to outperform.

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