Cue Energy goes dry

It was a permit with huge promise. Cue Energy had attracted industry heavyweights—first Woodside Petroleum then BHP Billiton—to pay for the drilling of permit WA-389-P in the Carnarvon Basin. Pre-well data was compelling, the real estate top notch and the probability of success high. Unfortunately WA-389-P came up dry. Cue Energy shares fell more than 10% after the result.

Such a large fall was surprising. The well was financed by the majors so there was no cash cost. The company’s oil and gas production is also growing steadily, if unspectacularly, and Cue carries about $50m in net cash. Yet this is the second high risk well to have failed. In 2010 a duster at the Artemis prospect (see 14 Dec 10 (Hold – $0.32)) was also met with disappointment and rebuke.

Investors have a choice to make. With two plum exploration permits having come up dry, what should they do now?

There are arguments for both holding and selling. Let’s examine each in turn.

Hold or sell?

We initially recommended buying Cue for exposure to two of the best exploration blocks available to a small driller. The unusual combination of large company involvement, zero-cost drilling and excellent pre-drill data was enough to warrant a punt.

As we explained in Cue Energy: ready to roll on 07 May 10 (Speculative Buy – $0.24), failure was always the most likely scenario but, in the event of success, Cue would be worth multiples of its price. It was classic speculation; large risk, large reward. It didn’t work out.

The 27% share price decline hasn’t necessarily made Cue a bargain. Significant upside has been lost and the initial investment case no longer stands. Buying the stocks today after its best prospects have proven dry is not intelligent speculation; it’s an act of faith.

There is a case for holding. Today’s price reflects disappointment and undervalues Cue’s base business. Oil production in New Zealand, high margin gas sales in Indonesia and a large gas resource in Papua New Guinea all have value. The remaining exploration isn’t as exciting as earlier targets, but it’s been enough to encourage the participation of the highly regarded Apache Energy.

Excluding exploration potential, we estimate Cue is worth about 20c a share. Although this is a 14% premium to today’s price, it’s not enough to warrant holding a small risky oil producer.

The case for selling is stronger. We recommended Cue for a specific investment thesis that didn’t work out. That is the lot of oil and gas companies. Even the best data and geology is hostage to luck. When a thesis doesn’t work out, it’s better to change the investment and look for another opportunity rather than to change the thesis and cross your fingers.

Some members may continue to hold the stock for further speculative gains. Having rolled the dice, we’re electing to take our cash elsewhere, especially in a market that is throwing up a number of bargains. Despite the share price falling 38% since 16 Mar 12 (Hold – $0.28), it’s time to SELL.