Tap Oil versus Oil Search

With it went much of the hope of making the 3200km gas pipeline from PNG to eastern Australia a reality. After the subsequent 18% share price fall, in this review we'll explain why we now believe it's a good speculative play.

We'll also provide an update on Tap Oil's prospects after its failed takeover attempt of ARC Energy earlier this year. Despite being a quarter of the size of Oil Search, it too, is a speculative buy.

These companies' names are a bit of a giveaway – both are in the business of searching for and producing oil and gas, a speculative game if ever there was one.

The bulk of Oil Search's assets are found in Papua New Guinea, while Tap Oil focuses on the rich pickings of the Northwest Shelf (Carnarvon Basin), off the coast of Western Australia.

Oil Search has recently gained a stranglehold in PNG after its $1.5bn merger with Orogen Minerals in January. Its most productive fields are Kutubu, Moran, Gobe and Saunders and, thanks to the asset overlap with Orogen (the reason for the merger) Oil Search has increased many of its well interests to over 50%.

Less exploration risk

Tap isn't as concentrated, operating in more fields but with a smaller interest in each. This reduces the exploration risk but it also means that Tap is only entitled to a smaller piece of the cake, if and when oil or gas is found.

The key fields for Tap are the Harriet JV, Agincourt, Simpson, Bambra and the oddly named Woollybutt – we offer no explanation as to why. Tap generally holds stakes of between 12% and 15% in each of its fields.

To the takeover: in March Tap offered ARC Energy shareholders one Tap share for every four ARC shares. Despite pushing ARC's share price up 35% the offer failed and Tap refused to make a higher bid.

This, we feel, is indicative of Tap management's approach.

Tap Oil has only been around since 1996 but has achieved an enviable record of increased production and profits, as the comparative share price chart suggests.

Oil Search, on the other hand, has suffered from a natural rate of decline in some of its key wells. Its 2001 full-year production was down 12% to 6.3m barrels but with the acquisition of Orogen and a boost to development, that trend should soon be reversed.

So, how do the two stocks compare on the exploration front? Well, Oil Search has more drillings planned for the remainder of this year at its Kutubu, Globe, Moran and Saunders sites. Tap, on the other hand, looks busier than a dentist in a lolly factory.

It has up to 16 drillings planned, with sites at Woollybutt and Simpson the most prominent. With just over a 50% success rate we're keeping our fingers crossed that at least half of these come good. It certainly means there's some excellent upside if they do.

That, though, does not warrant a buy recommendation in itself. What, then, of the fundamentals? With $26m in cash for the half-year ended December 31, Tap's net debt is non-existent.

It's cash positive to the tune of $12m, assisted by operating cash flows of $11.7m, although if exploration and development expenditure were included, it would have been a negative figure, $10.2m in fact.

This is one risk factor worthy of attention. Shareholders don't want to be forever drip-feeding cash via more stock issues.

Reasonable debt

For the full year ended December 31, Oil Search had a reasonable net debt-to-equity ratio of 35%. It generated a 25% increase in operating cash flow to $146m and for the record, $136m was spent on exploration and development.

By swallowing the debt-free balance sheet of Orogen, largely with scrip, the balance sheet of Oil Search will be stronger than it was at 31 December.

To hedging: in the past, Oil Search has suffered from a fixed priced hedging program at levels well below the prevailing market price.

But now it buys 'put' options for protection against oil price drops, without being excluded from potential rises.

For years Tap's hedging policy has been not to have a policy. With the share price up 99% since issue 29/May 99 (Accumulate – $0.71) it's a strategy that shareholders have liked but does this and Tap's other strengths make it a better stock than Oil Search?

We can't answer that without looking at the price. First, forget dividends. While these two companies are trying to establish themselves, all available cash is put back into the business.

On a PER basis, because of the Orogen merger, Oil Search is on an expected 2002 PER of 16.

Profits to double

We're forecasting Tap's 2002 PER to be closer to 14 but profits are set to double by 2003 so that would make it much lower, if it eventuates.

While the PER measure can help, it's not very reliable when valuing exploration stocks. What really counts is whether the companies can discover new fields and not get wiped out by lower oil prices in the process.

Here, we favour Tap's track record. With over 80 new sites earmarked for investigation, the future looks very promising.

Oil Search's future isn't so clear, although a full strategic review later this month should help it become so.

In issue 105/Jun 02 (Hold while Unstable – $0.81) we were cautious before taking a good look at Oil Search. We're now happy to recommend it as a SPECULATIVE BUY, believing that in the wake of the latest gas pipeline news the market has discounted the price too far.

Highly speculative

With benefits from the Orogen merger still to come and the chance of the project finally going ahead, the re-rating would be spectacular. This, though, is highly speculative.

For subscribers a little more risk averse but still fond of a punt, Tap Oil is a better bet. As we said in issue 104/May 02 (Speculative Buy – $1.58) it remains a SPECULATIVE BUY.

As the oil price, production levels and exploration results – not a massive pipeline – determine its fortunes, its prospects are more easily influenced by management than by external factors. That's not to say that its share price will be higher than Oil Search's in the future but it does imply less risk.