Spotting oil bid targets made simple

Low oil prices have caused a surge in industry M&A activity. Shell is buying BG, Spain's Repsol has picked up Talisman Energy, and Emirates National Oil Company (ENOC) is trying to snare Dragon Oil. Investors are rightly asking who's next? Broker Jefferies believes there's a simple formula to weed out the most vulnerable drillers.

The European exploration and production (E&P) sector currently trades at a simple average of $15.5 per barrel of oil equivalent (boe) of enterprise value (EV)-to-proven and probable (2P) reserves. M&A history shows an upper limit of $15-17/boe 2P reserves. "For M&A activity to occur, stocks must first trade significantly below this level to allow a 40-50% bid premium," says Jefferies.

It has done some work on reserve life metrics, too, based on the 2P reserves over estimated full-year 2015 production for each stock covered. "Value of de-risked reserves combined with strategic rationale is a constant in 17 corporate M&A deals stretching back to 2008," it says.

The E&P-weighted average for the past 15 deals is about $16/boe for 2P reserves. Include the Shell and Repsol deals and it falls to $13. "Crucially, though, the targets fell to significant discounts ahead of bids, allowing sufficient premiums (49% on average) to get the deals over the line."

"This may seem a simplistic argument, but to us it makes clear sense. Industry weighs the cost of bringing through production versus the access to barrels," writes the broker. "The exploration, appraisal and even development risk included in a premium trading metric is a tough acquisition hurdle to justify across the Board table."

Using this theory, the broker reckons the eternal M&A candidate Tullow Oil is just too expensive. It believes the value argument does not stand up at $25/boe 2P reserves before any bidder premium. East African 2C resources (best estimate of contingent resources) are also unlikely to convert to reserves anytime soon, which suggests the shares are worth just 285p, according to Jefferies.

Clear candidates to trade with "value M&A" premium parameters are tough to find, so look for stocks with either 2C resources about to convert into 2P, or stocks with early stage material discoveries which can grow in value through successful appraisal, such as Cairn.

Cairn is targeting the conversion of 330 million barrels (mmb) of oil gross (132mmb net) through appraisal of the SNE-1discovery offshore Senegal. Drilling is expected to begin toward the end of the year.

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"Consider that Cairn's $18.4/boe 2P trading metric today falls to $8.3/boe if its 40% share of the 330mmb SNE-1 Senegal discovery can be brought through by late 2016," says Jefferies. "The uplift to West African peer group metrics is therefore apparent."

A price target of 222p, up from 175p previously, is justified at $15/boe 2P even with $500 million of net debt. "Keep the balance sheet ungeared and 315p is possible upside at $17/boe EV/2P."

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.