Bulls bounce back on Wall St

This week, Briefcase is able to report directly from the streets of New York, where the mood among stock and commodity traders has taken a bullish turn.

The demise last month of long-established merchant banking organisation Bear Sterns is now viewed by many as the defining moment in this bear cycle, signalling a bottom, or at least a temporary base. Briefcase is not so sure if this is the case, but there can be little doubt that the mood has since swung dramatically to the up side.

Last week, on a day when bad news – ranging from ongoing poor corporate earnings, weak consumer confidence and a rising oil price – should have sent the market lower, we saw a key intra-day reversal.

After trading down on Friday morning, the bulls took control and the bears were forced to cover their shorts, sending the market to a higher close.

Supporting this bullishness is the high level of cash being held by many investment funds, wealthy individuals and hedge funds. Reports from ‘the street’ indicate that liquidity levels have never been as high. Clients are now keen to re-enter the market, since it appears to have settled. This news has also buoyed traders, many of whom are now recording record trading days on strong turnover.

A bullish outlook for commodity prices is all the buzz in New York. Agricultural commodities feature prominently in the sights of many traders, supporting my previously stated bullish views on PrimeAg.

This view should support Australia’s fertiliser and agricultural chemical companies, despite the rise in raw materials costs, which will be largely passed on to the user, as well as other stocks in the sector, such as beef producer, Australian Agricultural Co.

South American bourses have come into favour, with Brazil seen as a country with expanding arable land (most likely as a result of the destruction of the Amazon Jungle, which is another story altogether!).

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In a long awaited corporate move, Australian Worldwide Exploration (AWE) has broadened its shoulders, making an agreed takeover offer for Arc Energy.

In the case of Arc and AWE, both companies have net cash balances and both are supported by strong operating cash flows. However, as a result of a very strong performance from the Tui oilfield, AWE is swimming in cash and has to find ways to shore up its long-term growth profile. AWE hopes to consolidate positions in the Bass and offshore Perth basins, while gaining exposure to Western Australia’s strong natural gas market and high-value oil production through a position onshore.

In an unusual move, Arc is spinning off its high impact Canning Basin exploration permits into a vehicle that will be an escape capsule for some of the Arc team.

The companies say that a bid of 0.3 AWE shares, cash and 0.425 shares in Canning exploration spin-off, Buru, values Arc at $1.59 per share.

But Briefcase has another view, valuing Arc at $2.24 per share, of which, 67 cents per share represents its risk-adjusted exploration upside, leaving a value of $1.57 per share for oil and gas assets, plus cash and investments, less corporate overheads, which is close to the bid value. Under normal circumstances, a buyer (AWE) will not want to pay for exploration, but existing shareholders may have a different view.

In support of AWE, Arc has recently been unable to attract any market premium for its exploration upside, while AWE clearly does carry considerable value for its exploration, and thus it is willing to use its shares as part payment.

Meanwhile, Arc Energy has had a run of indifferent exploration luck in both its Perth and Canning Basin permits, so it trades at a discount to its risked exploration upside and even to its underlying value for oil and gas plus net cash assets.

While Arc has had a lack of commercial success, tantalising technical success holds out the opportunity for an eventual commercial result in both the Perth and Canning basins.

Arc shareholders might be right to feel a bit miffed at selling their shares at a value of $1.59, but they could maintain touch with the exploration assets via offerings in both AWE, which also has great exposure in the Taranaki Basin and Indonesia, and the Canning specialist Buru. Furthermore, an enlarged AWE would have the financial capacity to meet heavy exploration costs associated with deep drilling offshore New Zealand and development expenses associated with the Bass Basin’s Trefoil field.

Arc values the Canning Basin exploration spin-off Buru at 73 cents per share, which Briefcase thinks is fair, except that Buru would appear to have an obligation to refund Alcoa a $40 million pre-payment for gas, on which it may not be able to deliver. After allowing for this impost, and assuming 161.7 million Buru shares plus 54.1 million deeply out of the money options, Briefcase values Buru at 86 cents per share, including 71 cents per share for its exploration upside. Given Arc’s lack of market value for the Canning acreage, Briefcase does not envisage that Buru, being almost entirely an exploration play, will be highly rated for this upside, so a price target of 67 cents per share is estimated after discounting exploration to 30 per cent of its risk-adjusted value, giving Buru an estimated market cap on listing of around $109 million.

Buru’s problem will be that it will have finite cash resources of close to $75 million, $40 million of which is effectively a pre-payment for gas. Drilling wells in the Canning Basin can cost $4 million to $6 million each, so Buru might soon burn through this cash unless it farms out some of the exploration cost and risk.

If Buru’s recent technical successes fail to deliver, times would get very tough and there would be no fall back for Buru from cash flow or exploration in the Perth Basin to support its shares.

But if the results are positive, the leverage to success would be 3.5 times as great as for existing Arc shareholders, at current equity positions. 

For the purpose of this bid, AWE is valued on the basis of its recent trading performance at $3.63/ share. Briefcase actually values AWE at $3.34/ share, or $2.88/share, excluding its exploration upside. Applying this lower valuation to the equation provides 87 cents for 0.3 of an AWE share and 28 cents for 0.425 of a Buru share, adding 19 cents per share of cash, gives a value of $1.34 for each Arc share, if you doubt the market’s recent action on AWE and have a more severe interpretation of how the market will welcome Buru to the bourse.

Overall, Briefcase sees that AWE’s bid could succeed, but also sees room for a more generous offer, closer to its valuation of $2.24/share.

A sniff of gas from the Yulleroo or Valhalla prospects, or even some success at re-working Stokes Bay could easily change the equation.

• Peter Strachan is the author of subscription-based analyst brief StockAnalysis, further information can be found at Stockanalysis.com.au