Short-term gain, long-term pain ahead

01/10/2008 - 22:00

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RALLIES on global markets last week were a direct result of short covering and some over-exuberance by a few who have not yet lost all their investments or hope.

Short-term gain, long-term pain ahead

RALLIES on global markets last week were a direct result of short covering and some over-exuberance by a few who have not yet lost all their investments or hope. The market buoyancy flowed directly from measures introduced in the UK, Australia and the US to ban or restrict the use of short selling. Meanwhile, the 'Socialist People's Republic of the USA' is moving to effectively nationalise bad debts held by a large chunk of that nation's financial system, leaving the bonuses of those who created this mess intact and untouched.

There should be no celebration in the streets following these moves. Short-term market recoveries are likely to fade away as the enormity of the financial mess begins to sink in. The actions of the US Treasury, Federal Reserve Bank and government, along with actions by the UK's Financial Services Authority and other authorities globally, signal a near-disastrous financial situation. One US Congressman was quoted as saying that, but for the measures Treasury Secretary Paulsen is seeking to put in place, the US financial system was just weeks away from total collapse.

Meanwhile, legendary US investor Warren Buffett has made a shrewd investment of $US5 billion in Goldman Sachs preference shares, yielding 10 per cent per annum; and why not. Goldman Sachs is one of the survivors and Mr Buffett will make an absolute killing on this deal.

The people of China, watching this fiasco from afar, must be fascinated and somewhat confused by the operation of this so-called capitalist system. They might even find it vaguely amusing if it weren't for the losses and devaluation of their own savings so carefully invested in the AAA rated products, which those nice people from Lehman Brothers, among others, sold them.

Sovereign wealth funds have taken an absolute hammering as a result of this chaos. An inevitable devaluation of the US dollar over the coming years will also not help that situation, as dollar denominated bonds shrink in value. Still, some sovereign wealth funds are out trawling for value and we see the government of Singapore becoming a substantial shareholder in Mirvac, clearly showing that a value benchmark has been reached there.

Gold has finally shown some form and is now acting as it should in a financial crisis. Briefcase believes that, after gapping up in AUD terms from around $960/oz, some consolidation to fill in this gap may ensue, but if support at around $A980 should be established, much higher prices should be expected, both in AUD terms and in USD terms, especially as the $US devalues under the influence of the US's printing presses minting more dollars in a hugely inflationary action.

While Middle Eastern funds were shunned two years ago when Dubai Ports tried to buy control of significant US based infrastructure assets, Briefcase is sure investors from China or the Emirates could take their pick of US assets today with little objection by jingoistic regulators and government.

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Many ASX listed oil and gas companies now trade at a huge discount to their conservatively assessed corporate valuations. As a result, there is an emerging trend to corporate action by stronger companies looking for growth. The key for many executives is how to extract that value for shareholders before they fall victim to a low-ball takeover bid.

One strategy for stocks such as Amadeus Energy or Petsec, for instance, could be to effectively put most of the company's producing assets up for sale on the professional market, achieving a value on sale with is likely to be more than twice their current market capitalisation and then give all or most of that cash back to shareholders. After all, the companies are run for the benefit of shareholders and not their management. If the companies cannot achieve a fair market value for their assets as listed entities, perhaps they should just sell them and give the cash back to its owners.

The problem with this strategy is that the price for oil and gas assets has fallen as a result of the aforementioned credit crisis, as cash strapped developers seek to offload some assets.

Last month, we saw cashed up Cooper Energy bid for larger peer company, Incremental Petroleum. Fortuitously, Cooper had cashed up ahead of a big drilling campaign on two projects in Indonesia, only to record poor results with the drill bit. Left with just over 1,000 barrels of oil per day of Cooper Basin production from about 1.4 million barrels of reserves plus over $60 million of cash, Cooper began buying Incremental stock and made a bid, in the process buying a stake in Incremental on the market, to show its intent. Market conditions look set to have conspired to defeat this bid, while a strong holding by Incremental's board and management also renders the bid unlikely to succeed, but it is a sign of things to come.

Hard working Gulf of Mexico gas and oil producer, Strike Oil, finds itself with a market capitalisation of $80 million and an expected operating cash flow of about $40 million this financial year. Strike is not alone. Many small- to medium-sized companies, including Petsec, Salinas, Carnarvon, Beach Petroleum, Australian Worldwide Exploration (AWE), Roc Oil and Tap Oil are trading with market capitalisations of about two to three times their expected 2009 financial year operating cash generation, much to the frustration of their shareholders. Moreover, stocks in this cohort are also trading at a deep discount to the underlying value of their oil and gas reserves, making them all targets for cashed up predators.

Ongoing global financial market turmoil looks set to make it almost impossible for small companies of any description to secure new equity at a reasonable cost, while debt support will become much more expensive to obtain. Those in the box seat include companies with a strong operating cash flow or piles of cash. As companies come up against funding restrictions, their stronger peers will be able to pick off juicy projects or indeed, buy whole companies at the current bargain basement levels.

Key predators might include the Tui twins, AWE and New Zealand Oil & Gas, whose coffers have been considerably enriched by the success of their Tui oilfield operations. In fact, AWE has already shown its hand after buying Arc Energy for a song. Briefcase would be surprised if AWE halts its acquisitions at this stage. The company has little to drive growth organically over the coming 24 months from its existing portfolio; and anyway, opportunities in the market present a cheaper option for the company's growth than use of the drill bit.

Instead of paying dividends or making capital returns, AED Ltd could use some of its precious cash to grow its business. Buying Norwest Energy, for instance, at about half the value of its royalty interest in the Puffin project, would make sense while offering AED some diversity of interest outside of its Puffin project area.

Carnarvon Petroleum could also end up as a tasty morsel for a predator if it does not act first to use some of its mounting cash to buy into new projects. Nexus would be a grand prize for Japanese or Chinese money, securing long-term condensate and gas or LNG projects at effectively 25 per cent of its long-term value. Nexus can now be bought for effectively $7 per barrel of oil in reserves when $30 might be a more appropriate multiple.

Up in the Philippines, both Nido Petroleum and Otto Energy are on the farm-out trail, talking with some of the world's largest and most cashed-up companies. However, potential farmin-ees may see a better way to take in interest in these projects by not paying a premium to farm-in, but instead buying the whole company. These companies may find that, by alerting big oil, they have a tiger by the tail; and since Briefcase values Otto at close to 80 cents per share, the current price of 30 cents could prove too tempting for a potential partner.

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

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