As blue-chip stocks are running out of favour, investors should start paying more attention to small and mid-cap growth stocks. The ‘Small Ordinaries’ index has recently outperformed the ‘S&P/ASX200’ and research suggests that diversification into growth companies is healthy for most portfolios. Today’s stock in focus is the oil and gas explorer Carnarvon Petroleum (ASX:CVN) which made headlines in 2014 following a significant oil discovery in the North West Shelf of Western Australia.
Company in Focus: Carnarvon Petroleum
Carnarvon Petroleum Limited (ASX: CVN) is an oil and gas explorer focused on the North West Shelf of Australia. The company has a 100% interest in the Cerberus project and a 20% interest in the joint venture exploration project in the Phoenix area which gained popularity following a significant oil discovery in 2014. The discovery was the largest oil discovery in 20 years in the Phoenix area which is now a joint venture project between Carnarvon (20%), Finder Exploration (20%), JX Nippon (20% and Quadrant Energy (40%).
Carnarvon’s Strong Balance Sheet & Land Package are Near-Term Drivers
Quadrant Energy will commence drilling in the Roc-1 well project in the 2015 December quarter and the cost of the well is estimated to be at $70 million, which will be funded by Quadrant and JX Nippon. After the recent approval from the government to extend the licence term for the joint venture project until August 2017, the company does not have to relinquish any portion of the acreage for drilling and assessments.
The projects’ drilling and exploration activities come at a relatively favourable time for the company, as oil prices have experienced sharp declines over the past year. If resources can be converted into commercially viable reserves, future earnings would benefit from any cyclical recovery in oil prices.
The company has zero debt and more than $100 million cash after divesting its Thailand assets earlier this year. Its market capitalization is at ~$120 million as CVN is trading close to its cash backing and only little value is ascribed to its explorations assets. The company’s management team has a strong track record in the industry.
Hurdles: Volatile Oil Price & Operational Challenges
The company’s projects are still in the drilling stage and there is no guarantee that it can convert its assets into economically recoverable reserve. Furthermore the share registry is relatively fragmented and Carnarvon could therefore be prone to takeovers below fair value.
Global oil prices have dropped more than 40 percent in the past year and there is no guarantee that prices will recover in the near-term future. Therefore, any further declines in the oil prices will likely restrain the company’s ability to generate future earnings. Industry peers like Santos, Woodside Petroleum, Oil Search and Beach Energy have suffered substantial losses due to the oil price decline.
Wise-owl is attracted to Carnarvon Petroleum as it provides speculative exposure to the domestic oil and gas industry. We are attracted to its undemanding valuation of ~$120m which is only slightly above its cash reserves. Investors have little value ascribed to its exploration assets, which allows for significant upside if progress can be made in its exploration activities. Taking into consideration that global oil prices have declined sharply over the past 12 months, the timing for the scheduled exploration is generally favourable.
So far 2015 has been the year where clue-chip stocks ran out of favour and recent research suggests that the ‘Small Ordinaries’ have outperformed the ‘S&P/ASX200 over the past few weeks. The bull market of the past few years has left small caps behind, however the current environment appears favourable. This might be due to the ‘Turnbull Effect’ or because investors struggle to see value in overvalued blue-chip stocks. Investors should consider increasing exposure to small and mid-cap growth stocks. You can read more about investing in emerging companies here.
In summary Carnarvon Petroleum is a speculative oil and gas play due to its strong balance sheet, attractive land package and strong management team. The technical chance of success at Carnarvon’s Roc-1 well has been estimated at 42 per cent and if oil prices remain stable, then we believe CVN has the potential to double in value.