A high-potential oil prospecting stock

With investors as wary as they are, firms are being punished heavily for even minor disappointments. Take oil and gas explorer Afren. Two months ago, its shares dived on news that an exploratory well off the coast of Ghana had encountered water. Yet this accounts for just a tiny part of the group's reserves. There's still plenty to play for in this "very high potential basin".

Moreover, in April, chief executive Osman Shahenshah unveiled a "potentially transformational" oil discovery in the Kurdistan region of northern Iraq, in which Afren has a 20% interest. Results from a well operated by its US partner Hunt Oil pointed to "strong hydrocarbon shows" at a field that has previously been estimated to contain up to 917m barrels of recoverable oil (mmboe).

In January, Afren announced another huge find, in which it owns a half-share, off the coast of southeast Nigeria. Data indicate a possible resource of 157mmboe. This year the company plans to drill up to another 14 exploration wells across Kurdistan, east Africa, Nigeria and Congo, targeting new resources of 630mmboe. In March the CEO said the firm had 3.5 billion barrels of prospective resources.

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Afren (LSE: AFR), rated a BUY by Deutsche Bank

For 2012, management expects actual output of between 42,000 to 46,000 boe per day. By 2017, following the construction of a pipeline linking Turkey with Kurdistan, this is set to almost treble to 125,000 which suggests plenty of upside from today's valuation.

Even after factoring in its relatively high gearing, the shares look far too cheap. In the first quarter alone, Afren generated $300m of operating cashflow from lifting 41,308 boepd. At this rate, it should have little trouble repaying its net debt of $639.4m, $138m in finance leases and $217m in deferred consideration.

Corporate governance is one issue to watch the firm recently got a public tongue-lashing from a few major shareholders, after Shahenshah's pay more than doubled to $3.4m on a one-off bonus. Other risks include cost inflation, oil price volatility, geopolitical risk, environmental pollution, natural disasters and foreign-currency fluctuations.

But assuming a Brent crude price of $90 a barrel, I value the stock at 140p a share. Deutsche Bank has a target of 270p. Interims are out on 21 August.

Rating: BUY at 101p

Paul Hill also writes a weekly share-tipping newsletter. See www.moneyweek.com/PGI or phone 020-7633 3634.