One small-cap oil share for the brave

Kurdistan contains vast oil reserves, yet few major oil companies operate there. But if you can stand the legal and security risks, this small-cap oil company could give massive returns, says Tom Bulford.

There's no doubt about it. Kurdistan contains oceans of oil. Hopefully, you were among the readers of my newsletter, Red Hot Penny Shares, that made many hundreds of percent returns on Gulf Keystone (LSE: GKP) when it struck oil there recently.

Well now the hunt is on for the next get-rich-with-oil Kurdistan strike. With few foreign companies willing to risk the wrath of the Baghdad government, the number of candidates is small. But penny share aficionados have alighted upon Sterling Energy (LSE: SEY).

I wrote about Sterling on 21 May. Back then, I told of my surprise that this once respected oil junior had managed to get into so much of a mess.

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Well, four months on and things have now reached a predictable conclusion. Shareholders have been obliged to stump up fresh capital to keep the business alive. The former directors have been shown the door.

Could this be another Kurdistan success story?

Replacing them in charge of the operation is Alastair Beardsall, whose credits include the successful turnaround of Emerald Energy (LSE: EEN). Here he oversaw a rescue rights issue at 25p per share in 2003 and today [10 september] Emerald is in receipt of a 750p cash offer from Sinochem. Sterling Energy's shareholders would certainly settle for a similar return.

Beardsall likes the fact that Sterling has interesting assets but has been strangled by a lack of finance. He has a reputation for running a tight ship, and for issuing a minimal number of new shares. In a new research note, these are all arguments put forward in favour of Sterling's shares by broker Evolution. But the overriding matter, at least in the short term, is Sterling's drilling programme in Kurdistan. What could success be worth?

I'll come to that in a moment. But first, let me tidy up Sterling's other interests and the tricky matter of its relationship with the bankers. For the last year and a half Sterling has been living from one banking review to the next. But it has now raised the hefty sum of £62.5m through an issue of shares at 1.3p.

A further £20.6m may follow, depending upon how many shareholders elect to take up the open offer to buy shares, also at 1.3p, which closed on Tuesday. Given the discount to the prevailing stock market price of 3.6p, one would expect the majority to do so, so Sterling's coffers should be about £80m better off.

With this out of the way, Sterling can now proceed with the sale of its producing assets in the Gulf of Mexico and this could raise another £50m or so. Set against these cash sums, Sterling has debt of some £70m and it may have to pay its share of drilling programmes off-shore West Africa and Madagascar. Unless Sterling farms out its interests here, these projects could require an investment of £60m, but this will not be until late next year. By that time we should know how Sterling has fared in Kurdistan.

The gamble that investors in this company take

Here it has an interest in the Sangaw North Block, and drilling is expected to start before the end of this year. It should hit the first potential oil bearing rock in 60 days and complete drilling in 150 days. Sterling's interest is likely to fall as partner Addax farms into the project and the Kurdistan Regional Government takes its share. Even so, Sterling will still be left with 40% and Addax will pay all of the initial 'dry hole' drilling costs, leaving Sterling to chip in only at the point where any oil flows are tested.

So, basically, Sterling now has a clear run at this prospect, without having to worry about appeasing its bankers or progressing its other exploration projects.

Of course, there is no knowing whether Sterling will strike oil at Sangaw, although the success rate in Kurdistan seems to be pretty high. But as a guide we have an independent report. That gives a 'best estimate' of Sangaw's oil reserves at 1.335 bn barrels of oil (Gulf Keystone has estimated 1.5-3bn bbl at its Shaikan strike), with the chance of success given as 27% at the shallower levels and 10% at greater depth. On this basis the prospect at present is valued at 2.2p per Sterling share, assuming a $70 oil price and a £/$ exchange rate of 1.65.

But Sterling will not 27%-find-oil. Either it will or it won't. And if it does, then these estimated reserves become worth 10p per share. It is also possible that while Sangaw could contain much less oil than the 'best estimate' it could contain much more perhaps worth close to 20p per Sterling share.

On the other hand it might find nothing at all. If that turns out to be the case, the shares will have, in the opinion of Evolution, a value of just 0.5p. And that's the gamble that Sterling investors take! Whenever you go looking for big rewards, just be aware of the risks...

This article was written by Tom Bulford, and is taken from his free twice-weekly email The Penny Sleuth.

Tom worked as a fund manager in the City of London and in Hong Kong for over 20 years. As a director with Schroder Investment Management International he was responsible for £2 billion of foreign clients' money, and launched what became Argentina's largest mutual fund. Now working from his home in Oxfordshire, Tom Bulford helps private investors with his premium tipping newsletter, Red Hot Biotech Alert.