Three small-cap oil stocks to watch

For investors prepared to take a bit of a gamble, it's hard to beat an oil exploration company. Find oil, and everyone makes a fortune. Here, Tom Bulford picks three small-cap oil stocks with the potential to strike it rich.

I've followed the Falklands oil story for a while now. To get the background, see: Four oil shares for the brave.

Anyone with money in Falklands oil will watch Desire Petroleum (LSE: DES) in the days ahead. The Ocean Guardian rig is expected to arrive at Desire's Liz prospect on Friday.

And, according to Upstreamonline.com, the Ocean Guardian could 'spud' as soon as two days later - that's when the drill bit actually hits the ground.

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We should know pretty soon after that what sort of oil discovery Desire has (or otherwise). If it's good news, the Falklands oil frenzy will begin in earnest.

And with Rockhopper (LSE: RKH) and Falkland Oil & Gas (LSE: FOGL) booked in to use the Ocean Guardian, too, this story has plenty of room to run.

But today's article is not about the Falklands, it's about something that has even more potential. Let me explain

Looking for the next great penny share oil play

It's no wonder penny share investors flock to the oil sector like seagulls to a fishing fleet. In the last 12 months, no fewer than 48 oil companies on the London Stock Exchange have seen their share prices double; 17 have seen a more than three-fold increase in their share price in that time; and seven have multiplied their shareholders' money by 500% or more.

Among the small cap oil 'wonder stocks' of the past year have been:

Gulf Keystone (LSE: GKP) (+585%),

Bankers Petroleum (LSE: BNK) (+595%),

Xcite Energy (LSE: XEL) (+835%) and

Matra Petroleum (LSE: MTA) (+1100%).

These companies all have one thing in common. It's not simply that have all gone through the lengthy, expensive, laborious and politically fraught process of exploring for oil. It's that after all that, they have all made discoveries.

And at the end of the day, in the high-risk, high-reward world of oil exploration this is all that really matters. It doesn't matter where it is or how you got there; find oil and you have something the world wants. You have made your fortune.

The oil industry is full of entrepreneurs. More often than not they once worked for a major oil company; they learned the ropes, got plenty of good experience around the world and then decided that the greasy pole of big corporate life was not for them.

Often these people come out of the head office with a little secret. They spent a bit of time out in some distant, dusty land, and whilst there, they looked over the shoulders of geologists. They pored over maps and seismic surveys; they rolled lumps of rock between their fingers; and they picked up the industry gossip in the local bar.

Armed with this, they think they know something a little special, something too valuable to share with their employer. Something, in short, that could make them rich. So they decide to go for it and start their own exploration company.

The five steps to starting an oil company

Starting an oil company is not that hard.

1. Assemble an acceptably competent team.

2. Apply for an exploration licence from some government that is only too willing to have somebody else spend the money to discover whether or not the country has oil.

3. Scrape together some money from friends, family, colleagues or speculators.

4. Start to pull together some information. Once the area has been mapped, the geology has been surveyed, the seismic surveys have been run, and surface rock samples have been sent away to the laboratory for analysis, some targets can be identified.

5. Then it is just a matter of hiring a rig, telling it where to drill, and standing back with fingers tightly crossed.

And as we've seen from the companies mentioned earlier, when they get it right, the pay-off can be huge. Not just for the directors, but for ordinary shareholders who put their money in.

For investors prepared to take a bit of a gamble for the chance of a huge return, it's hard to beat an oil explorer. The sector still has the romance that comes with frontier territories, bold adventurers and fortunes made overnight. Who can resist the lure? It has been the stuff of legends for decades and it is not about to change.

Of course, there is a debate in the industry about the future demand for oil. If you are an investor in the industry's majors, this is important.

On one side of the argument, we have the International Energy Agency. It points out that demand for oil in the USA peaked at 25.5 million barrels of oil per day (bopd) in 2007. In 2010 it forecasts daily demand of just 23.4m bopd, and it does not expect the 2007 figure to be surpassed.

In this it has the backing of BP and the evidence from this cold winter. Forecasts that the biting cold conditions could lead to a surge in energy prices in the USA and Europe have been disappointed. This is evidence, perhaps, that as population growth eases and our energy usage becomes progressively smarter, we will gradually wean ourselves off oil.

But on the other side of the argument are two unrelenting trends. The first of these is the economic growth of emerging economies led by China; this growth and increase in prosperity leads inevitably to an increase in the number of motor vehicles and of air travel.

The second trend is the ever increasing cost of finding oil. Today the cost of discovering a barrel of oil is about three times what it was a decade ago - there has been a similar escalation in the cost of extracting oil. As companies drill in less hospitable conditions, in deeper seas and are forced to settle for oil of lesser quality, costs rise.

These are shifting sands, but they do not shift fast. The bottom line is that the world is hooked on oil and will remain so for many decades to come. This is still a place for the bold adventurer.

As John Paul Getty famously said, the formula for success is: "Rise Early, Work Hard, Strike Oil."

There are still fortunes to be made in oil, and you don't need to start your own company and strike oil to make spectacular returns. Finding the right oil penny share company can do that for you.

Three oil stocks to watch

I've seen many companies that offer great potential. I've mentioned many over recent months, including:

Aurelian Oil & Gas (LSE: AUL), currently drilling in Central Europe.

Sterling Energy (LSE: SEY), which has been touted as 'the next big play in Kurdistan'.

KEA Petroleum (LSE: KEA), a New-Zealand-focused outfit which successfully started trading on AIM recently. Those shares ended up 14% on their launch price on the first day of trading.

All of these look interesting; they are ones to watch. But I've not done the deep analysis I like to do before making a decision on whether to invest.

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.

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