Why small oil companies offer bigger upside

Despite a recent price plunge, oil is set to strengthen again as winter kicks in in the Northern hemisphere. Oil majors may be the safest investment, but the small players offer the prospect of greater returns. Here are two to keep an eye on.

Oil investors can't help but be aware of the precipitous plunge in the price of the black stuff in recent weeks. Having topped $78 a barrel in August, oil is now flirting with $60 a barrel on a regular basis.

Why the sudden turnaround then? There are several reasons, not least that this is traditionally a weak time of year in terms of demand. But oil price moves these days are exacerbated by traders, who are drawn to the market as they are to any bull run. The result of their actions is to make the market extremely volatile they overbuy on bullish news and oversell on bearish news. That seems to be what's happened this time; traders ran up the price too heavily on Middle East problems and the risks of a severe Gulf of Mexico hurricane season, then bailed out even more quickly once tensions eased, hurricanes failed to appear and the economic news from the US pointed to a slowdown or recession.

Why the oil price will strengthen again

In the near term, there are good reasons why oil is likely to strengthen again. With regards to demand, the arrival of winter in the northern hemisphere will boost heating oil consumption in the US and Europe. And the supply picture hasn't resolved itself: supplies remain tight and the world is highly dependent on the Opec cartel, which is used to strong oil prices. Any sign of further weaknesses is almost certain to provoke output cuts from Opec members to support the market. The result is that oil has a good chance of rebounding towards $70 a barrel as we head into winter. At the very least, oil should stay in the $50 to $60 a barrel range still a healthy price by historical standards.

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Long-term, the oil-price outlook remains very bullish, for the reasons we often discuss in MoneyWeek: demand from emerging nations such as China and India, a shortage of major new discoveries and long lead times to bring new fields into production.

Which oil companies offer the best returns?

So which oil companies are likely to provide the best return for investors? The safe route is to buy into the oil majors, such as BP, which offer stability and decent dividends. However, smaller players offer the prospect of greater returns albeit at commensurately greater risk.

One reason for this is that small oil companies are generally more leveraged to the oil price than large firms, because many of their fields are marginal and become uneconomic at low prices. This applies particularly to players such as Venture Production a scavenger' that specialises in picking up assets in which other producers are no longer interested and Nautical Petroleum, which has developed a niche in heavy oil. These firms are unappealing when oil prices are low, but in a bull market their cash flows rocket and so do their valuations.

Another factor is the potential for company-transforming finds. While no single discovery would have much impact on the reserves of a large firm, a decent-sized find can make a major difference to a small explorer. And at this stage of the industry cycle, once these juniors have fattened themselves up they become bid targets: for example, Tullow Oil, one of the largest London-quoted independents, recently agreed to buy Australian group Hardman Resources for £580m, a near 40% premium to its pre-bid share price.

So while small oil firms are definitely riskier investments, their potential returns make them well worth a look during an oil bull market. Below, we suggest two interesting prospects.

Two overlooked fields to keep an eye on

Venture Production (VPC, 725p) began developing overlooked fields in the North Sea in 1999. Now it's seeing the rewards, with first-half production up 80% year on year and net profit of £55.9m compared with a £2.8m loss previously. Reserves stand at 190 million barrels of oil equivalent (BOE) up to ten years' worth of production. On a price/earnings ratio of 7.2 times for year ending December 2006 and 5.8 times for year ending December 2007, it's cheaply priced, although its scavenger' strategy makes it highly dependent on oil prices staying strong.

Holders of Sterling Energy (SEY, 17.5p) shares have had a tough year, with the stock price collapsing 50% as investors backed away from smaller exploration firms. But Sterling offers one advantage over many of its exploration peers it's actually generating cash to fund its activities, with both revenues and profits increasing markedly in the first half. Production interests include gas fields in the Gulf of Mexico and oil assets offshore Mauritania, with output up 175% on the first half of 2005. But as its high forward p/e of 14 times for both 2006 and 2007 indicates, Sterling is attractive for its exploration upside rather than its current production. Reserves stood at 16.6 million BOE at the end of June, and the firm's drilling programme for Gabon, Guinea-Bissau, Mauritania and the US next year could more than double this.