A great opportunity in one of the world’s hottest oil markets

One of the hottest oil plays in the world right now is in South America.

I'm not talking about Brazil, or even the waters around the Falkland Islands.

I'm talking about Colombia.

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That might surprise you, but investors in the know have already done well. Oneoil firmin the country, London-listed Amerisur, has seen its shares rise by around 400% in the last few years.

However, don't worry if you missed that one Colombia's oil and gas boom isn't over yet. And one local firm in particular looks well placed to benefit.

How the Colombians got the oil flowing again

Ten years ago the Colombians had a big problem oil production was falling fast.

For years, the country had relied on the massive Caa Limon oil field. But as it started to decline it dragged the country's oil production down with it.

By 2004, Colombia's overall production had slipped to 550,000 barrels of oil equivalent per day (boe/d), down from 800,000 boe/d just five years earlier.

It wasn't that Colombia didn't have oil. In fact, geologists told the Colombian government that more oil would probably be found in the unexplored mountains. The problem was that poor security and unhelpful regulations meant few companies wanted to explore.

That's all changed now. Thanks to some shrewd government policy and a fair bit of luck, oil production is now almost at a million boe/d, and predicted to hit 1.5 million by 2020.

One smart move was to reorganise the oil and gas sector and change the rules to allow explorers to keep more of the income from any oil they found. Another was to allow producers to charge a fair price for the oil in Colombia - many other Latin American countries fix the price of domestic oil, meaning that local producers are often forced to sell to locals for well below the going rate, hurting profit margins.

Security has also improved. Colombia's murder rate fell to a 26-year low last year. Meanwhile, the strength of FARC, the country's oldest and largest insurgent group, has been reduced by a series of military strikes.

Hugo Chavez, president of neighbouring Venezuela also inadvertently helped to boost Colombia's hydrocarbon business. In 2002 and 2003 workers at Venezuela's national oil company, PDVSA, went on strike in an attempt to oust Chavez. Eventually Chavez got the upper hand and expelled them from Venezuela.

It's estimated that 18,000 skilled oil technicians, engineers and managers left in the years following the strike. This diaspora of oil talent spread from Canada to the Middle East, but many thousands settled in Colombia. "It was a huge boost to our oil industry", says Colombia's ambassador to the UK, Mauricio Rodrguez Mnera. "They brought the extra skills and knowledge we needed for the sector to grow."

All these factors encouraged people to invest in Colombian oil and gas projects. Foreign direct investment in Colombian natural resources has increased from $500m in 2001 to more than $9bn in 2011.

Local investors have also backed oil and gas projects. Five years ago, oil and gas firms were not present on the local stock exchange, the Bolsa de Valores de Colombia (BVC). Now they make up almost 50% of its value.

The boom has only just begun

Colombia's growth is impressive but there is plenty more to come. The country remains underexplored. Later this month ANH, Colombia's National Hydrocarbons Agency, is holding a round of auctions, including the first offshore blocks, to open up more of the country.

Better yet, Colombian producers enjoy some of the lowest costs in the world. That's because they operate exclusively on dry land, and so avoid the expense of offshore rigs and the like. That's good it means that even if the oil price tumbles, Colombian onshore producers will still have healthy profit margins.

Costs are set to fall even further. Colombia's transport infrastructure is terrible. Shifting goods across the Andes mountain range is expensive and time-consuming.

But the government wants to change all that by building more transport infrastructure. According to Vanessa Buendia from the Infrastructure Journal, "the ten-year development plan is estimated at circa US$20bn". One important highway has already been completed and more are being built.

This new transport network will cut costs for oil producers in remote areas. Most importantly, it will help oil firms exploit the fact that Colombia has both Atlantic and Pacific ports, giving easy access to almost any major export market.

The security situation could also improve further. While overall Colombia is stable, FARC has stepped up attacks on oil and gas infrastructure in the last year. The head of Colombia's national oil company, Ecopetrol, told me that attacks only account for about 1% of the country's production. But he admitted that the need for extra security measures drives up costs.

This month the government is due to sit down with FARC for historic peace talks. There's no point in being nave - very few people expect any huge breakthroughs. But Colombia has made huge progress in the last decade, and if the talks help to reduce FARC attacks on oil pipelines, it will give producers another boost.

So how do you invest? Amerisur is a great company with good prospects, but on a forward price/earnings (p/e) ratioof 20, it's too expensive for me. I have my doubts about Ecopetrol too. Earlier this month it briefly overtook Brazilian oil company Petrobras as Latin America's biggest company by market cap, even though it has around a quarter of the reserves. It's a good company but again, seems pricey on a forward p/e of 13.

I prefer local player Pacific Rubiales (TO: PRE). Headed up by a Venezuelan oil migr the company has grown rapidly to become the second biggest in Colombia. Since the start of the year, Pacific has spent $1bn on buying up new assets and investing in old ones. In the short-term, JP Morgan expects that improvements to existing fields will boost production to almost 110,000 boe/d from less than 90,000 last year.

Longer-term growth will come from its undeveloped blocks. Rubiales offers an attractive mix of "technological expertise, exploratory and development acreage and access to infrastructure", says JP Morgan analyst Felipe Dos Santos. Another advantage is that many of its Colombian assets are sheltered in a basin that is relatively protected from terrorist attack.

It trades on a forward p/e ratio of just eight. On that multiple, says Dos Santos, "investors are not paying for non-producing assets", which include exploration blocks in Peru, Guatemala and Papua New Guinea.

Of course the firm isn't risk free. Labour disputes flared up at one of its sites this year, while the licence for one of its important fields expires in 2016. But these issues are more than priced in. It currently trades on $23 a share, but JP Morgan expects it to hit $37 by the end of 2012.

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