Battered exploration stocks may still be worth a gamble

Once upon a time, those who wanted to get rich quick grabbed their gold pans, saddled up and rushed off to prospect in far-flung regions where traces of the precious metal had been discovered.

Nowadays, an investor who wants a piece of the action has merely to call a broker and buy shares in the latest exploration company to strike lucky.

But if today's investor does not face the perils of the prospector, his path is not without pitfalls. Exploration companies have less than a one in 10 chance of success and shareholders' money can be quickly gobbled up by exploration and administration costs and directors fees as firms struggle to find producing assets.

Those companies lucky enough to strike gold, oil, or any other precious mineral are then exposed to the vagaries of global commodity prices and often the political risk associated with exploring in less than stable parts of the world.

But the high risk inherent in investing in the sector brings high rewards and has tempted many Irish investors (even those with most of their money safely locked away in banking stocks at the other end of the risk spectrum) to take a punt.

However, the exploration sector has taken a battering of late, hit by the global drop in commodity prices, while the recent report on Bula has done little to enhance the image of the industry at home.

The decision by OPEC toward the end of last year to increase production, the return of Iraqi oil to world markets, a mild winter and the Asian crisis have triggered a collapse in commodity prices right across the board, with everything from oil to gold and nickel to zinc being hit. The price of crude oil is currently some $6 below that available at the same time last year while gold has fallen to around $290 an ounce from $368 at the start of last year.

"Commodities are very much out of favour," says Mr Jon Wright, exploration analyst with Merrill Lynch in London.

As a result, exploration companies are suffering with the sector down 40 per cent in London in the year to date, while Irish exploration shares have fallen by 26 per cent compared with an overall increase of 25 per cent in the ISEQ index.

Meanwhile, the conclusions of the 187-page report by Government-appointed inspector Mr Lyndon MacCann into Bula Resources can hardly be welcome news for the sector in Ireland. The report, which strongly criticised Bula's directors, found that the former chairman and managing director of the company, Mr Jim Stanley, was the beneficial owner of a British Virgin Islands company, Mir Oil Development Ltd, which came into the possession of £2.5 million worth of Bula shares as a result of a deal set up by Mr Stanley.

Bula paid over the shares for a stake in a Russian oilfield which now appears to have little value.

The negative publicity surrounding Bula, although regarded by many as a one-off situation and not exclusive to the sector, is unlikely to help exploration shares in a climate where the strong performance of traditional industrial and banking stocks means investors do not have to dabble in high risk shares to ensure high returns.

Exploration companies are also facing increased competition for investment from high-tech stocks as private investors seeking higher returns are attracted to the highly-rated sector.

"If you wanted to include in your portfolio some high-risk stocks, would you invest in a fashionable sector that has had a good performance over the last number of years or one which has done poorly and has the Asian crisis hanging over it?" says one analyst.

However, most observers believe the exploration sector will not remain in the doldrums forever. Human nature means the allure of striking gold, be it yellow or black, will always be there while the industry remains as relevant as ever.

"It's a primary industry which looks for the things we use," says Mr Job Langbroek, exploration analyst at Davy Stockbrokers. "If our cars don't rust, it's because they are galvanised with zinc. It's at the very front end of the production chain."

There are already signs that the oil industry is looking beyond the current downturn. Analysts note that merger and acquisition activity in North America has picked up as has joint venture activity while the price being paid for exploration acreage is very high.

"The sector has very considerable upside potential. All we need is a catalyst," says Mr Wright. This could come in a variety of forms including a major merger or takeover bid, a large discovery which reminds investors of why they put money into the sector in the first place, or the long-awaited recovery in the oil price which many forecast should come through towards the end of the year as the OPEC production cuts begin to have an effect.

However, the sector tends to be illiquid and volatile with sharp swings in sentiment often driving it too far in both rallies and dips and some analysts believe now may be the time for those who wish to get in ahead of any future rally to look again at the sector.

In an Irish context, analysts note that the exploration industry has matured a lot in recent years with several companies making the critical jump to production from the early cash-consuming exploration stage where the principle winners appear to be directors and the consultants employed by them. Firms such as Tullow Oil, Dragon Oil, Arcon, Ivernia, Navan and Kenmare now have production assets and shareholders should begin to see a return on their investment.

"It may seem like Irish exploration companies have been around a long time, but they are only really there since the early 1970s," says Mr Langbroek. "They are just pulling out of the exploration phase and we should see an improvement in cash flow and earnings."

Although the overseas interest that many expected to follow Statoil's acquisition of Aran has failed to materialise so far, the Irish sector is unlikely to remain immune to overseas bid interest as the market recovers.

Already Glencar, which expects to produce the first gold from its Wassa mine in Ghana by January, has been tipped as an attractive takeover target. Tullow, which has been invited by the Bangladesh government to finalise a production sharing agreement for two key exploration areas onshore Bangladesh, could also be of interest to one of the US majors interested in establishing a foothold in the region.