Recently I’ve been covering what I reckon is one of the most exciting stocks I’ve seen in years. It’s Brazilian oil explorer HRT Participacoes. Over the last couple of years, its share price (quoted on Toronto’s Venture exchange) has fallen from about $10 to $1.
A couple of weeks ago I tipped it at around the dollar level, and just last week it bounced to $1.44. That sort of move just shows the potential for stocks in this sector.
HRT is now back at around $1.18 and I’d definitely still be a buyer at these levels.
The reason stocks like HRT are volatile is because they’re hard to value. There are no meaningful revenues to speak of (yet) and the value of the exploration potential is totally subjective. The stock can put in a big rally or take a nasty dive on nothing more than market sentiment.
To try to make sense of it all, I showed you a method I like to use to help put a price on investments that don’t lend themselves to normal fundamental analysis. My risk-adjusted fair value method is, admittedly, based on a lot of guesswork, albeit educated guesswork. But I know that this method rankles with many readers.
Why could I not use the traditional methods adopted by most of the City analysts, one asked? Well, because they’re almost always wrong.
Today I’ll show you why.
Who knows what we have, or what it’s worth
Let’s start at the beginning. The oil explorer owns the drilling rights to certain tracts of land, or sub-sea areas. Before they get anywhere near the drilling stage, they’ll collect data (mostly geologic seismic analysis) to help identify oil and gas resources.
If they find evidence of hydrocarbons, they’ll try to estimate how much could be there. Then they have a guess at whether the resources can be economically extracted.
Put the two things together, and you come up with something called proven resources. And many analysts use this as the basis for estimating the value of the project. They estimate the cost of recovering the stuff, the proceeds of sales (less any other costs and commissions), and then come up with potential profit figures.
Sound like anything could go wrong with that calculation? Of course it does. It’s fraught with uncertainty.
For starters, proven resources aren’t really proven at all. They are just a best estimate. In the case of HRT, there are certified resources of nearly eight billion BOE (barrels of oil equivalent). This table is provided by the company:
||Contingent - 3C
Source: HRT, Institutional presentation
An exclusive report from The Right Side
But who knows what will be recoverable off the west coast of Namibia – maybe nothing! Or there may be an awful lot more to come. Just off Namibia, 3-D seismic suggests there’s another 28 billion BOE that might be recoverable. If they can get at that, then we really could be in business. There’s a good reason why I said that this a lottery ticket type of stock!
Anyway, back to the point... not only do we lack information about what resources we’ve got, we also lack information on what it’s going to cost get them out of the ground. A high oil price itself leads to higher input costs for explorers. The oil price has knock-on effects for practically everything. And seeing as these guys aren’t yet producing oil, then all they get are higher input costs. Not good news right now.
And then there are all the other inputs – rig hire and the cost of all the other plant and equipment varies considerably according to demand. Labour does too.
Local conditions are constantly changing. In the Amazon, HRT has been plagued by droughts and floods, causing severe delays which have more than doubled the cost of drilling exploratory wells.
The point is we can’t be sure of what assets we have, and what it’ll cost to get at them... but there’s more. We don’t even know what we’ll get for our oil on the market.
In July 2008, crude was trading at just under $150 – yet five months later, it was nearer $40. This sort of change can be the difference between life, or death for a small explorer. It really is a case of famine or feast for this industry.
As we’ve struggled on from 2008, the price of crude has rallied. It’s now back up to about $115 – but most in the industry don’t expect it to stay there. Futures prices are pointing downhill all the way out to 2018.
But as I argued last week, I reckon crude will remain at today’s prices and possibly significantly higher, far into the future. And it’s the guys that are exploring now that should reap the rewards.
Profiting from unknown unknowns
I would love nothing more than to sit down and try to value HRT on fundamentals. But there are just too many unknowns. As Donald Rumsfeld famously said...
“There are known knowns; there are things we know that we know. There are known unknowns; that is to say there are things that, we now know we don't know. But there are also unknown unknowns – there are things we do not know, we don't know.”
Because I cannot value this company on any sort of fundamentals, I do the next best thing. That is a risk-adjusted analysis. If you missed it, why not take a look – I came up with a valuation of over $8!
But the point I really want to make today is to be very wary of any analyst report trying to justify a stock price based on future revenues... especially in any industry as highly changeable as oil exploration. Take it with a very large pinch of salt. Remember, those analysts are nearly always wrong.
If you invest in this sort of stock, there’s a large element of luck involved – analytical minds don’t like to accept this fact. That said, there are times when you can get in with extremely good odds. And HRT is a case in point.
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