Desire Petroleum - Wings of Desire?

The Falklands seem to be all action these days – at least as far as UK oil and gas explorers are concerned. There's Falkland Oil & Gas and Borders & Southern Petroleum in the southern basin, and Rockhopper Exploration and Desire in the northern basin, so quite a lot of choice for the investor.

Until earlier this year, things looked rather boring for investors. The development of the basin has been a sort of two steps forward, one step back business. Back in 1998, Shell and Amerada Hess drilled the North Basin, with relative success – out of six wells, five had oil shows, and one also had gas. That's not a bad success ratio. But at an oil price below twenty bucks a barrel, it just wasn't commercially viable to develop the field – end of story for the time being.

Now, of course, with the oil price trading above $60 a barrel, things look different. Desire actually raised money back in 2005 to start a further programme of drilling. So that was a step forward – but it's not been able to get its hand on a rig till this year.  One of the big issues in exploring the Falklands basin is that it's incredibly remote – two weeks to a month transit time from most of the other major oil exploration sites, depending on the type of rig used. (There's an interesting table in the company's 'Rig deployment' presentation [ref] Rig deployment: http://www.desireplc.co.uk/images/uploaded/9632112_9597081.pdf [/ref]   that goes into detail on this.)

Desire points out that with utilisation over 90%, despite some slackening of demand, out of 100 units that are technically capable of being deployed in the Falklands, only 6 are actually available. The cost of the rig is considerable, too – over $300,000 a day.

However, that hurdle has now been crossed. A provisional deal with Diamond Offshore Drilling [ref] Press release, 2 October 2009: http://www.desireplc.co.uk/investor_relations_announcements.php?article_id=140 [/ref] will give Desire what it needs to carry out a major drilling programme starting in February 2010 (that is, the first well to be spudded in February) using the Ocean Guardian rig. Desire wants to drill four wells, in a minimum 80 day campaign, and has options for another six. Rockhopper Exploration will participate in the program – it has farmed in to Tranches C and D of Desire's prospects.

The company is deliberately not betting the bank on a single prospect; it aims to drill as many different play types as possible, improving its chances. [ref] 2009 AGM presentation http://www.desireplc.co.uk/images/uploaded/9632112_7309363.pdf [/ref]

The North Falkland Basin, where both Rockhopper Exploration and Desire are exploring, is very different in its characteristics from the South Falkland Basin where the other two UK quoted explorers are looking. It's relatively shallow waters, at 100-600 metres, and relatively good drilling conditions compared to the deeper southern basin. The targets are relatively large; the British Geological Survey estimated there are 60 bn barrels of oil [ref] Investors Chronicle, 16 June 2009, http://www.investorschronicle.co.uk/MarketsAndSectors/Sectors/article/20090616/a5630054-5996-11de-bbc4-0015171400aa/Falklands-oil-dream-taking-flight.jsp [/ref] potentially recoverable. (It has to be said, though, that the targets in the southern basin are even bigger.)

Rockhopper has already announced its first hydrocarbon discovery, in May this year. Admittedly it's not a drilling find – it was based on reinterpretation of a decade-old well originally drilled by Shell. But it shows a huge gas field is there, though it's not commercially viable to develop at the moment.

It's not just the junior explorers who are interested in the Falklands now. Some of the major players have already farmed in to the area – Bhp Billiton for instance has farmed into Falkland Oil & Gas's exploration prospects. Desire has already secured farm-in deals with Arcadia Petroleum on three of its fifteen prospects, though it retains high equity stakes. Desire has  kept a  57.5% share of the Ann prospect, with an estimated 202m barrels of oil; 30% of Alpha, with up to 15 trillion cubic feet of gas, and 92.5% of the Liz prospect [ref] Preliminary results presentation: http://www.desireplc.co.uk/images/uploaded/6827291_7681301.pdf [/ref] .

Desire is now aiming to raise further funds to support its 2010 drilling programme. In order to facilitate this, it commissioned a Competent Person's Report (CPR) from independent consultant Senergy, which has evaluated the top ten prospects in Desire's portfolio [ref] Competent Person's Report:  http://www.desireplc.co.uk/investor_relations_announcements.php?article_id=141 [/ref] . This report, released on 5th October 2009, takes us another step forward – assessing the mean net, unrisked prospective recoverable resources as over 3 billion barrels of oil, and more likely to be oil than gas (which is good, as gas is going to be significantly more difficult to recover).

On one level, the CPR just confirms what Desire has been saying all along about the prospectivity of the North Falklands Basin and its various prospects. But it is also important in that it shows all ten prospects are potentially commercial – the CPR states that the minimum commercially recoverable field is just over 56 million barrels, while Ninky, the smallest of the prospects studied, has 122m barrels unrisked prospective recoverable oil.

So that's another step forward. From here on, the share price is obviously going to be driven by newsflow – but we're not going to get any more of that till at least March next year.

My concern is that the 'one step forward, one step back' history of development in the Falklands Basin might continue into the future. While the Basin has been well surveyed, and isn't perhaps the most risky prospect, the success of the drilling campaign can't be guaranteed.

But even if drilling is successful, and proves up the prospects, there remains the huge problem of how to access the resources and develop them commercially. The problems getting the rig into the area in the first place show how big an issue the remoteness of the Falklands is. There is no pipeline and there are no terminal facilities. There is no nearby market for gas – there is basically no distribution network at all. So it's going to be impossible for the smaller players to develop this acreage – there's a huge capital expenditure requirement.

That means Desire not only has to prove up the discoveries, but it also has to surmount quite a big hurdle – it has to prove large enough fields that the majors are going to be interested in committing to an exploitation programme. The farm-ins announced so far are a good start, but Shell and Amerada walked away once – they can always do so again.

On the other hand if the majors do come in, then Desire can get quite a long way along the route of de-risking its prospects before it sells – which would increase the value to shareholders considerably.

The market capitalisation of the company currently stands at £230m, and the company might raise another £40-50m to support the drilling campaign. The value of the prospective oil assessed by Senergy is at least $180 billion. That's a very big margin for risk, cost of exploitation, and taxes... but of course that's not really a scientific calculation.

It seems though that investors have been impressed by the raw numbers. The shares have had a very strong run so far this year, from a 52-week low of just 19p to a high of 114p at the end of September. They've come back a bit since then – some investors have clearly wanted to take profits – but none the less, they're clearly trading on high expectations.

Given that the drilling programme hasn't yet started, and won't for several months, it's difficult to see what will make the shares perform in the near term. And there's a huge exposure to downside if the first well is dry.

This is really a 'double or quits' play. After all, it is possible that shareholders may see no value at all, if the drilling campaign doesn't achieve its objectives. There is a single prospect, admittedly quite a good one – but I remember Chinguetti looking like this, back in 2005. That didn't work out at all well, with Hardman Resources having to cut its estimates of recoverable oil by 50%.

So right now, I'm not sure I'd want to be in the stock. It's not that I don't believe management's story of huge oil reserves in the North Falklands Basin. For all I know, they may score four out of four successful wells drilled, and the shares could carry on upwards. It's just that I think the share price performance so far this year leaves shareholders extremely exposed to any bad news. So I'm going to lurk for the time being – and maybe, if the shares do come back a little, I could get interested.