Falkland Oil and Gas Limited - a company that does what it says on the tin

Well, here's a company that does what it says on the tin!  Falkland Oil and Gas Limited (FOGL) is exploring for oil and gas in the South and East Falkland Basins. It has an aggressive exploration programme, and is now drilling its first wells, hoping to develop “a new hydrocarbon province in the South Atlantic” [ref] 2008 Annual Report, cover: http://www.fogl.com/documents/FalklandOilandGasLimited-AnnualReport-YearEnding-311208.pdf [/ref] .

The Falkland Islands have a mixed history when it comes to oil exploration. In the late 1990s Shell, Lasmo and Amerada Hess all drilled in the area, making a number of discoveries. But none of the discoveries were of a large enough size to justify development. This is going to be a high cost producing region, after all - it's deep water, and it is, quite literally, miles from anywhere - which explains the difficulties most companies have had getting a rig for their drilling programmes.

Investors may be interested to note that CEO Tim Bushell has previous experience in the Falklands, admittedly in the North Basin rather than the south and east side where FOGL is looking - he was working with Lasmo at the time. He later headed up Paladin Resources' Norwegian operations - exploration director Colin More also hails from Paladin, having also managed exploration in China and India for Cairn Energy.

When it published its 2008 annual report, FOGL had four initial prospects, representing 8 billion bbls potential mean reserves between them. Management estimates that a discovery as small as 100 mmbbl  would be viable at oil prices as low as USD 25 a barrel [ref] Annual Report 2008, p 4 [/ref] .

Next year should see the beginning of the drilling programme; FOGS brought BHP Billiton in as a partner (and as operator) in 2007, and BHP will pay 68% of the cost of the first two wells. BHP is a well regarded company,  so its involvement is an encouraging sign. It's in for 51%, and has an option to increase its take to 65% (for an initial payment of USD 10m reimbursing FOGL's expenditure on the development).

The big milestone though is “Secure a rig” [ref] Annual report 2008, cover [/ref] , and that's been a major stumbling block for FOGL. For most of its prospects it needs either fifth/sixth generation semi-submersibles or drill ships - and they have been in high demand, particularly from discoveries offshore Brazil. There are up to 35 rigs that might be suitable - but they're 100% utilised, and the high rate of utilisation has meant most of them are locked into long term contracts. Even with the chance of a sub-let, rates are still high - there's a horrible looking chart in the annual report - and drilling will eat up a lot of funding.

So far, FOGL has been a cash sink, as you'd expect from a pure explorer. The 2008 results showed administrative expenses down from USD 3.5m to USD 2.9m, though cash flow has to take account of a further USD 6.9m in exploration costs that were capitalised [ref] Annual report, p 29 [/ref] . At the interims, the company declared a USD 1.2m loss from operations; however, the declared number is a bit of an accounting fudge as there's a massive foreign currency adjustment (USD 1m). At the same time, because exploration costs are capitalised, the real story is shown on the cash flow account rather than the P&L, with another USD 6.2m deferred exploration cost [ref] Interim statement: http://www.fogl.com/documents/FOGL_Interims_Results_2009.pdf [/ref] . I'd want to do quite a lot more combing through the notes to the accounts before I invested in FOGL.

FOGL has been raising funds - in May 2009 it raised £7.6m through a placing at 73p a share, and most recently it has announced a further placing to raise £50m for the East Falklands Basin drilling programme [ref] Proactive Investors, 26 November 2009: http://proactiveinvestors.co.uk/companies/news/10635/falkland-oil-gas-to-raise-50-million-for-east-falklands-drilling-programme-10635.html [/ref] . The latest placing is at a relatively small discount to the market price - 115p against 136p the day before the announcement. The company states in the placing documentation that it should now have enough funds to finance the drilling programme in its entirety [ref] Placing completion: http://www.fogl.com/documents/CompletionofPlacing26.11.09.pdf [/ref] .

The problem is that it's still looking for that rig. It's hoping to get the Ocean Guardian rig from Desire Petroleum, and is already negotiating; the rig will be coming to Falkland waters in February 2010. Using Ocean Guardian, it could begin drilling in the first half of 2010 on the Toroa prospect (530-770 metres deep), but deepwater drilling is unlikely to happen before the second half of the year on the Loligo, Nimrod and Endeavour prospects, all at depths over 1,000 metres. And for these, a rig still has to be located, secured, and brought to the Falklands basin.

The Toroa programme will cost £12m; the other prospects, £30m. That leaves a modest amount to fund working capital, which management states will last through 2011.

The difficulty I have with FOGL as an investment is that there really isn't an awful lot to go on in the company information. And the rig situation has left the company stymied for years.  BHP originally said, back in 2007, that the first well would be drilled 'in a year'; it didn't happen in 2008, it hasn't happened this year, and it won't be early in 2010. So FOGL has been on hold - not for any devious reason but simply because it can't get the equipment to proceed [ref] The Times, 3 October 2007: http://business.timesonline.co.uk/tol/business/industry_sectors/natural_resources/article2577806.ece [/ref] .

In the near term, it may be progress from the other Falklands oil players - Rockhopper and Desire in particular - that has most impact on the FOGL share price (even though they're in the north Falklands basin, so you shouldn't really read across from them to FOGL).

However there's another little fly in the ointment. Tullow is widely regarded as one of the smarter UK operators. But it let its 22.5% stake in the FOGL licence area lapse, back in 2007 [ref] Falkland Islands Government Department of Mineral Resources: http://www.bgs.ac.uk/falklands-oil/whats_newARCHIVE.htm [/ref] . What was the reasoning behind that, I wonder? It may simply be that Tullow looked at the difficulty of developing the Falklands fields, and thought it could make a much quicker impact elsewhere - which turns out, of course, to have been the case. Even so...

The potential of the South and East Falklands Basin is considerable. A review three years ago by TRACS International only looked at FOGL's top ten prospects, and assessed unrisked P50 reserves at over 10 billion barrels [ref] BHP Billiton farm-out presentation: http://www.fogl.com/documents/FalklandOilandGasLimited-BHPFarmOut-Oct07.pdf [/ref] - each prospect above 300 mbbls in size. That was out of 100 prospects and leads identified as a result of seismic survey. The total basin potential, management says, could be as much as 60 bn barrels, and looking at the map, FOGL has most of the acreage if not all of it.

The Falklands basin could be massive. If it is, FOGL will undoubtedly be worth many times today's £133m market capitalisation. But it is very, very early days. And FOGL only has four chances to get those holes drilled in the right place. That means it's absolutely an investor judgment call - there just isn't any way you can really quantify the opportunity.

What's this company waiting for? Well, getting that deepwater rig has to come first! And that's still the same issue that management highlighted back in 2007 in the Billiton farm-out presentation; there's an amusing drawing of a chicken and an egg - the chicken sitting on top of a drilling rig. (Actually the whole presentation seems to have some sense of humour - the front page has a couple of walruses sunbathing, which apparently symbolise FOGL and BHP Billiton. I hope the CEO looks a bit less chubby than that!)

Looking at the chart, FOGL has traded as low as 60p in the last year, and is now towards the top end of its 52-week range. I get a feeling that if it doesn't make progress with its drilling programme over the next six months or so, it could head downwards again. That might be a good time to pick some up. Meanwhile, I may make the same judgment as Tullow - and head for some of the other fast developing oil and gas fields around the globe.