Oil investors make billions in Kurdistan

KurdistanSmall companies that want to raise capital by selling shares to the public often find that the cost of obtaining a full listing on the London Stock Exchange is too high to make it worth their while. One way to get around this is to list on the Alternative Investment Market (AIM), which has lower costs and a reduced regulatory burden.

Thanks to several high profile regulatory failures many investors now liken AIM to the Wild West and won't go near it, but some AIM companies have done exceptionally well for their shareholders. Arguably the biggest success story is the oil explorer Gulf Keystone Petroleum whose shares were first listed September 2004 at 48p and now stand at 411p.

The story

Initially the Gulf Keystone Petroleum story was all about its Algerian operations. As so often happens things didn't work out, and by March 2009 you could have picked up its shares for as little as 6p. Yes, 6p, that isn't a typing error!

When Algeria failed to deliver, all the company had left was its interests in four exploration blocks in Iraqi Kurdistan. Then in August 2009, when large quantities of oil were discovered in each block, its shares took off like a rocket and they ended the year at 90p.

Today Gulf Keystone Petroleum is valued at £3.5 billion, with its share price having trebled during the last six months in large part because of the rumour that the supermajor ExxonMobil has approached it with a takeover offer pitched at 800p a share. The company has formally denied this, but the story continues to attract investors' attention.

Billions of barrels

The biggest buzz surrounds Gulf Keystone Petroleum's 75% stake in the Shaikan block which is thought to hold some 7.5 billion barrels of oil (all figures quoted in this article are for P50 reserves). However, the Kurdistan Regional Government (KRG) has the option to increase its 20% holding in Shaikan and reduce Gulf Keystone Petroleum's interest to 51% in the process.

Next up is the more modest Akri-Bijeel, thought to hold 2.4 billion barrels, where Gulf Keystone Petroleum owns 20%, which the KRG could reduce to 12.8%. The KRG doesn't have any option to dilute its stake in the other two blocks; Behr Bahr (40%) with 1.9 billion barrels and Sheikh Adi (80%) with about one billion barrels.

Already producing oil

Technological limitations and the laws of physics mean that it isn't possible to extract every last drop of oil. Consequently the reserve figures noted above are for "oil in place."

Current technology means that the recovery rates in most parts of the world tends to be in the region of 30% to 40% of the oil in place. But in theory it is possible for rates to reach as high as 80% if the geology is favourable and techniques like steamflooding are used.

Gulf Keystone Petroleum is already producing from Shaikan, and it and its fellow consortium members continue to explore the four blocks to increase production and pin down the oil reserves. For further information about field development, I suggest checking out the presentations on its investor relations website.

We're losing money, but who cares about that

Gulf Keystone Petroleum is not profitable at the moment but frankly that doesn't concern investors. As always the story for early stage oil explorers like this is finding oil and then developing the oilfield, after which the cash will soon start to roll in.

Its losses per share were 4.19 US cents in 2010 and 1.37 cents in the first six months of 2011. After the oil reserve figures, the most important number in its most recent accounts is $134 million of cash (and no debt) which should be enough to fund its drilling programmes for a good while.

Investors who swear by the balance sheet will immediately run into difficulties as they'll (incorrectly) assume that Gulf Keystone Petroleum is highly overvalued because its net asset value is $427 million, which is less than 8% of its market value. Their problem is that oil reserves are not valued in the balance sheet; instead what was spent to find them appears as an "intangible asset."

The prospects

The upside for shareholders is that the colossal amount of oil that's involved means that the oil majors will soon be sniffing around Gulf Keystone Petroleum, if they aren't already. If it isn't eventually bought by one of them it should be able to turn itself into a major producer within the next few years.

But there's a big fly in the ointment. Iraq's central government has been arguing for years that the KRG's contracts are invalid because only it has the legal authority to issue oil licences in Iraq. The KRG naturally disagrees with this stance, but with the dispute having been ongoing for five years no major oil company except for ExxonMobil has entered Iraqi Kurdistan.

So whilst there's still plenty of upside in Gulf Keystone Petroleum, shareholders need to be aware that there are political risks to consider.

Investing in the sector

Small oil companies are not for the faint hearted. Their share prices are often extremely volatile as they are easily moved by any combination of drilling results, hope, fear, greed, politics, rumour and even deliberate misinformation.

The biggest risk is that they don't find anything when they drill, but if they do there are still plenty of things that can go wrong. For one thing success often causes the host nation's government to demand a bigger piece of the action, as we saw last year in Britain with the budget day tax raid on North Sea Oil.

Consequently, private investors who specialise in this sector tend to spread their investment between several companies. Most will have seen at least one of their shares collapse due to a lack of commercial discoveries and/or operating problems (I've had three of these), and almost certainly regret having sold at least one holding because its price subsequently soared after a big discovery. This comes with the territory.

I used to own shares in Gulf Keystone Petroleum, but sold out at a much lower level having made a tidy profit. But I have great hopes for my remaining Kurdistan explorer, the Toronto-listed WesternZagros Resources, and I can't really complain having had more than my fair share of successes such as Dragon Oil which is up by over 4,500% in nine years.

Small oil companies offer investors the prospect of tremendous rewards and nothing in the FTSE 100 will ever come close to doing what the likes of Dragon Oil and Gulf Keystone Petroleum have done. But the sector is very risky, to put it mildly, and investors should know what they're getting into before they buy shares in a small oiler.

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