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Oil Column: Smaller oil stocks offer big upside

According to Goldman Sachs there are plenty of opportunities in the oil sector, particularly among the market’s ‘smaller’ companies - which it defines as those worth less than US$1bn.

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Investors looking to put 2013’s hard fought gains back into the market could do well to snap up the relative bargains in the oil and gas sector.

The early bluechip rally has ground to a halt, and a few weeks of hesitancy and profit taking has left many investors scratching their heads as they ponder the next trade. More often than not London’s investors eventually find themselves owning an oil stock.

And, according to Goldman Sachs, there are plenty of opportunities in the sector, particularly among the market’s ‘smaller’ oil companies.

Smaller oil companies, defined by Goldman as those valued at less than US$1bn, have underperformed both their bigger rivals and also the relative crude price.

The investment banking heavyweight says as many as fourteen of these so-called smaller companies now offer more than 40% upside.

According to Goldman the ‘dislocation’ between the values of small companies and long dated crude prices is extreme, and are on a par with those seen in early 2009.

And as the equity market is underplaying valuations consolidation, via mergers and acquisitions, are increasingly likely.

“Typically we believe that high levels of dislocation between equity and commodity values presages M&A activity, offering an opportunity for larger, well funded industry participants to acquire cheap assets,” analyst Christopher Jost said in a note.

That said, Jost emphasises that asset quality remains key, if smaller companies are to draw the attentions of the bigger industry players.

“Although smaller companies offer significantly greater upside using standard costs of capital, asset quality is typically lower with much of the value sitting in smaller assets,” he said.

“Our backtesting of deals suggests that large, high quality assets that can attract major IOCs and NOCs as acquirers can command significant premiums over less strategic assets where smaller independents are acquirers.”

Screening these opportunities Goldman upgraded four oil companies - IGas (LON:IGAS, current price 115p, target 202p), Gulf Keystone (LON:GKP, current 16.25p, target 258p), Heritage Oil (LON:HOIL, price 147p, target 333p) and Coastal Energy (LON:CEO, price £11.05, target £18.43).

Goldman’s preference, it says, is for companies with exploration upside as well as tangible value in large strategic assets.

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