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88 Energy: A Case Study in the Risk Tolerance of Private Investors

By Graham Neary | Saturday 27 August 2016

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from ShareProphets). I have no business relationship with any company whose stock is mentioned in this article.

For my sins, I took some time to read through 88 Energy’s Interim Report released last Monday. While continuing to believe that the attractiveness of a stock is inversely related to the number of other investors who are analysing it, I decided nevertheless to see what all the fuss was about.

The big-picture thesis is attractive, no doubt: an estimated net c. 2 billion barrels of oil equivalent, buried deep below the permafrost of Alaska and made feasible thanks to the improved technology of modern times.

I don’t usually dabble in resource plays myself, because I understand well that a physical asset like a mine or an oil field is a “wasting resource”. The resource gets extracted over a period of time until it is depleted, and the story ends at the point (unless another mine or another oil field is purchased – i.e. a completely new round of capital expenditure is required).

By contrast, companies in industries like media, tech or pharmaceuticals can generate semi-permanent revenue streams after their initial period of investment. There are natural limits to the upside when it comes to how much demand there might be for a film, a piece of software or a new drug, but there are much stricter limits when it comes to how much demand there might be for the natural resource extracted from a particular asset.

Those limits are ultimately set by the physical supply of resource at each particular asset.

It is impossible to create something out of nothing and so the upside is most certainly capped, in an absolute manner, whenever we analyse physical resources.

But even though the upside is capped, it’s true that resources plays are frequently the most volatile stocks on the market – because nobody knows for sure how much resource is left at any particular asset, how much it will cost to extract it, and how much it will be possible to eventually sell it for!

This to me is a very unattractive combination, perhaps the worst of both worlds: capped upside and extreme uncertainty!

But of course we should be willing to make exceptions, and examine each case on its merits. When I bought Orosur Mining (OMI), I did so at a very healthy discount to tangible book value and at a juicy free cash flow yield. The risk-reward made sense at that time and at that price.

When an enterprise is very risky, we should firstly consider whether we are willing to risk any capital in it at all, and secondly consider what price might be low enough to make it attractive.

Buying at less than tangible book value means paying less for the asset than someone else has already paid for it, or less than it was officially measured to be worth at some previous point in history. That’s a good starting point for me.

88 Energy has balance sheet net assets of $39 million. So if I was considering an investment I’d need to understand why I was paying more or less than this figure. The current market cap is £137 million ($180 million).

But I’d also want to consider whether fair value was affected by risk sounding the company’s financial position, funding issues, operations and costs.

88 Energy:

  • has drawn bank borrowings of $24 million;
  • needs to flow test its second well (scheduled for early next year),
  • will then need a new funding solution or joint venture partner for this well;
  • estimates that its breakeven oil price per barrel for the project will be between $27-$68, depending on costs.

I have no idea what fair value might be for 88 Energy but I’d simply urge shareholders to consider whether these risks are fully reflected at the current market cap!

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