Despite prices slowly increasing over recent time frames, it is safe to say that crude oil is still deep-seated in a slump and is a far cry from where it was just two years ago.
So why is Cavendish Asset Management’s Paul Mumford (pictured) snapping up shares in the small-cap oil sector?
“If you’re looking at the sector itself, it’s completely friendless because the oil price hasn’t improved and nobody really wants to get involved as they think the oil price is going to be at this level for the next two or three years,” he admits.
Performance of oil and indices over 1yr
Source: FE Analytics
However, Mumford – who runs the Cavendish Opportunities and Cavendish UK Select funds – is drawing on previous experience which has left him optimistic over a long-term view.
He said: “What tends to happen is you find that, first of all, you get an overreaction in the share prices. For instance, if you look at the house-building sector, that recovered long before the housing market recovered. In this case the prices got very depressed indeed.”
“Another example more recently is Tesco. Tesco went down to the mid-150s and nobody wanted to buy it – the income funds didn’t want it because it cut its dividends. The growth funds didn’t want it because it was ex-growth and even Warren Buffet a cut £347m loss on the thing because he didn’t want to hold it.”
“And lo and behold, the share price recovered, at a time when there was still competition with the supermarkets. I think this sort of thing is going to happen with the oil and gas sector.”
Mumford has a wealth of investment experience. Before becoming a fund manager in 1988 when he joined Glenfriars, he worked as an analyst for Norris Oakley Brothers and also as a smaller-companies expert at R Nivison.
As a result of this, he’s witnessed many market truisms first-hand.
“One of the reasons I think the oil price is going to recover is because it’s happened in the past,” he said. “Many years ago, I bought a number of companies when oil got down to $14 per barrel and I said to myself: ‘Do I take advantage of this by buying BP or Shell?’ And the answer was: ‘No, I’ll go for the smaller companies.’”
“The reason for going for smaller companies is because BP and Shell have got to have special discoveries just to replace the oil that they’re using up.”
Mumford contrasted this to smaller companies, where just a reasonable find can be completely game-changing in terms of both assets and income.
He said: “I prefer smaller companies because not all of them will go right, but the ones that do go right could go up ten-fold over a period. It might not happen for some five or 10 years, but who cares if you’re going to make that sort of money?”
Because of the risk involved with smaller stocks, Mumford has been strict on the criteria that he has adopted when choosing companies to invest in.
“I’ve avoided places like the Falkland Islands as it’s too remote,” he said. “I’ve avoided places like America where it’s just a completely different game. I’ve stuck to the North Sea where I understand what’s going on.”
“In a lot of cases, some of the shares I’ve bought have hedged their oil so that, for the next 18 months or so, they won’t have any particular financial problems. Alternatively, they’ve got sufficient production to get them a cash flow through which will see them through this sticky period.”
Ithaca Energy, one of Mumford’s favoured small-caps, has hedged 6,300 barrels of oil per day at an average price of $102 until 30 June next year.
“[Ithaca] is producing around 12 000 barrels each day, and it’s got an oil field coming into production next year which will give it another 16 000 barrels of oil,” the manager said.
“The share prices got whacked back because the second field has been delayed and people have been very disappointed about it.”
The company, which has a current market cap of £121.58m, is set to have a cash flow of over £330m when the second field comes into production.
“It’s astonishing value,” Mumford said. “But, the problem with it is the fact that it’s got debts of about $700m or $800m and I think these are going to peak at about $850m.”
“It’s got head room of up to $1bn so it is risky in as much as it has got this borrowing situation, but if I’m right and oil doesn’t come down much further, then it’s going to pay back those debts fairly quickly. Also, its average production cost is about $30 a barrel, so it’s got plenty of head room to make a profit.”
Another small-cap oil company in Mumford’s portfolio is Hurricane Energy, which still needs to raise money in order to bring its field into production.
Mumford said: “It made some money the Christmas before last and it drilled an appraisal well in July which came in at quite an astonishing rate. This proves that the company had 208m barrels of oil in that particular North Sea oil field that it owns. In its current state, they can sell that for $5 a barrel, and the company’s value in the market is £100m, so you can see the value on that.”
Hurricane Energy shares were issued at 43p and are now selling at 15.5p, which Mumford says demonstrates how friendless and oversold the market is in this area.
“I have a few [oil] stocks which I think may not work, there’s always a possibility of some of them going bust,” he admitted. “I’ve only got about 6 per cent in my portfolios. I’ll probably build it up to 7, 8 or 9 per cent, but I wouldn’t bet the ranch on them.”
“The most I would happily put in each particular holding is about 1.5 per cent, on the basis that, if something goes wrong with the company, I’m only losing a penny to the pound. But, if it goes right then I’m making several times that.”
The icing on the cake for Mumford would be if the price of oil improves, which he is certain will happen at some stage, even if it doesn’t occur for a long time.
“I think as sure as eggs is eggs, the stock market does tend to anticipate these sorts of changes,” he said. “The price of Ithaca’s come down from about 140p and the current price is 36p which is completely ridiculous. But then there are larger companies, like Cairn Energy, that have sufficient cash to get them through the next couple of years.”
However, Mumford notes that investing in larger companies doesn’t necessarily offer better security and cited BP’s spillage in the Gulf as a prime example.
He said: “The share price cratered, they cut the dividends, and the liabilities mounted up. In my opinion, that’s the danger of having big stocks.”
“If you can get 70 stocks with good potential, then I’d prefer to have that than 40 stocks which have got great potential but, if something goes wrong, the capital growth of the fund is ruined.”