It's not all doom and gloom for junior O&G companies as this article proves. Interest mention on farming out but dissapointing that it did not mention Falcon who managed to do it with Exxon Mobil. If you did not know know this already :-) we are really in a comfortable position for now......

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LOWDOWN: Investing in junior oil and gas

The oil price has slipped way off its mid-2008 high of $147 a barrel. Weighed down by concerns over excess supply and falling demand due to the global recession, it now languishes at around $40 a barrel. The price collapse has eaten into the profits of oil producers and forced many firms to delay or cancel projects and rein back on exploration.

That said, the outlook for oil remains positive. Oil will remain the world’s dominant fuel for many years to come. Despite underperforming relative to the 2008 record, the oil price remains higher than in many recent years.

The International Energy Agency forecasts oil demand rising from the current 85m barrels of oil per day to 106m barrels per day in 2030. This, it estimates, requires $350bn (£239bn) to be invested in oil and gas exploration and extraction every year between now and 2030. Significantly less is being spent, which risks future supply constraints.

These supply constraints plus the possibility of the US dollar weakening and equity markets falling further will create upward price pressure on oil (and other commodities such as gold). The oil price may recover during 2009, depending on the severity and duration of the recession. If it doesn’t, this will simply store upward price momentum that should release when economies eventually recover. Indeed, reviving economies coupled with reduced current exploration due to the low oil price could trigger another over-correction and price spike (the oil price over-corrected to reach $147 a barrel, and over-corrected downwards in the subsequent crash).

With many analysts forecasting a sustainable oil price of $60-80 a barrel, junior oil and gas explorers that can find and develop hydrocarbons offer exciting growth prospects. An important point to note is that firms only benefit from high oil prices if they are producing hydrocarbons. Many juniors aren’t producing, at least in significant quantities, and probably suffer overall from high oil prices due to increased input costs.

The potentially high investment returns don’t come without risks. It is inherently difficult to find hydrocarbons. Statistically, the success rate in drilling is only around one-in-five to one-in-seven, which means that companies drill on average four to six ‘dry holes’ for every successful well. Drilling failures within the accepted range should be price-neutral events, accepted by the market as the normal course of oil and gas exploration. In practice, the announcement of any dry hole is likely to see a junior explorer’s shares hit hard.

Hydrocarbons are found in many parts of the world but the challenges of producing them vary enormously depending on location. Given the world’s dependence on oil, politics overlay all other considerations. Whereas the United States offers fiscal and political stability, operating in Russia risks theft of assets. Operating in Nigeria risks physical violence, kidnapping or worse.

Companies can mitigate their risks, however. Targeting proven but undeveloped hydrocarbon fields carries lower risk – albeit with generally lower potential returns – than ‘wildcat’ drilling in unexplored regions such as the Falkland Islands, where the costs and risks – and returns – can be orders of magnitude higher. Drilling shallow onshore wells is much less risky and expensive than drilling deep offshore wells buried under several kilometres of sea, salt and rock.

Companies can further de-risk projects by ‘farming-out’ interests to other firms in return for these firms carrying out work on the licence, for example acquiring seismic surveys or drilling. Faroe Petroleum, Aurelian Oil & Gas and Northern Petroleum have added substantial value to their portfolios through adroit use of their ‘hydrocarbon wealth’ in this manner.

Developing oil and gas fields is expensive work and company financing is critical, particularly for juniors that don’t yet have production cash flows. Companies with proven oil and gas reserves can secure farm-in capital. However, the difficulties in debt and equity markets are threatening the existence of inadequately-financed juniors without such reserves. Production remains king, particularly in the expectation of a rising oil price, failing which investors should look for a healthy cash balance and proven, ideally low risk, reserves