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Oil and gas stocks have been slugged by lower oil prices as well as the credit crisis but these very factors are creating opportunities that will spark action in the sector this year. Mergers, takeovers and asset sales will generate excitement as producers with cash flow and no debt in pursue companies that are running out of funds.

Although smaller explorers are likely to be the first to fall, some of the majors could find themselves pursued from abroad as international players such as ExxonMobil, Shell or China’s oil companies chase reserves and the low dollar makes local stocks comparatively cheap. Among the majors, Santos could attract an acquirer interested in its Papua New Guinea liquefied natural gas (LNG) assets as well as its oil production.

Australian oil and gas stocks have fallen in tandem with the world oil price, down from a record US$147 a barrel in July to US$46 this week. But the impact on company revenues is not so bleak due to the fall in the Australian dollar, which was 95 US cents in July. Revenues have fallen by about half in Aussie dollar terms.

The last few years have also enabled many companies to pay down debt and build up exploration and production. Australian Worldwide Exploration (AWE) and Oil Search are cashed up with no debt and are able to fund operations out of cash flow. AWE in particular is on many brokers’ buy lists and is expected to be a likely acquirer, although its strong cash position means it might come under offer itself. Oil Search, while cashed up, does have to fund its share of the Papua New Guinea liquefied natural gas (LNG) project in coming years.

AWE managing director Bruce Wood says there will be a flood of opportunities for companies that are cashed up and he has already had approaches from companies wanting to partner “and we are working our way through a lot of options.”

AWE has $350 million in the bank and is generating cash after tax even at current oil prices but Wood says with a $200 million exploration program planned for 2009-10 and its own projects the company does not have to acquire assets to get growth.

OPEC gave oil stocks an early Christmas present in December with a production cut of 2.2 million barrels a day from January 1. Global demand is 85 million barrels a day but how that will decline due to recessions and slow downs in major economies this year is anyone’s guess. Wood expects the oil price to remain soft in the short term but says it will move higher as production shuts down, because oversupply is not so great. In the meantime, he says exploration is already falling in Australia and small companies are being squeezed, particularly if they have no production, because they are not getting the revenue benefit of the lower dollar but are being hit by higher capital costs.

What is an opportunity for AWE is a dilemma for smaller companies because a market fixated on cash flow and production is not ascribing value to stocks with exploration potential. In this market, a disappointing result from exploration will depress a stock and a positive announcement will just keep the price steady. AED Oil is trading below net asset backing while Beach Petroleum is not expensive at the current price of 95 cents nor highly geared at 17.97 per cent (debt/debt plus equity at June 30.)

Origin and AGL were among the better performing stocks across the market in 2008 due to their utility activities and in Origin’s case its coal seam gas assets and a takeover bid. The coal seam gas business is trading on promises at the moment but activity in the sector means that even the smaller coal seam stocks have held up comparatively well and will probably do so this year because of the amount of corporate manoevering (see compareshares report on August 4, 2008.)

Oil and gas companies are closer to each other than in many other industries because they share ownership, and therefore risk and rewards, from exploration and production acreage. This does give those who are strapped for cash options other than being taken over. Expect to see a greater number of deals where companies farm into acreage, or acquire an interest by funding a share of exploration, or outright sale of assets to others they are already in partnership with.

Oil and gas stocks are not expected to recover to their 2008 highs this year unless on takeover interest. The current oil price is probably only this high because of the conflict in the Gaza strip. Nevertheless, there will be activity in the sector and that will provide opportunities for investors. It seems inevitable that there will be fewer stocks to choose from by the end of this year.