Between a ROC and a hard place (II)

ROC proposes to purchase AZA by issuing 0.792 ROC shares plus 5 cents per every AZA shares. It is reasonable to assume that each CEO thought he had a good deal. The proposal at the time it was made values AZA at a 40% premium based on ROC's share price at that time.

So we have these three alternatives:

1. both CEOs believe it is a good deal because AZA is undervalued and ROC is market value.

2. both CEOs believe it is a good deal because ROC is overvalued and AZA is market value.

3. both CEOs believe it is a good deal because ROC is slightly overvalued and AZA is slightly undervalued.

In an environment where all eyes are focussed on oil and all matters related to it, I rate the chances of the market undervaluing AZA as extremely low to non-existent. So scenario 1 is extremely unlikely, scenario 3 is quite unlikely and scenario 2 is your best bet.

I suppose that every rookie trader, upon looking at the deal, would sell ROC and buy AZA.

So it was a very very dumb decision not to sell ROC when the deal was announced. Dumb mistake.

So what now?

Using a rather crude measure (pun intended) of dividing market cap by announced 2P reserves, I compared 8 stocks in the sector, namely AZA, NXS, ROC, TAP, ARQ, AWE BPE and AED. Of all these, AZA, ARQ and AED have similar market caps. Apart from TAP, ROC has one of the highest dollar value per barrel of 2P reserves (about $24). As a matter of comparision, NXS, AZA and BPE come in at the low to mid teens per barrel. You can refine the calculations by backing out cash, shares, gas assets, etc but I am only using a crude measure. Better to be vaguely right than precisely wrong.

This shows that the market has placed a hefty premium on exploration success. For example, TAP is at $34 per barrel with only 6.5 m 2P reserves.

For comparison, AZA has no exploration, just the BMG resources at 27m. I backed out 65.7 m worth of NXS shares which it holds, and I arrive at $14 per barrel.

ROC at current prices with $24 per barrel, in comparison to its peers, has a significant premium build into its price for blue sky exploration.

I believe that ROC is quite likely to have some success in Angola. But to catch up with its peers, it needs to add at least 14m barrels to its reserves to justify its current price. It will probably add another 5m barrels from its Chinese development fields, so Angola has to come up with another 10 m barrels.

AZA is now trading at $1.18. ROC's offer at its current price of $1.58 still values AZA at $1.32, a premium.

Again, I stress that this is a crude measure, and does not account for the fact that some of ROC's producer wells have already been developed, and that AZA's BMG resource requires another $1 billion (about $45 per barrel) to develop.

On a valuation basis, I believe ROC is at best a hold at this time, and as a hedge to the portfolio for rising oil prices, it will still play a part.