My Investment in Africa Oil

Postion Sold Sept. 3, 2010 at $1.34

Click Here for an Update to Africa Oil Investment--June 20, 2010

I first heard about Africa Oil after Rick Rule of Global Resource Investments presented the idea at a Casey's Research Conference. He had just taken a major stake through a recent capital raise.

About Africa Oil

Africa Oil is an oil exploration company focused in Ethiopia, Kenya, and the Puntland region (Somalia). The company has a large acreage position totaling 200,000 km in the largely unexplored regions of East Africa.

Company's Website: Click Here

Investment Analysis

Africa Oil represents a compelling opportunity to participate in the oil exploration business in geographical regions which could produce multi-billion barrel finds. The company has obtained a sufficiently large land position in under-explored regions where few wells have been drilled.

Somalia is the company's hidden gem. Because of numerous civil wars, Somalia has been largely untouched by major oil companies in the past, even though it shows excellent potential. There have been numerous oil seeps over the years indicating that there is some oil there, but it remains to be seen if any of it is commerically viable. The basins of Somalia and Yemen used to be contiguous millions of years ago before they separated. The two major areas of interest are the Dharoor and Nogal basins, which were connected to the Masila, and Shabwa basins in Yemen. These same basins in Yemen have produced large oil finds in the past.


While Somalia is a political morass, the Puntland is a self governing, stable  region in the north of the country. Africa Oil has exclusive drilling rights to the region (with their partner Range Resources) and will begin drilling in mid 2010 and early 2011. The only potential problem with this site is that the Somalian government has challenged the agreement, claiming that a self governing region cannot grant drilling concessions to a company without the approval of the central government. I am not particularly concerned about this as the President of the Puntland Region recently noted that the central government has no practical authority in Somalia outside the capital. The Puntland region has its own elected government and military. For more on Oil in Somalia Click Here

The company also has exploration licences in Ethiopia located around the Adigala and Ogaden basins. The Ogaden basin in particular looks to be the best prospect because oil and natural gas deposits have already been discovered by other companies. The only problem in this area is the Ogaden National Liberation Front, which is a separatist militia group which has committed acts of violence against companies in the past. The NLF opposes oil exploration and has threatened to attack any company who tries to drill in the area. Most of the western oil majors are unwilling to accept this type of risk.




Kenya is another place of interest for Africa Oil ,which has interests in three major blocks in the northern section of the Anza basin. This basin is thought to be a continuation of the hugely successful Muglad basin in Sudan that has produced large oil finds. While hopes are high in Kenya, it has a poor track record when it comes to actually finding commerically viable oil and natural gas deposits (drilling has found large concentrations of gas though). One of the main reasons for this could be that the majority of wells only reached a depth of 3000-3500km. Another reason is that only 37 exploratory wells have been drilled in the country. For a comparable example, it took over 90 exploratory wells to find oil in Sudan. Africa Oil and its partner CNOOC are currently in the process of drilling the deepest well ever in Kenya (5,500km) in Block 9.




Timeline

One of the best aspects of Africa Oil is their timeline for drilling. Unlike other explorers who promise drilling in the future, Africa Oil is commencing all of its drilling within the next two years. Their first well in Kenya was spud on Oct. 2009 with their partner CNOOC (Chinese oil company). In May, 2010, they completed drilling and announced that they had hit natural gas in four pay zones. Testing is currently underway to test the commercial viability of the find. The Company is expected to begin drilling in the Puntland in Q4 of 2010. In 2011 they should be drilling in Ethiopia and Kenya.

Management

The team at Africa Oil is experienced in the exploration business and has a strong record of bringing value to shareholders. CEO Keith Hill was the founder of Valkyries Petroleum which was successfully sold to Lundin Petroleum for $700 million. Management has hinted through interviews that their goal with Africa Oil is to find and prove oil resources and then sell the company rather than spending 5-7 years and hundreds of millionsof dollars to bring the resources to production.

Financing

One of the more frustrating aspects of the exploration business is the large amount of capital required. To finance exploration, companies seem to issue shares almost on a quarterly basis, which results in severe dilution to existing shareholders. While Africa Oil has has had to do this as well, they are now in a position  to  finance fully their drilling program for the next year. They will be able to accomplish this through farm out agreements that reduce their interest in the well but help pay for the large exploration costs (up to $26 million per well). So, in my opinion, shareholders do not have to worry about any more dilution for the foreseeable future. Furthermore, the company has 44 million warrants outstanding which expire in 2012. This gives the company access to more capital if the warrants are exercised without having to go the capital markets again.

Major Investors

I like to see respected resource investors invest alongside me. In the case of Africa Oil, there are two major investors who have significant stakes in the company. Rick Rule has an approximately 9% interest through common shares and warrants. Another major investor is the Lundin family of Sweden, well known for their oil company Lundin Petroleum. There are certainly smart people investors in this endeavor.

Summary

I consider Africa Oil a valuable call option on oil exploration in East Africa. It is a high-risk high-reward situation where you have to be willing to lose your entire investment. If the company hits oil in any of their blocks, the stock will do incredibly well for shareholders. Conversely, if they fail, the stock will most likely go to zero. There are no guarantees in the resource exploration business no matter how good the prospects look on paper. The company is also exposed to major political risks in Ethiopia and Somalia, which could result in the company losing their exploration licenses. Overall, I think the potential far exceeds the risk and am willing to invest in the company.

Disclosure: 3% of my portfolio is invested in Africa Oil. I may bring that number up to 5% if the opportunity presents itself. By basis in the stock is .91 cents.

Legal Disclaimer: I am not an investment advisor and nothing on this site should be interpreted as investment advice. Please consult with your own financial advisor before investing in the stock market or any financial asset.

My Investment in Africa Oil