Trees don’t grow to the moon. And oil prices don’t go up in a straight line, though you might be tempted to think they do given the price action in the energy sector this year.

While energy prices will remain strong, they will also fluctuate. Consequently, if you buy shares in a large oil company, you can pretty much expect it to track the oil prices… that is, if the company can continue to efficiently replace depleting reserves… no sure thing in this era of peak oil.

There is a better way to invest. As Dave Forest, Managing Editor of our new Casey Energy Speculator newsletter touches upon in the following article, focusing on small companies still in the process of building their reserves is a far more profitable approach. In this instance, the small-cap companies are hunting for elephants in an area usually reserved for giants… the North Sea.

Doug Casey

The North Sea: Small Explorers, Big Payoff
By Dave Forest

The world today is more desperate than ever for new sources of oil and natural gas. Exploration companies are now pouring over nearly every inch of our planet, looking for new pools.

This of course means that big discoveries are becoming increasingly rare. In proven basins in Canada and the U.S., targets are shrinking rapidly as an increasing number of players vie for a piece of the ever-shrinking petro-pie.

So, where is a junior Exploration & Production (E&P) company to look these days in order to make a big find?

Answer: the North Sea. Early in September, the British Department of Trade and Industry announced the latest round of awards for oil and gas licenses in the UK portion of the Sea. And there were several new kids on the block looking to take advantage of the sizeable pools found here.

Traditionally, the high cost of offshore drilling has meant that the North Sea was the domain of majors like Apache, Encana and ExxonMobil. But increasingly, these waters are being tested by small-cap explorers; the type of companies that stand to gain several multiples of their share price should they tap one of the multi-million-barrel oil and gas pools hidden beneath the ocean floor.

This trend began in 2003 when the British government-seeing that North Sea fields were being idled as major oil companies pulled out in search of bigger prospects-introduced a new program called the “promote license”. The idea was to open up the North Sea to smaller, more innovative firms by reducing license fees to one-tenth of the normal amount and allowing license holders two years to complete geological and geophysical work on the properties before making the decision to drill.

This was a big advantage. In the past, getting a North Sea license meant that a company was compelled to drill within two years, generally at a cost of several million dollars. Under the new licenses, however, companies could get a “sneak peak” at a property, and if they didn’t like what they saw, could walk away without ponying up for a rig.

The last two years have thus been somewhat of an experiment, as investors waited to see if smaller companies could indeed hack it in this part of the world. The results have so far been encouraging.

One of the first juniors to be awarded a promote license was Sterling Resources (V.SLG), who received three blocks in the 2003 bidding round. In 2004, while the promote program was still under the radar of many companies, Sterling snapped up another 8 exploration blocks. On the strength of these acquisitions, the company has appreciated as much as 430% since we began following them in the Casey Energy Speculator.

Perhaps the most remarkable thing is that Sterling’s run has come without drilling a single North Sea well. The stock price has risen purely on increasing investor interest in the area, and the market’s recognition that SLG holds some of the best ground around.

How good? Enough that producer Oilexco (T.OIL) was willing to farm in on Sterling’s block 21/23a in the central North Sea, agreeing to pay 95% of the cost of a well in order to earn a 65% interest. In effect, Sterling gets a near-free ride while retaining over a third of potential revenue.

Other deals struck by SLG include an agreement with Grove Energy (V.GRV) on block 42/13 in the southern North Sea, whereby Grove will pay 50% of the cost of a well in order to earn a 25% interest. Sterling has also signed a deal with Lundin Petroleum AB for Lundin to earn a 40% interest in blocks 210/25b, 210/29 and 210/30 in exchange for footing nearly 62% of the first 10 million British pounds of costs for an exploration well.

Because of deals like this, the promote license program is starting to garner more attention from junior companies, meaning that the rush is on to grab leases. This year, the British government awarded more than 150 new licenses.

The region is even starting to attract some truly micro-cap explorers. One of the awardees in the latest license round was Exall Resources (T.EXL), weighing in at a miniscule market cap of C$25 million at the time of the award. In our analysis of the new licenses for the Casey Energy Confidential, we noted that Exall, because of its size, could well be one of the best plays on the North Sea story, in terms of potential upside. This theory has since proved out-following the awards, EXL has gone from a share price of C$0.36 to as high as C$1.13, up 214% in just three weeks.

If the past is any indication, we expect that many of the companies holding North Sea licenses will enjoy this type of appreciation over the coming months as they work up targets, sign farm-out deals and move closer to drilling. The bottom line is that there aren’t many operating areas left on the planet where junior E&P companies can get exposure to reserves of the size found here.

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