Fat Prophets take some profits

Although we remain of the opinion that crude oil will see stronger days in the years ahead, there are certain times when booking profits is the prudent move irrespective of any long term bullish stance. With the share price of Dragon Oil (LSE, DGO) currently 980% higher than upon our initial recommendation (and trading higher than the value of a recent takeover offer) this is one such occasion. The company though continues to excel operationally and as such we are maintaining half of our holdings.

As our recent coverage of both Dana Petroleum and Tullow Oil have highlighted specialist oil and gas exploration and production companies provide greater leverage to a the price of crude oil than fully integrated energy companies such as BP and Royal Dutch Shell. Earnings of the industry heavyweights have been hamstrung by weak downstream operations… something alien to the likes of Dragon Oil.

Instead, Dragon has been able to focus on what it does best boosting its production profile through its expertise with the drill bit. Indeed during 2009, the Turkmenistan focused company increased average daily output by 9% to 44,765 barrels of oil per day completing eight wells with two rigs in full time use.

Unsurprisingly 2009 revenue was hit by lower oil prices and came in 12% below the 2008 level at US$624 million. Pre tax profit for the year fell to $259 million in 2009 from 2008’s US$369 million from as the labouring price of crude oil (US$62 per barrel realised versus US$91 last year) outweighed a 40% increase in volumes of crude sold.

Focussing on the charts, Dragon’s ability to consistently ramp up production has not gone unnoticed. Looking at the long term technical picture we can see the phenomenal run that this stock has had over the past six years. The stock sold off heavily in 2008 but has rebounded strongly since bottoming in 2009.

As a reminder, Dragon is an independent oil development and production company, engaged in upstream oil and gas exploration, development and production activities primarily in Turkmenistan. The energy E&P company operates oilfields located in the Cheleken Contract Area offshore Turkmenistan, in the Caspian Sea.

Given Dragon’s plans for the years ahead there is every chance that the share price rally may well continue through 2010. The company is aiming to complete another 11 wells this year and for the period from 2010 through to 2012, Dragon anticipates completing up to 40 new wells to support its targeted production growth.

Such growth comes at a cost. Dragon estimates an associated capital spend on infrastructure over the period of around £390-450 million. The company has stated that it would target annual output growth of 15% in 2010 and between 10-15% on average up to 2012.

Dragon is also looking to beyond oil to when it comes to underpinning earnings in the years ahead. At present the company is producing a significant amount of gas as a bi product of its oil production however, due to a lack of infrastructure, remains unable to commercialise. With another fillip for earnings in the offing, the company is pressing ahead with the construction of a gas pipeline and will build an onshore gas treatment plant provided negotiations with the Turkmen government proceed as planned.

Whether this provides an immediate spur for earnings is doubtful. We remain bullish on the long term prospects for the price of natural gas however technological advances have opened up supply and with economic data remaining sketchy we may have to wait a little while before we see a recovery in gas prices.

Dragon is also actively looking to expand its geographic footprint beyond current territories with parts of Central Asia, the Middle East and Africa being targeted. The company is certainly not constrained by its finances in this regard…. cash at the year end stood at a cool US$1.2 billion.

Another factor which could provide the catalyst for a higher share price would be yet further potential takeover activity. Our last coverage of Dragon stated that Members faced a ‘win-win’ situation as majority shareholder the Emirates National Oil Company (ENOC) sniffed out a potential bargain, offering shareholders 455p per share.

The offer though was rebuffed and Dragon’s current share price suggests the group’s net asset value will only increase and possible suitors will have to sharpen their pencils before making any future approach. As we commented at the time a £2.36 billion offer for a company with Dragon’s cash pile and a rapidly escalating, highly profitable production profile, is somewhat chancing it.  Despite ENOC's seemingly emphatic claims to the contrary, the M&A game is such that a higher offer could well be on the cards... although selling half, we retain half of our Dragon Oil shares and therefore will continue to watch the space with interest. 

Even though Dragon trades on a discount to the net asset values attributed by various analysts, the market current vulnerability is such that our decision to sell half our holding was a straightforward one. The crystallisation of a near 1000% gain is not a daily event and Members looking for further exposure to the energy E&P sector are advised to ride the rotation into larger companies such as Tullow Oil, a theme which will resonate through 2010.

Looking more closely at the daily chart of Dragon we can see that the stock has formed a strong uptrend for the duration of 2009 and is currently hitting new 2010 highs. After such a strong performance we have now ventured some distance from the nearest support at the 360p level.

From a valuation perspective, Dragon’s forward price earnings multiple of 10 times is undemanding however given the meteoric rise since our initial recommendation, prudent portfolio management dictates some profit taking at this stage.

Accordingly, we advise Members able to lock in significant gains sell half of their holdings in Dragon Oil.  For Members who have bought in at higher levels, the spectre of further M&A action looms and as such no action is recommended.