The Circle Oil (COP:AIM) story is starting to gain traction with investors thanks to exploration success in Tunisia. Upcoming appraisal drilling could prompt a more material re-rating, even after a big share price rally in the past month.

The Middle East and North Africa-focused firm got a significant bump when it announced a new oil discovery off the coast of Tunisia at the end of August. The El Mediouni well, or EMD-1, on the Mahdia permit encountered very good light oil shows in both the primary Lower Birsa target and the secondary Upper Ketatna target. Based on initial information Circle believes it could be sitting on a 100 million barrel discovery, more than twice pre-drill estimates.

COP - Comparison Line Chart (Rebased to first)

Technical difficulties led Circle to suspend the well but appraisal drilling could confirm this potential and further de-risk neighbouring prospects – achievements which will help in attracting an industry partner to help fund a large-scale development. These catalysts could help lift the shares at least to broker Westhouse’s core net asset value of 35.4p per share. At the current 27.7p and with Investec forecasting 2014 free cash flow (FCF) per share of 4.9p the shares offer a FCF yield of 17.6%.

More to come

There are more drilling prospects on the horizon with Circle set to spud wells in the southern part of Block 49 onshore Oman and its Tunisian Ras Marmour licence. Alongside this effort it is also progressing a development drilling programme in Morocco.

Unlike some of its peers, Circle has the balance sheet to carry out this work without returning to the market for funds. Available cash as of the end of June was $29.9 million, up by 27% year-on-year, and the debt facility agreed with the World Bank in March offers $100 million of headroom.

Though half-year results (3 Sep) were slightly light of expectations – thanks to some delays in the drilling of EMD-1 and increased costs – the company’s average output of 6,600 barrels of oil equivalent still generated $25.1 million cash flow. The majority of this production is located in Egypt where the company has been able to operate with relative impunity despite several years of instability.

Clearly the company is based in a region with a fair degree of instability and the challenge now is to take a view on whether the current valuation offers sufficient compensation for the levels of political and security risk. In our view it does – particularly given management’s track record of managing this issue to date.

Issue Date: 16 Sep 2014