OGX beyond the Hype
Comment of the Day

July 30 2013

Commentary by Eoin Treacy

OGX beyond the Hype

This blog post by Mark McHugh focusing on OGX may be of interest to subscribers. Here is a section
It was naive to expect that OGX was somehow going to remain immune from the scrutiny of the market forever. There exist undoubtedly huge potential and strong indications that OGX will be successful—a world scale resource base, energy sector experienced management team and board, and a good liquidity position. However, there is still little tangible on which to base a full evaluation at this time—hence investors in some senses are placing bets on the upside. Early results have been seized upon and have taken-on disproportionate significance. Moreover, exploration companies like OGX, are notoriously high risk, volatile and will have erratic earnings during the early stages of development. OGX can only be properly assessed in the future, based on its long-term performance in consistently finding and producing oil and gas in profitable, commercial quantities.

Meanwhile, Eike Batista and OGX's management must accept the blame for their current predicament. It is an inevitable consequence of their hard sell, raising unrealistic expectations in the market with little substance to back it up. Even so, the share price debacle has had a positive side—it appears to have created a realignment of company objectives as part of the natural transition towards development and production. Consistent with this, there appears to be greater realism in target setting.

Eoin Treacy's view The collapse of OGX has been making headlines because of the losses taken by its CEO Eike Batista, who has seen his wealth deteriorate by more than $33 billion in less than 18 months. The company's assets include both shallow and deep water reserves as well as other valuable resources. A number of news items are now talking about a fire sale, where stronger participants will have the opportunity to pick up at least some of these attractive assets at fire sale prices.

The share (log scale), which had previously been one of the largest in the Bovespa Index, has declined precipitously this year to find support earlier this month near BRL0.38. Potential for a further short covering rally can be given the benefit of the doubt provided the flow of negative news has ended.

While the collapse of the OGX has weighed on the wider market, it represents a symptom rather than the cause of the decline. The Index is dominated by resource companies not least VALE and Petrobras both of which have been negatively affected by overestimating Chinese demand and underestimating the cost of increasing supply. The Index broke below the psychological 50,000 in June and has now rallied back to test that area. While there is additional potential for an unwind of the overextension relative to the 200-day MA, a sustained move back above it will be required to suggest a return to demand dominance beyond the short term.

The weakness of the Real represents an additional headwind for foreign investors in the Brazil. The US Dollar has been trending higher since late 2011 and while somewhat overbought in the short term, a sustained move below BRL2.2 would be required to question medium-term potential for outperformance.

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