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Small cap oil and gas stocks have surged on the back of rising prices caused by the instability in the Middle East and increasing global energy demands. But is the sector now fully valued or will prices maintain their momentum over the next six months? Robert Tyerman investigates

Outrages in Saudi Arabia and Iraq have rekindled interest in the price of energy and the potential for companies in the oil and gas business. After two years nursing junior mining companies for flotation, stockbroker WH Ireland is now preparing to raise £5 million with an Aim launch for exploration hopeful Meridian Petroleum, with a clutch of 'low-risk' oil and gas prospects in the USA and the Philippines. Other groups are also planning similar moves.

A year ago, hardly anyone was interested. 'Everyone thought crude prices would stick around $20 a barrel,' recalls Richard Slape, analyst at stockbroker Seymour Pierce.

There is a very different mood in the market now. Crude prices recently grazed $40 a barrel and are hovering in the mid-$30s and backers are dipping into their pockets for promising projects.

Small cap surge

Overall, mining shares, as measured by the FTSE Actuaries Index, reflecting the giants as well as the smaller fry, have gained a modest ten per cent over the past year. But some of the smaller exploration-focused companies have fared much better than that.

Fully-listed Cairn Energy has captured the market's imagination and pushed its shares from less than £2 to nearly £12 on the back of a find in the Indian state of Rajasthan that chief executive Bill Gammell says could potentially contain 1.1 billion barrels. Tullow Oil has perked up 50 per cent to 108p on a potentially large gas find at its Lalmai-3 well in Bangladesh and prospects in Morocco.

After a long spell in the doldrums, JKX Oil & Gas has surged on winning the right to export some gas in the Ukraine at world prices. The company also hopes that its 30 per cent-owned Civita 1 in Italy could be part of a structure holding three billion cubic feet of gas.

Hardman Resources, an Aim-quoted Australian group developing offshore gas projects in West Africa, had a placing last year at 22p, recently pulled in £70 million in a 45.5p placing and has since seen its shares hit 70p. Canadian-based Aim counter First Calgary Petroleum has found favour with its gas project at Ledjmet in Algeria and claims proven, probable and possible resources of 986 billion cubic feet.

Shares in Petroceltic Resources, a speculative Aim oil and gas play with interests in Tunisia and the Celtic Sea, have soared from 0.5p to 8.5p, enabling the company to raise £4.3 million at 5p on the way. On a smaller scale, investors recently put up £1.6 million for English minnow Hereward Resources, steered by Bristolian entrepreneur David Bramhill, to pursue projects in Hampshire, the Solent and the Isle of Wight.

One of Hereward's partners in some of these projects is Black Rock Petroleum, a formerly bombed-out Aim-listed Australian group now rallying ahead of drilling results from its Myponga 1 well in South Australia's Cooper Basin. Director Ivan Burgess says it would consider tapping the market for funds if results justify it.

Also participating in the Isle of Wight is Northern Petroleum, headed by Derek Musgrove, which wants to drill another well there and is testing targets at Wytch Farm in Dorset. Northern's shares have swung between 2p and 10p over the past 12 months and now stand at 6.75p, after a £3 million placing at 6p.

Colourful Irish entrepreneur John Teeling, whose South America and Gulf of Mexico oil and gas play Pan Andean Resources has raised £2.8 million at 13p, is hoping to profit from the projected restoration of Iraq's oil industry through his speculative projects hopeful Petrel Resources. Up nearly fourfold at 39p, AIM-listed Petrel, which worked in Iraq under the pre-war UN 'oil for food' regime, is tendering for three hefty projects – Khumala Dome in Kirkuk, Hamrin and Subba/Luhais, all capable of yielding hundreds of thousands of barrels of oil and millions of cubic feet of gas daily. Petrel has teamed up with some heavyweight groups, including Halliburton and GE, to further its cause.

Aim minnow Texas Oil & Gas found favour recently with its ambitious expansion plans in the southern USA. However, at 16p the shares have come back somewhat on anticipation of a fundraising.

Reassessing the market

Recent excitement in the crude oil market provoked dire warnings from market sages of $50 a barrel or more in the foreseeable future and major disruption to the world's economy. The shifting sands of Middle East politics are focusing the market's attention on this sector at a time when spectacular long-term growth prospects for China, the world's most populous state, suggest a major new source of continuing demand.

Few believe pious undertakings by Western countries to curb their use of fossil fuels will have much, if any, immediate impact on the balance of supply and demand, especially while the United States, the world's biggest energy user, remains so unenthusiastic. Saudi pledges to increase production to offset supply interruptions elsewhere are set against a new realisation that the present regime in Riyadh may not keep its grip on power all that much longer.

For now, resource companies, fund managers and analysts fight shy of committing themselves to an all-out 'oil boom'. The Organisation of Petroleum Exporting Countries (OPEC) has increased its forecast for world oil demand this year to 80.58 million barrels a day, the highest rate since 1997, and US commercial crude oil inventories have been growing below expectations.

But even the latest act of sabotage in Iraq, causing the temporary loss of 700,000 barrels a day, was slow to provoke a ripple in the market. Dealers with memories of how short-lived were the oil price spikes caused by the past decade's two Gulf wars are divided about the right strategy to adopt.

'The consensus has broken down,' says Slape. 'If you think oil prices are going to come back down to the low $20s, the sector is fully valued.'

On the other hand, considering the long-term impact of continuing Chinese growth (if it does continue) prospects and the more immediate reverberations of Middle East terrorism, Charlie Sharp, analyst at broker Canaccord, comments, 'it is easy to see why oil prices should stay strong for at least six months.' He argues OPEC would be hard put to increase production enough in time to meet demand.

Exploration companies offer 'blue sky' growth potential. However, they are vulnerable to the risk of energy prices flattening or falling and, when they do find something, could well need more money to develop it.

Meridian stands a good chance of being well received, while bold punters could take a chance with JKX, Cairn, Hardman, Hereward, Black Rock, Northern and First Calgary. For the truly strong-nerved, Petroceltic and Petrel could bring useful rewards.