THE INVESTMENT COLUMN

Oil companies' attractions slip

Among the market's worst laggards until November, the oil sectors (both integrated and exploration stocks) did a good job of catching up in the final two months of the year and ended up more or less matching the All-Share's impressive growth during 1995.

There were a number of factors at work. Wall Street's continuing surge dragged the US's big oil majors higher, which in an increasingly global market for international energy stocks carried Shell and BP up. There was also an element of rotational buying as US investors searched for alternatives to the high-tech stocks that had driven the Dow's boom year and were beginning to look ever more overpriced.

At home, the earlier-than-usual cold snap meant downstream inventories ran down unexpectedly quickly which pushed the always volatile price of Brent crude sharply higher. From less than $16 a barrel in October, the price is currently over $18. Shell benefited from a hint to the market that it planned to maintain its dividend payout ratio, suggesting that investors would feel the full impact of any rise in earnings.

At the smaller end of the market, where most of the exploration and production tiddlers are found, a mini-wave of speculation hoisted share prices across the board.

After Aran was targeted by Arco in the summer, most analysts dismissed the bid as a one-off special situation but when Goal was bid for, attention started swinging to which company might be next in the takeover sights.

That has been the good news. Looking forward, however, it seems that both sectors have probably seen the best of their recent runs, although for different reasons.

The large integrated stocks are really an amalgam of two different cycles, chemicals and refining, together with an upstream exploration business where demand is relatively stable but pricing is out of the producing companies' hands.

Both Shell and BP benefited from historically high chemicals margins last year and it is only reasonable to assume these will fall this time - the argument between different analysts is the extent of the downturn. BZW, for its part, is expecting Shell's chemicals profits to fall from pounds 1.29bn last year to pounds 890m this time. BP's chemical profits will also slip pounds 300m.

Most of that will be made up for by improvements in refining margins which due to overcapacity were unusually low last year, but both companies will do well to achieve more than a repeat of last year's group profits, pounds 4.76bn for Shell and pounds 1.99bn at BP, as it becomes apparent that improving profits in the past three years have been more about recovery and less about underlying growth.

They will receive little help from the oil price. BZW is sticking with its forecast of $17 a barrel for 1996 as a whole.

That said, as the chart shows, there have been and remain to be seen some notable improvements in operating performance from most of the oil majors both in the US and Europe. Severe industry restructuring and a recovery in the chemicals business has put them all on a much sounder financial footing than in the black days of 1992, either paying down debt or maintaining broadly stable gearing ratios.

Improved cashflow positions have resulted in a return to more acceptable levels of profitability and within a few years the industry should be matching its cost of capital, conventionally accepted to be about 12 per cent.

How should all of this be valued in the market? Probably at a slight discount, given the cyclicality of two of the integrated companies' main businesses and the low growth prospects for their remaining activity.

On the basis of BZW's forecasts, Shell stands on a prospective p/e ratio of 16.5 this year and BP on 14.5. That compares with 13.6 for the market as a whole, suggesting little upside.

At the smaller end of the market, the 15 per cent rise in the exploration index over the past two months, has probably taken most of the shares to a sensible compromise between their former prices and the amount a notional bidder might be prepared to pay. Lasmo and Enterprise, neither integrated nor potential bid target, are respectively fairly priced and expensive.

Zergo profits from good press

In its six months of existence the Alternative Investment Market has provided plenty of proof that shares in small, young companies can be volatile investments. Even in that context, however, yesterday's performance from Zergo Holdings was dramatic.

Shares in the company, which develops anti-hacking software for computers, rocketed 80p to 250p on nothing more substantial than a "buy" recommendation in a rival newspaper. At one stage they rose as high as 290p, despite no trades being recorded in the stock.

The main reason for the rise is that, like a lot of AIM companies, Zergo has a relatively small number of shares in issue. This makes them difficult for investors - particularly smaller investors - to buy. It also means that the slightest whiff of good news - or bad - can send the shares into orbit or free-fall.

But Zergo is far from all hype and no substance. The company has developed a useful niche in producing anti-hacking software and other information security to the financial sector. Two weeks ago it launched a new Firewall system for the encryption of credit card numbers on the Internet.

As the risks of hacking and other forms of computer crime grow, such security systems will become increasingly important. So far Zergo has built up a blue-chip client list which includes the Bank of England, Lloyds Bank and ABN Amro. It is also one of the service providers to Crest, the Stock Exchange's new automated settlement system.

Zergo only came to AIM in September, when its shares were priced at 97.5p, but it was founded eight years ago by Professor Henry Beker, a world-wide authority on information security who spent 11 years at Racal. Though small, and not without competitors, it has developed technology that even larger rivals will be hard pushed to beat.

The company is still very much in its formative stages. Last month the company issued results for the six months to October which showed a pre- tax loss of pounds 479,000 on sales of pounds 4m compared with a pounds 46,000 profit in the previous year. However, the company says it expects to be modestly profitable in the full year. No dividend is expected yet as the company will invest profits into developing products.

Fund managers who follow AIM stocks remain positive on the shares due to the company's innovative products and the prospects of expanding into other sectors outside financial institutions.

An attractive bet, if you can get hold of the shares, though not without substantial risk.