Interactive Investor

Stockwatch: a bullish case for oil & gas stocks

7th January 2022 13:16

Edmond Jackson from interactive investor

Oil shares have been the ones to own at the start of 2022, and our companies analyst thinks the sector may be at an inflection point. Here’s why.

A key challenge for 2022 is to discern which sectors and stocks may be able to withstand the effects of tighter monetary policy. 

The early days of January have given a taste of this, with US stocks selling off after minutes from the Federal Reserve Boards December meeting conveyed its intent to reduce monetary stimulus more aggressively than anticipated. The minutes also firmly asserted its inflation targets, indicating that higher interest rates will be pursued even at the cost of upsetting financial markets.  

Few UK stocks withstood the cold blast. Interestingly, Next (LSE:NXT) fell over 2%, despite raising 2021 profits guidance and declaring a special dividend, after warning how surging inflation and tighter household budgets would hamper 2022 growth. This affirms my recent wariness towards consumer discretionary stocks. 

A bullish case for oil & gas stocks  

While soaring European gas prices relate partly to the politics of supply from Russia, the aggressive push towards green energy seems likely to keep gas and oil prices relatively high because insufficient investment is being made in fossil fuel extraction. 

The International Energy Agency has called for exploitation of new oil and gas fields to halt if the world is to stay within safe limits of global heating and meet the goal of net-zero emissions by 2050. But the supply of green energy is unlikely to meet demand in the medium term. Strong cash flows for producers therefore looks a clear probability. 

The stock market underestimates this by way of equity pricing, however, because ESG (environmental, social and governance) criteria have meant a steady drip-drip supply of stock as institutions tick boxes on asset allocation and individuals regard oil & gas as a graveyard. BP (LSE:BP.). and Royal Dutch Shell (LSE:RDSB) have traded sideways-downwards since the early 2000s. 

I suggest all this has created conditions for an inflection point; so far this January, BP has risen 8% to 355p and Shell by 6% to £17.21, while the indebted (hence more speculative) Tullow Oil (LSE:TLW) is up 12% to 52p.  

Sustained high energy prices will aid debt reduction 

If this scenario is fair, the market is correct to sense leverage in Tullow. At end-June 2021, the company had around $2.3 billion (£1.7 billion) hence $267 million negative equity,  versus a market capitalisation of £715 million currently. 

When I drew attention to Tullow as a ‘buy’ at 45p after last Septembers interim results, a key aspect of the rationale was management’s comment that if oil prices stayed at over $60 a barrel for the rest of the year, it would achieve $600 million underlying operating cash flow. Brent crude is currently just over $80.  

Under its previous management, Tullow had assumed too much debt to fund its various ambitions; I would say it also reflected a loose approach to monetary policy by financial authorities since the 2008 crisis. 

But September’s results showed net debt reducing from $3.0 billion to below $2.3 billion, with management claiming its business plan would see gearing reduce below 150% by 2025. The assumption behind that appears to be oil at $60 or lower, so a scenario with prices around $70 would still be very positive. 

A debt refinancing last May has dealt with maturities arising last year and due 2022, such that $792 million with a 7% coupon is due in 2025 and £1.8 billion with a 10.25% coupon is due in 2026.  

Bear in mind, however, that this relatively higher debt cost – and on a substantial amount – is yet to kick in. In contrast, the interim net interest cost stood at $157 million relative to $370 million operating profit.  

It is a mercurial situation and dependent on oil prices, but I am unsurprised to see the consensus confident enough still to project $160 million net profit in respect of 2021, and $252 million for this year. Implied 2022 earnings per share of around 14 cents or 10.3p implies a price/earnings (PE) ratio of 5x. 

Despite Tullows substantial debt – putting the stock off-limits to conservative investors – I believe the combination of high oil prices and a disciplined 10-year plan for development makes it net attractive for speculators.      

Current CEO since July 2020 has a realistic approach 

Rahul Dhir was promoted from running Cairn India, where he is credited with having done a good job cutting costs after the 2008 crisis in order to capitalise when oil rebounded. Possibly this experience puts him in good stead currently. 

A latest Bloomberg interview quotes him saying: We have an opportunity to really do something transformational,” which he describes in terms of a more modest approach. As well as partnering on major projects, the proceeds from divesting over-ambitious exploration assets may be used to acquire assets sold off by the majors as part of their decarbonisation plans. 

I recall such a ‘scavenger’ strategy applied with material success as long ago as the 1990s, when North Sea assets were similarly divested, enabling small caps such as Dana Petroleum and Premier Oil to advance. While not as exciting as high-impact” frontier exploration, this sounds a more realistic approach for Tullow in the medium term.

Remember, the stock – down from over 200p pre-Covid – can re-rate simply on proof of well-managed debt reduction. 

Tullow Oil - financial summary
Year end 31 Dec
reporting in US dollars

  2015 2016 2017 2018 2019 2020
Turnover ($ million) 1,607 1,360 1,885 2,048 1,725 1,396
Operating margin (%) -68.1 -55.5 1.2 25.8 -80.3 -72.9
Operating profit ($m) -1094 -755 22.4 528 -1,385 -1,018
Net profit ($m) -1035 -600 -176 84.8 -1694 -1,221
Reported EPS (cents) -96.7 -56.0 -13.7 5.9 -121 -86.6
Normalised EPS (cents) -17.0 8.9 21.7 19.2 -26.6 -26.3
Op cash flow/share (cents) 91.4 47.9 95.1 83.7 89.8 49.5
Capex/share (cents) 163 96.3 23.9 30.6 37.1 30.5
Free cash flow/share (cents) -71.2 -48.4 71.2 53.1 52.6 19.0
Dividend per share ($) 0.0 0.0 0.0 4.8 0.0 0.0
Covered by earnings (x)       1.2    
Cash ($m) 356 282 284 180 289 805
Net debt ($m) 3,982 4725 4,868 4,452 4,208 3,582
Net asset value ($m)  3,155 2,230  2,706 2,893 984 -210
Net assets/share (cents) 295 208 195 208 69.9 -  14.9

Source: historic company REFS and company accounts

An improving operations narrative continues 

Even last September, the West African producing assets – with over three billion barrels of oil equivalent in place – were performing well, with production at the upper end of guidance. 

Drilling had started in Ghana and a revised development plan for Kenya held potential for a ‘farm-out’, generating cash both for ongoing debt reduction and for the transformational projects the CEO alludes to. 

A mid-November update continued the theme of strong operational performance in West Africa, and also of Ghanaian drilling. Full-year production guidance was on track for 58,000 to 61,000 barrels of oil equivalent per day (boepd), translating into $600 million of operational cash flow. 2022 production was guided over 85,000 boepd, with three new wells on-stream at the Jubilee field offshore Ghana. 

After $265 million capital expenditure, $100 million of free cash flow was projected for 2021 as a whole, according to working capital movements. Additionally, Tullow will receive $75 million early this year from French oil major Total for Ugandan assets it sold in October. 

Hedging details lower down the update cite plans to cover 40,000 boepd production as of November 2022, falling to 31,000 in 2023 and 10,000 in 2024. The weighted average floor protection was guided from $48 a barrel to $55 in 2023. All this involves a cost of $2.6 a barrel currently, reducing to $2.0, but does limit downside risk.  

Potential operations news for 2022 includes Gabon in West Africa, where the Wamba discovery has scope to deliver production from mid-2022. In Guyana South America, a mid-year well targets over 200 million barrels.  

Recent share trading disclosures are modestly positive trend 

Three remaining disclosed short-sellers, constituting 3.2% of the issued share capital, edged down respectively last September, November and this week. If oil prices remain strong, this trio may buy back further. 

The only recent institutional stake change was on 11 November, when Azvalor Asset Management of Spain raised its stake from 8% to 9%. 

I reiterate Tullows high risk/reward status, but those able to stomach this could be well-rewarded. Buy. 

Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.

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