Stockwatch: how to play these high-risk zombie oil stocks

by Edmond Jackson from interactive investor |

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Despite big debts, these shares tripled in value, but what does our companies analyst think of them now?

Does a renewed slide in high-risk oil plays have a wider message? Reviewing fallen stars Premier Oil (LSE:PMO) and Tullow Oil (LSE:TLW) in March, I concluded that despite speculative rebound potential (with OPEC targeting production cuts), these companies were too weighed-down by debts to prosper in a lower oil price environment. 

Eventually, I added, the medium-term depressive effect of Covid-19 would check OPEC’s ability to prop up prices with output cuts. It is essential to keep an eye on oil prices as reflecting economic demand and whether global stimulus measures are having effect. 

I wrote: “In six months’ time, it will be interesting to look back and see whether a simple adage to “be greedy when others are fearful” proved more practical than much analysis.” On a genuine investing view, my stance was Avoid. 

A game of Snakes and Ladders 

Long/short traders certainly did well in these “high beta” stocks which accentuate the market trend. Having plunged from over 100p to 15p in mid-March, Premier soared to near 54p by mid-June; Tullow, down from roughly 40p to below 8p, rebounded to 38p. Multi-billion-dollar debts versus small-cap rated equity, makes these stocks effectively option money as to medium-term prospects. As “unlimited” stimulus boosted financial assets and OPEC talked tough, rallies took hold.

Yet such stocks have plunged again: Premier back to 17.5p and Tullow to 15p. Reality has weighed over hopes, especially now September is underway and oil prices are struggling. The severity of falls is nowhere near as severe in March, but is enough to beg the question about a chronic demand/supply imbalance. “Big oil” stocks such as BP (BP.) and Shell (RDSB) have also eased this month. While petrol station prices have yet to show any sign of falls, crude oil’s weakness may signal global demand remains compromised.   

Governments have attempted to get populations back to both work and leisure, after lockdowns. But can liberal Western societies succeed with “test and trace” like the more regimented Singapore, South Korea and Taiwan? Meanwhile, Israel has already reverted to three weeks of national lockdown. Covid-19 is showing itself remarkably canny, and the seasonal onset of coughs/colds/regular flu will stretch already challenged testing even further. Is this virus’s ability to remain disruptive another reason oil and gas prices are not rising ahead of winter heating demand in the Northern hemisphere? 

Oil shares peaked soon after OPEC’s June cuts 

After rising sharply in late March on the back of monetary stimulus, BP (LSE:BP.) and Royal Dutch Shell (LSE:RDSB) traded volatile sideways during April and May, as if representing more disciplined investment money. Premier and Tullow, however, continued to advance, especially as hopes grew of OPEC production cuts. Remember, when 10 million barrels of crude oil were taken out of daily supply from 6 June to end-July, the whole sector spiked. 

Yet oil shares have lacked conviction about OPEC’s ability to cope. Their prices have drifted back, with Premier and Tullow plunging as befits their "high beta" status - i.e. more volatile than the market. The fear appears to be around lower revenues and how lower oil prices will extend the timescale for these companies to recover from debt piles. This is despite their good progress at restructuring operations and finances, and also renegotiating debt covenants more realistically for a lower oil price environment. 

Interim results have provided a reality check  

Even recognising the likelihood of being a sea of red after lower oil prices coincided with a string of exceptional costs, Premier and Tullow’s numbers were dispiriting. You have to be a red-blooded speculator looking through the company-specific carnage and past low oil prices to buy in. 

On 20 August, Premier’s outcome showed a like-for-like $327.5 million operating profit become a $199.3 million loss, chiefly due to revenue down 39% to $530.6 million plus spending on exploration and new ventures up from $8.7 million to $242.1 million. You could therefore view this spending as investment, hence operating profit effectively down to about $40 million.  

Premier   Oil - financial summary            
Year end 31 Dec reporting in   US$ 2014 2015 2016 2017 2018 2019
Turnover ($ million) 1,629 1,067 937 1,043 1,398 1,585
Operating margin (%) -13.9 -66.0 -18.2 3.2 38.0 28.7
Operating profit ($m) -226 -704 -170 33.8 531 455
Net profit ($m) -210 -1014 123 -254 133 164
Reported EPS (cents) -43.3 -210 21.3 -52.6 12.2 17.20
Normalised EPS (cents) 52.8 -80.0 165 -6.0 6.2 0.20
Price/earnings multiple (x)           1.2
Op. Cashflow/share (cents) 1.77 1.58 0.84 0.97 0.84 1.23
Capex/share (cents) 2.29 1.94 1.30 0.54 0.32 0.27
Free cashflow/share (cents) -0.52 -0.36 -0.47 0.43 0.51 0.96
Cash ($m) 292 401 256 365 245 198
Net debt ($m) 2,094 2,214 2,748 2,607 2,307 2,704
Net asset value ($m) 1,872 735 809 617 1,026 1,132
Net asset value/share ($) 3.7 1.4 1.6 1.2 1.3 1.4
Source: historic Company REFS   and company accounts

Yet even after writing back amortisation costs etc, the cash flow statement showed $23.7 million generated from operations, down from $544.6 million. After a $135.5 million net finance charge the company and a $333.8 million deferred UK tax charge the reported loss expended to $671.5 million. It is indeed possible this marks a low as negatives conflate, but as yet the bear phase in Premier continues, with the stock down to 17.5p.  

Possibly, there is some despair at equity dilution. Alongside its interim results, Premier declared a refinancing of 45% of its debt facilities to March 2025 with covenants re-set to reflect “a prolonged lower commodity price environment.” A further $300 million equity was sought, additional to $230 million for acquiring assets from BP, versus net debt around $1.9 billion.  

Tullow’s 9 September interims made the company look similarly mired. Normalising for £941.4 million exploration costs written off, $418.3 million impairment charges and $58.6 million restructuring costs, there would have been a $53.8 million operating profit instead of £1.3 billion operating loss. Adding back various such costs meant $202.6 million net cash generated from operations, albeit wholly absorbed by finance costs and repaying just $110.0 million of $3.2 billion total debt, also before $222.2 million was spent on investment. Management gave a reassurance of sorts how net debt of $3 billion was backed by around $500 million of liquidity headroom. 

Tullow   Oil - financial summary            
Year end 31 Dec reporting in   US$ 2014 2015 2016 2017 2018 2019
Turnover ($ million) 2,213 1,607 1,360 1,885 2,048 1,725
Operating margin (%) -88.8 -68.1 -55.5 1.2 25.8 -80.3
Operating profit ($m) -1,965 -1094 -755 22.4 528 -1385
Net profit ($m) -1,556 -1035 -600 -176 84.8 -1694
Reported earnings/share ($) -146 -96.7 -56.0 -13.7 5.9 -121
Normalised earnings/share ($) 28.9 -17.0 8.9 21.7 19.2 -26.6
Operating cashflow/share ($) 140 91.4 47.9 95.1 83.7 89.8
Capex/share ($) 220 163 96.3 23.9 30.6 37.1
Free cashflow/share ($) -80.0 -71.2 -48.4 71.2 53.1 52.6
Dividend per share ($) 0.0 0.0 0.0 0.0 4.8 0.0
Covered by earnings (x)         1.2  
Cash ($m) 319 356 282 284 180 289
Net debt ($m) 3,023 3,982 4725 4,868 4,452 4,208
Net asset value ($m) 3,996 3,155 2,230 2,706 2,893 984
Net assets per share ($) 374 295 208 195 208 69.9
Source: historic Company REFS   and company accounts

The image problem is these companies – for the time being at least – look like the proverbial “zombies” where shareholder returns are swamped by debt management costs until oil prices can better recover.  

Exemplifying George Soros’s concept of “reflexive bias” 

Sharp volatility in Premier and Tullow ridicules the notion of market efficiency, given it was possible in March to see these stocks had no real intrinsic value. They are call options on management racing against time, to straighten out operations and juggle debts, hoping oil prices can strengthen. Yet cute and clever traders could have trebled their money by playing sentiment. 

It is a prime example of what Soros calls “reflexivity”, of expectations feeding on each other. Intrinsic value is no more than a wild goose chase. Since the climax of OPEC's temporary agreement in June, reflexivity has appeared to work downwards on these stocks, their results adding grist.

Not to write Premier and Tullow off, but, digesting global reports on Covid-19, it looks to me as if the world remains very much in its grip, at least for disruptive effect. We shall see if OPEC takes further action in support of prices. Meanwhile, Libya seems set to resume full energy production after a recent oil export blockade, potentially adding an extra 1.2 billion barrels a day of supply, making it harder for OPEC to achieve its balancing act. I suspect this helps explain oil shares weakening right now.  

Accordingly, my wary stance on Premier and Tullow continues, and easier oil prices also imply tough times ahead due to Covid-19. Yes, I missed the chance to treble money, but it was a snakes and ladders game. With fresh money: Avoid

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

Disclosure

We use a combination of fundamental and technical analysis in forming our view as to the valuation and prospects of an investment. Where relevant we have set out those particular matters we think are important in the above article, but further detail can be found here.

Please note that our article on this investment should not be considered to be a regular publication.

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