Stockwatch: Two oil stocks worth owning now?

Risk/reward remains on the upside for these key mid-cap oil stocks, argues our companies analyst.

Is it worth chasing the rise in oil shares – especially those livelier, in exploration and production (E&P), or does America's self-sufficiency in oil nowadays mean the current price spike is less likely to hold and hurt the global economy?

When I first heard predictions in response to the attack on Saudi facilities, of a $20 hike in oil prices into an $80 range, I wondered if this might be the last straw – in context of the US/China trade war, generally slowing corporate profits and fewer effective tools for central banks to offset recession.

But even $80-plus would only take oil prices back a year, since when its fall has been seen as reflecting lower global demand and plentiful supply overall.  Yes, the near-term "spot market" can be sensitive – prices initially jumped as much as 20% yesterday, settling back up 10% - but for stock selection and the economy, it really depends how things pan out.

China is nowadays the crux for oil supply

Recalling the 1973 crisis, oil saw a near four-fold rise over six months, and during the second crisis in 1979 a doubling over 12 months.  The crux depends on the Saudi response both in terms of clarifying the extent of damage to facilities and what retaliatory actions may follow. Effectively in partnership with the US, the chief risk is an escalation in Middle East war disrupting supply in the Strait of Hormuz.  

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Decades ago, US consumers were important, but the advent of shale oil and China's reliance on imports – up to 10 million barrels a day – means this time it's the Asian powerhouse at risk.

So, yes, there is a worse-case scenario here, while you'd also like to think the departure of President Trump's security adviser – hawkish towards Iran – means level heads are now more likely to prevail.  For medium-term oil prices, quite a lot depends also on OPEC's response, and to what extent they might release strategic reserve oil to cap price rises so as not to damage their market (by way of underlying economies).  This has been quite a Saudi priority in recent years, although the OPEC power balance has shifted, while non-OPEC producers have become more significant.

Tactics for a highly uncertain context

Much, therefore, rests on speculation, and, while E&P stocks jumped initially, it's hard to speak of investment credentials – margin of safety and so on.  What should be underlined, however, is potential utility to hedge a portfolio should a worse-case scenario happen.  You can also mitigate the risk that this latest Middle East crisis might blow over, by selecting stocks with "event-driven" catalysts.

Two key reasons explain why mid-caps Tullow Oil (LSE:TLW) and Premier Oil (LSE:PMO) both rose nearly 10% in response to the oil price spike. Both companies carry high debts, a typical legacy of management bravado. In US dollars according to oil industry convention, Tullow last reported $3.1 billion net debt (£2.5 billion) and Premier $2.2 billion.  This makes their shares responsive to oil price changes swinging revenues. Their liquid mid cap status also attracts traders.  

Source: TradingView Past performance is not a guide to future performance

Secondly, both companies have project developments in the offing, potentially to cut debt: Tullow, a second oil discovery offshore Guyana where there's potential to monetise part of its stake; and Premier has launched a sale process for a stake in Zama, a 2017 discovery of some 800 million barrels of oil in the Gulf of Mexico.

Reports vary as to a 15% stake in Zama – which I think must apply to the well – versus Premier's website citing a 25% stake in the block. Anyway, the ballpark estimation from broker Jeffries is the Zama stake could fetch over $430 million.  Premier would also retain a holding it wants to drill next year in a nearby asset the CEO entertains as "another Zama" where, justifiably, the risk/reward should have increased after the discovery.  Part of a 60% holding in Sea Lion, an offshore-Falklands project, is also up for sale.

Such divestments are hardly transforming for debt yet are able to enhance the stories around both stocks.  I wouldn't think about their specifics too deeply: they're unpredictable anyway and there's risk you lose sight of how the risk for oil prices now looks broadly on the upside due to Middle East politics and the approach of winter.  There's a case for exposure to Tullow/Premier as a speculative play in itself, but also for portfolio insurance lest a US/Saudi versus Iran confrontation flares.

The US is in a very tricky position: complacency towards Iranian (sponsored) hostilities risks them multiplying, while retaliation may just escalate trouble.  Trump cannot bear a new Middle East quagmire going into a 2020 election campaign, but equally cannot look weak.  So, I suggest a base-case scenario that oil prices at least remain firm, demanding a risk premium for the uncertainties.  Such a view is affirmed by Tuesday's trading, starting with modest rises in both Tullow (up 2.7p to 248p) and Premier (up 1p to 95.2p) instead of consolidation.

Premier as a perennial play on tidying itself up

I'm intrigued how, in following Premier for 34 years, the rationale surrounding its stock has not really changed.  From a cash flow base in conservative UK production (in 1985, a stake in the Wytch Farm Dorset project, nowadays a 50% interest in the North Sea Catcher area) it has taken adventurous positions globally – some of which like Angola, Myanmar and Pakistan became a political headache, so were divested or pruned back. Nowadays, you could say the same of Premier's involvement in Alaska and offshore the Falklands.

Nor has the stock broken out of long-term trading ranges – according to oil price fluctuations and disappointments with its more radical ventures – because management committed to capital intensive projects then saw the oil price slump in 2014, creating a debt millstone that’s hung around the stock ever since.

Source: TradingView Past performance is not a guide to future performance

More positively, the late August interims had shown good underlying progress. The reason I didn't draw attention then was wariness that a weakening global economy could see oil prices drift.  

First-half 2019 revenue from continuing operations' rose nearly 40% to $871 million as production averaged a record 84,100 barrels of oil equivalent per day; and a 21% reduction in operating costs helped a 77% advance in operating profit to $327.5 million.  

Subtracting a higher depreciation/depletion/amortisation charge, the advance in normalised operating profit would have been 82%.

Yet highly relevant on a medium-term view

My point about operational gearing and re-rating potential, if debt can be cut, is shown by a stable $219 million interim finance costs charge whittling down profit to $120 million pre-tax, or $466 million before depreciation.

Free cash flow had improved to $182 million versus as $90 million like-for-like outflow, supporting an 8% reduction in net debt to $2,251 over the first six months of 2019, in the context of $226 million cash and $420 undrawn debt facilities.

Overall, financially, this is moving in the right direction and, with over 40% of 2019 oil production for the second half hedged at $69 a barrel, Premier has both revenue security and exposure to likely higher oil prices in the final quarter of 2019.  So, forecasts could rise and the stock's prospective price/earnings (PE) ratio reduce even to single figures. There's no dividend though. 

My following Premier a long time probably raises my intrigue in its current "special situation" status – asset sales for debt reduction, alongside higher oil prices boosting earnings – though thematically you can make a similar case for Tullow, hence there's a trading/hedging case to own both stocks.  Be aware how mid cap oilers are fundamentally speculative if less so than the minnows and more so than BP (LSE:BP.)/Royal Dutch Shell (LSE:RDSB). Buy.

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