Mid-cap oil stocks have rebounded strongly so far this year. Shares in both Premier Oil (LSE: PMO) and Tullow Oil (LSE: TLW) have risen by 55% in just six months.

But these gains can also be seen as a warning. One of the reasons shares in Premier and Tullow fell so low at the start of the year is that the market was pricing-in the risk that these firms might have to raise cash from shareholders.

That hasn’t happened so far, partly because oil’s rebound has eased the pressure on both companies’ cash flows. But statements this week from Premier and Tullow have made it clear that the situation remains tight.

Bank tests delayed while talks continue

Premier Oil issued a statement on Friday morning confirming discussions are on-going with its lenders. The firm is trying to persuade its debt holders to relax the terms of its $2.68bn net debt, for the second time in two years.

Premier said today that the planned test of its financial covenants on 30 June has been delayed until 31 July. This will give the company and its lenders more time to negotiate a new deal.

My reading of this is that if Premier’s covenants were tested today, it would breach them. Once in default, Premier would have little choice but to raise cash through a fire sale of assets or an issue of new shares.

Although it’s good news that the lenders are still willing to work constructively with Premier’s management, these discussions have been going on for some months. Finding a solution obviously isn’t proving easy.

In today’s statement, Premier said that “in return for the proposed amendments … additional security will be provided for existing debt holders.” No further details were provided, but this could affect shareholders’ interests.

For example, Premier might issue debt holders with warrants or additional shares. Another possibility is that Premier will have to sell or suspend certain projects — such as Sea Lion in the Falkland Islands — until its financial situation improves.

Premier is an excellent firm operationally, but in my opinion there’s still a strong chance it will have to raise cash by issuing new shares. After this year’s gains, I’d sell.

Better, but not good enough?

Thursday’s trading update from Tullow Oil was broadly positive. Like Premier, Tullow is an excellent operator with a track record of successful delivery. Tullow’s West African TEN project is expected to start producing oil in the next three-to-six weeks, on schedule and on budget.

The problem is that developing TEN has cost Tullow a lot of money. Net debt is now $4.7bn, up from $4bn at the end of last year. Although the firm currently has undrawn debt and cash of $1bn, this could fall fast. The group’s borrowing facilities are scheduled to be reduced by $250m in October and by a further $200m in April 2017.

Tullow plans to refinance its loans in 2017, but admits that “strengthening the balance sheet and debt reduction” are key priorities for 2016. Options under consideration include asset sales and “other funding options”. This could include issuing new shares.

Like Premier, Tullow is an excellent operator with too much debt. In my view, this makes the shares a sell. I believe there are better choices elsewhere.

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Roland Head has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.