Does $6m deal make this oil company a better buy than Royal Dutch Shell plc?

Why this much smaller oil & gas company could handily outperform Royal Dutch Shell plc (LON: RDSB) in the coming years.

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For a £1.2bn market cap company such as Cairn Energy (LSE: CNE) the $6m deal announced this morning was a drop in the bucket. But in the long run this tiny deal tells us quite a bit about what a good position the oil producer is in.

The deal is a farm-out agreement with Europa Oil & Gas that will see Cairn pick up the tab for exploring a block off the coast of Ireland in return for 70% of any future proceeds. This is unlikely to be a blockbuster deal for the company, but it does show us something very important — that it is confident in its cash position and is looking to add to its potential reserves at an attractive price when the rest of the industry is desperate for financial assistance.

This shouldn’t come as a surprise to those who have followed Cairn for any amount of time. The company has access to $400m in bank loans and is sitting on $335m in cash, and will be coming into even more as the Catcher and Kraken North Sea fields, in which it has a 20% and 29.5% interest, respectively, begin to pump oil in 2017.

In the long run this cash will directed towards funding what it believes could be a blockbuster offshore development off the coast of Senegal. And the company is taking a respectably cautious outlook towards this development, entering into a joint venture with Australian giant Woodside Petroleum that will limit its downside.

To be sure, Cairn is still a risky bet for most investors. The company produces no oil, and won’t do so until later this year. That makes valuation work incredibly difficult, given the shifting sands that prospective oil & gas reserves stand on. But with a ton of cash, more to come, a history of success in India, and major partners on board for Senegalese developments, I will be following the company’s progress closely.

A safe haven in a volatile industry? 

Cairn certainly has more upside potential than Royal Dutch Shell (LSE: RDSB), but for those investors looking for a less risky oil & gas option there are few better that this industry giant. Despite historically weak oil prices in 2016 the oil giant still posted $7.2bn in earnings on a current cost of supplies basis, the company’s preferred metric.

And thanks to enviable downstream assets such as refining and trading businesses that benefit from greater volume when oil prices are low the company’s operations as a whole generated $20.6bn in cash flow. As oil prices recover slightly and the company cuts operating costs and non-financially feasible capex this situation should continue to rise in coming quarters.

This means Shell’s 7.4% yielding dividend was covered by cash flow for the second quarter in a row in Q4 and net debt was also reduced. And in the long run Shell still makes quite a bit of sense as an investment as it is now the world’s largest commercial supplier of liquefied natural gas. This cleaner burning fossil fuel is becoming increasingly popular amongst countries looking to combat climate change and looks to have a rosy future.

For more risk-averse investors looking for exposure to the oil & gas industry there are few better options than Shell. But for those who are willing to take a punt on a stock with more upside, I’d recommend taking a closer look at Cairn.

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

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

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