These small-cap oil stocks could be dangerously overvalued

Roland Head takes a fresh look at two popular oil stocks.

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Shares of North Sea oil firm Enquest (LSE: ENQ) gushed up to 10% higher this morning, after the firm said oil production had begun from its Kraken oil field.

This project has been completed on time and under budget and has an expected production life of up to 25 years.

Cheap or expensive?

The completion of the Kraken project should enable Enquest to cut capital expenditure and focus on cash generation and debt repayments. Operational costs are expected to fall to between $21 and $25 per barrel in 2017, thanks to the impact of Kraken production and to cost reductions across the board.

Analysts expect Enquest’s revenue to rise by 18% to $944m this year and by 59% to $1,501m in 2018. After several years of losses, a net profit of $145m is forecast for 2018. This is expected to translate into earnings of $0.18 per share, giving a forecast P/E of 2.1.

Surely that’s too cheap? Well, maybe. The big risk facing shareholders is that the company must start repaying the $1.8bn net debt mountain it’s built up while developing Kraken. Doing so will absorb much of the group’s cash flow over the next few years.

Enquest shares doubled at the start of this year, as the market priced-in a sustained recovery in the price of oil. That hasn’t happened. The price of Brent Crude oil has fallen by 18% so far this year, while the share price has fallen by 25%.

In my view, buying these shares is effectively a bet on a near-term recovery in the price of oil. This seems risky to me. I think there are better options elsewhere.

Another four-bagger?

Chief executive James Parsons gained a big following in 2016, as shares of the gas exploration and production company he runs, Sound Energy, climbed 450% in just four months.

Now investors are betting that Mr Parsons can repeat this trick at Echo Energy (LSE: ECHO), where he took over as chairman in March. Echo’s strategy is much the same as that of Sound. The firm plans to invest in gas exploration projects in Latin America and develop these into a gas production business.

Mr Parsons scored a coup when he recruited the former chief operating officer of Rockhopper Exploration, Fiona MacAulay, to be his chief executive. Echo has also attracted debt and equity funding from institutional backers, which has given the group a £26m war chest.

The company’s first acquisition is an 80% interest in the 75 sq km Huayco block in southern Bolivia. This comes with 3D seismic survey coverage and is close to gas export pipelines, which could provide access to Brazil and Argentina.

Management estimates that Huayco could have “multi-Tcf gas potential”. If Huayco does contain trillions of cubic feet of commercially-viable gas, it could be very valuable. But it’s far too early to say.

Echo’s market cap of £58m is already pricing-in a high degree of expectation for a company with no revenue and just one exploration asset. I’d wait for a cheaper opportunity to buy.

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.

Roland Head has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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