Sound Energy plc isn’t the only hated commodity stock I’m avoiding

Roland Head explains why he’s wary of Sound Energy plc (LON:SOU).

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Shares of small-cap oil and gas firm Sound Energy (LSE: SOU) have lost more than 40% of their value so far this year. The big disappointment was the failure of the Badile well to yield commercial results. Sound’s share price has slumped from 77p to 43p since the announcement.

The firm’s management is transferring its attention to exploration prospects in Morocco. But should shareholders stay loyal or is the stock still too expensive to buy?

Sound’s main success over the last year was the Tendrara gas project in Morocco. Testing of the TE-6 and TE-7 wells produced flow test results that were “significantly” better than expected. The company believes the entire Tendrara and Meridja permit areas may contain between 9trn cubic feet (Tcf) and 31 Tcf.

Of course, the multi-Tcf gas-in-place volumes I’ve mentioned above will be considerably higher than the amount of gas which can be qualified as commercial reserves for production. No one yet knows how much gas will be produced at Tendrara, or how profitable it will be.

What we do know is that Sound still has a market capitalisation of £321m, even though the company is not expected to generate any revenue in 2017 or 2018. In my view, the shares remain highly speculative and could easily fall further. I believe investors can find a better balance between risk and reward elsewhere in the oil market.

A better choice?

Cairn Energy (LSE: CNE) stock has lost 40% of its value over the last five years. But unlike Sound, the FTSE 250 firm does have commercial reserves which will soon start producing cash. Production has now started from the Kraken field in the North Sea and the Catcher project should soon follow.

Looking further ahead, Cairn also has 239m barrels of contingent resources, mainly as a result of last year’s successful Senegal exploration campaign. In some circumstances, I might be tempted to invest. But to be honest, I’m not sure the firm’s shares are really cheap enough to offer good value.

Back in 2012, management retained $1.2bn of the proceeds from the sale of Cairn India to invest in new opportunities. Shareholders were supportive, given the blockbuster success Cairn had delivered in India.

However, huge wins of this kind are rarely repeated. According to today’s half-year results, the company’s net cash balance was down to just $254m at the end of June. So what is there to show for this expenditure?

According to a presentation in April, Cairn has 51m barrels of proven and probable reserves. Given the company’s current enterprise value of about £800m, this equates to around $20 per barrel. That’s not cheap. Although the group’s 239m barrels of contingent resources may also be converted to reserves, this will require further spending.

Cairn expects to start producing revenue in 2017. Broker forecasts show $113m this year and $458m in 2018, when a modest $45m profit is also expected. Although promising, these figures still seem low to me for a £1bn company.

The only value ratio that does attract me to Cairn’s stock is its 40% discount to book value, which is now £1.7bn. However, I’m not sure how quickly this value will be realised for shareholders. In my view, there are still better buys elsewhere in the oil and gas sector.

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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