Light is starting to appear at the end of the tunnel for oil producers and explorers. After three years of market turbulence and oversupply, signs are now starting to emerge that the oil industry is returning to normality. Demand is rising, production is falling and inventories are starting to decline.
This is all good news for the price of Brent oil, which has stabilised in the high $50s during the past few weeks. This year, the price of Brent has averaged around $53 a barrel, up from last year’s mid-$40s.
Shares in Africa-focused oil explorer Tullow Oil (LSE: TLW) have reacted positively to this development. Over the past three months, the shares have gained 21% as investors have returned to the company following more than four years of selling.
However, while Tullow’s outlook is improving, there’s another company I believe is a better bet on oil prices.
High returns
In my view, Tullow’s biggest problem is debt. Earlier this year, the company raised $750m in a rights issue and cut its debt from $4.8bn to $3.8bn. Of this total, management is currently in the process of negotiating a $2.5bn debt refinancing that should be confirmed during the final quarter of this year.
Along with this restructuring, Tullow is preparing to resume drilling in Ghana after the resolution of a maritime border dispute with Ivory Coast. Now that this dispute is cleared up, the firm is expecting to resume drilling at its Ten development around the end of this year, where the opening of additional wells will allow it to increase production by 60% to around 80,000 barrels a day. When these additional barrels come on stream, the firm should be able to begin paying down debt with cash flows from operations.
Still, even the most optimistic forecasts for Tullow’s debt reduction look insignificant compared to those of smaller peer Enquest (LSE: ENQ).
Cash cow
Production at the Kraken field in the East Shetland basin could net Enquest as much as $700m a year in free cash flow even at current oil prices, according to City analysts.
The project will drive down its breakeven cost for producing oil in the UK to between $21 and $25 a barrel, giving margins of 100% or more with oil at $50. The company expects to hit its production target of 50,000 barrels a day (the level at which analysts are predicting free cash flows of $700m) during the first half of 2018.
When production hits the projected level, I believe that the company’s debt, which rose slightly to $1.92bn at the end of June compared with $1.91bn at the end of April, should fall quickly. Management is also planning to sell part of the Kraken field to speed up debt reduction.
Deeply undervalued
As well as Enquest’s brighter balance sheet outlook, the shares also look cheaper compared to City earnings projections for the company. At the time of writing, the shares are trading at a forward P/E of 5.9, compared to Tullow’s 20.5. With this being the case, I believe that shares in the company could double, or even triple from current levels as the oil environment continues to improve.
