One of the most significant problems early-stage oil and gas companies face is access to funding. Exploring for oil and gas is not cheap, and it usually requires tens of millions of dollars to explore new prospects.
As a result, just one or two well failures can be the difference between success and failure for oil exploration businesses.
Unfortunately, more often than not, investors end up footing the bill for oil companies’ failures, which is why I tend to avoid early-stage oil businesses altogether.
Indeed, for some time I have been warning investors about the precarious cash situation at small-cap oil explorer 88 Energy (LSE: 88E) as it has burnt through cash reserves in its quest to find oil in Alaska.
Stuck in the mud
As my Foolish colleague Peter Stephens recently pointed out, 88E’s share price has hardly budged over the past 12 months because investors seem unsure about the prospects for the business following a summer of disappointment.
The firm’s Project Icewine was supposed to be a world-leading hydrocarbon prospect, but so far, testing has not yielded any concrete evidence of recoverable reserves.
Since the beginning of the year, management has devoted everything the company has to its exploration activities, and cash reserves are now starting to dwindle. To keep the lights on, the firm is now pursuing an £8m rights issue to help fund 2019’s exploration programme.
Rights issue
According to 88E, the cash from this raise will be used to fund the Winx-1 exploration well, which could contain as much as 400m barrels of oil. According to the company’s figures, the chance of being able to extract this oil successfully is estimated to be in the range of 25% to 30%. These are not particularly attractive odds, and when you factor in the failures over the past 12 months, it looks to me as if 88E is only suitable for the most risk-tolerant investors at the current time.
Another poor drilling season could require yet another rights issue next year.
Improving outlook
Personally, I would avoid 88E for the time being, although I’m more positive on the outlook for the firm’s peer, Tullow Oil (LSE: TLW).
As my colleague Harvey Jones recently noted, after several years of austerity, Tullow has recently begun exploring again using cash flow from operations to fund the development of two large onshore developments in East Africa.
And after turning a $557.9m first-half loss into a $150.5m profit, it looks as if the group’s fortunes are only set to improve over the next 12 to 24 months as it starts chipping away at its net debt pile which fell from $3.8bn to $3bn by 30 June. The firm reported a free cash flow of $401m for the first half of the year, which in my opinion is enough to both fund exploration activities and reduce debt.
That being said, the company’s outlook remains tied to the volatile price of oil. However, with the stock currently changing hands for just under 11 times forward earnings, I believe there’s a healthy margin of safety baked into the stock price here, which should protect investors against any oil market swings.
