With Brent crude now priced at over $40, it’s evident that oil has made a decent recovery. This resulted in the Premier Oil (LSE: PMO) share price rising over 300%, to 54p. It is currently around 42p. While there has been a slight recovery in the oil sector, problems still abound. As such, is the Premier Oil share price a definite buy or is it destined for a decline?
Balance sheet weakness
Premier Oil has one of the weakest balance sheets in the oil sector, and I believe this could weigh heavily on its share price. Currently, the firm has $1.97bn of debt, compared to just over $200m of cash, and $1.1bn in shareholder’s equity. This is an excessive amount of debt in normal times, but in the current economic climate it’s a significant worry. Royal Dutch Shell and BP have recently had to write down the value of their assets. Similar action could be a major problem for Premier Oil, especially because its debt-to-equity ratio already stands at around 180%.
What does the future hold in store?
The oil major has recently announced the acquisition of BP’s Andrew Area and its Shearwater assets in a deal worth up to $565m. This was slightly lower than the original price, and only $210m will have to paid up front. It is also stated that the new assets will be “immediately cash generative” and will therefore help the firm reduce its debts.
While this sounds good in principle, I do have some concerns about the deal. For example, it seems an odd time to be making expensive acquisitions, especially in the firm’s indebted position. As a result, many analysts believe that it will have to raise funds from shareholders in order to complete the deal. Equity funding has the result of diluting existing shareholders, and the Premier Oil share price should fall as a result.
Is the Premier Oil share price too cheap to ignore?
Premier Oil shares are down around 60% this year, with key metrics proving it’s a significantly undervalued stock. For example, it has a current price-to-earnings ratio of 2.7 and a price-to-book ratio of just 0.4.
But I’d take both of these values with a pinch of salt. Firstly, earnings should drastically decrease over the next few years, and this means that the current price-to-earnings ratio is not an accurate representation. The price-to-book ratio also doesn’t take into account the fact that many of the assets on the balance sheet are also overvalued.
In this respect, I believe that Premier Oil shares are too risky. While there is significant potential upside, bankruptcy is also a genuine worry. This would leave shareholders with nothing. If I were to bet on an oil recovery, I’d buy Royal Dutch Shell shares instead.
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Stuart Blair owns shares in Royal Dutch Shell. 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.